Energy markets outlook: what’s next as Iran conflict fuels oil and gas volatility

The situation in the Middle East has had a dramatic impact on global energy markets. In the space of just 24 hours on Monday and Tuesday, Brent crude oil traded as high as $120 per barrel and at less than $90 per barrel as expectations about the duration and intensity of the conflict waxed and waned.

Reopening the strategically important Strait of Hormuz, a key shipping route for oil and liquefied natural gas (LNG for short) is likely to be key to the future trajectory of prices.

The natural gas market, which is more localised and fragmented, has been even more volatile than oil. In this uncertain environment, what can we glean from futures markets and the impact of Russia’s invasion of Ukraine four years ago to get insights into where energy prices could go next?

Why it matters?

As well as impacting the price at the pump and the cost of heating our homes, higher oil and gas prices feed into higher costs of plastic goods and packaging. Businesses are also likely to pass on their own higher energy costs in the form of increased prices for goods and services.  

These inflationary pressures, in turn, will affect central bank decision making and the future direction of interest rates, which has a knock-on effect on the cost of your mortgage and any other borrowing.

What can we learn from the futures market?

The futures market, while not a crystal ball, offers a clue on the direction of energy markets. Most commodities are traded in futures contracts. This means the purchase or sale of a commodity is agreed at a fixed price for delivery on a specified date. So if, for arguments sake, the May contract for oil for next year was trading at $50 per barrel that's the price someone would be willing to pay then.

Futures markets facilitate the buying and selling of commodities without anyone having to take physical delivery of a barrel of oil or LNG shipment, for example. Because they can 'roll' the contract forward to the next month.

Looking at the current prices of contracts for oil and gas over the coming months, the clear implication is prices will fall from current levels. For gas, we have used Dutch TTF Natural Gas Futures which is the most followed benchmark for European gas prices.

Contango is industry jargon for a situation where the price of a futures contract in a commodity is trading above the price today. The resulting futures ‘curve’ would be upward sloping with prices for dates further in the future trading at ever higher levels.

Backwardation describes the reverse – where futures are trading below the current price – often because of short-term pressures on supply in the underlying market. This is the current result from the situation in the Middle East. Arguably contango is a more natural state as it reflects costs of ownership such as storage and insurance.

What happened to energy prices after Russia’s invasion of Ukraine?

Before we look at how energy markets reacted to the last major period of disruption, when Russia invaded Ukraine in February 2022, it is worth comparing how significant a role Russia and the Middle East played and play in global oil and gas markets.

Pre-invasion, Russia provided 12% to 13% of global oil supply and 16% of global gas supply. The Strait of Hormuz accounts for 20% of global oil supply and 20% of global LNG supply. In turn, LNG is around 15% of natural gas supply worldwide.

The Middle East as a region speaks for 30% and 17% of the world’s oil and natural gas production, respectively.

In 2022 the increase in oil and gas prices was substantial on a one-month view but eased as the market adapted to the impact on Russian supply. One year later, prices were lower than they began for both commodities.  

In this context, it is worth noting that both oil and gas had run up in price in the weeks leading up to Russia’s invasion. And, at their respective peaks (June 2022 for oil and August 2022 for gas) prices were substantially higher than they were before the invasion.