Will Tensions With Iran Really Push Gasoline to $5 a Gallon?

Conflict with Iran could send the price of oil soaring and push gasoline prices to $5 a gallon, according to analysts. Here’s how to assess the chances that will happen.

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The prospect of war usually gives oil prices a boost. In 2008, the possibility of conflict with Iran, combined with troubles in Nigeria, sent oil soaring above $145 a barrel. Recent tensions with Iran have pushed up oil above $100 a barrel, and commentators warn of much bigger price increases to come. If oil does go to between $150 and $200 a barrel, analysts say that gasoline could hit $5 a gallon. Is that really likely? And if so, what would the impact be on the economy and the markets? 

The source of the problem, of course, is Iran’s nuclear program – or rather attempts to prevent Iran from developing nuclear weapons. One risk is a military attack on Iran’s nuclear facilities by Israel or the U.S. The second, and more likely, danger is that sanctions by the U.S. and Europe will lead to an Iranian blockade of the Strait of Hormuz, through which one-sixth of the world’s oil shipments pass. The U.S. could break the blockade by force, but that also would lead to fighting.

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Assuming that tensions with Iran do intensify – as seems likely – it’s crucial for investors to be able to assess the outlook for oil prices. In fact, the forces that could affect the price are varied and complex. But here are the factors to keep in mind:

  1. Oil prices already discount the conflict – up to a point. Based on the current sluggish state of the world economy, the price of oil should be somewhere around $75 a barrel. The fact that it is above $100 already reflects investors’ awareness of a certain level of risk to the oil supply.
  2. Disruption to the oil supply could be offset. Iran exports around 2.3 million barrels a day. In the short run, Saudi Arabia could temporarily increase production enough to make up for most of that amount and can ship its oil through pipelines to the Red Sea, avoiding the Strait of Hormuz. Moreover, Saudi Arabia would be happy to undercut Iran and would be glad to sell extra oil as long as those sales didn’t depress the world oil price. Any remaining shortfall could be made up by tapping world petroleum reserves.
  3. The real risk is a shooting war. If the conflict were to expand beyond sanctions and a fight over control of the Strait of Hormuz, the global oil supply would face an entirely different level of risk. In particular, warfare or terrorism that damaged the Saudi oil fields would cause supply disruptions that could not be made up elsewhere.
  4. High oil prices could reduce demand and cause a temporary pendulum swing to below-average oil prices. Analysts calculate that oil demand in most countries declines significantly at prices above $120 a barrel, especially if accompanied by a recession. After oil reached $145 a barrel in 2008, the U.S. suffered a recession intensified by the banking crisis. As a result, oil prices fell briefly to less than $35 a barrel in early 2009. A year later, as the economy began to recover, oil was back up above $80.
  5. Over the long term, the price of oil will probably move higher. It’s true that recent discoveries of oil, plus new technologies for extracting oil and gas, will guarantee the long-term availability of fossil fuels. But while the world is not running out of oil, it is running out of cheap oil. Almost all the new sources – drilling in the Artic, extracting oil from tar sands or freeing gas from shale – are expensive and environmentally hazardous. As a result, rights to existing oil fields stand to become increasingly valuable over time.

To sum all this up: Today’s oil price reflects a certain level of conflict with Iran. But a spike that would send gasoline prices to $5 a gallon in the near term is unlikely unless fighting spills over into Saudi Arabia. When the conflict abates, oil prices may drop, especially if the global economy has slowed. Any such decline would be an excellent long-term buying opportunity for the shares of major international oil companies, some of which pay attractive yields even at today’s prices.

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Among the stocks worth considering are Exxon Mobil, with a 2.2% yield, and Chevron, 3%. ConocoPhillips, which is splitting into two companies, is attractive with a 3.6% yield. Among foreign companies, Royal Dutch Shell pays 4.4% (the B shares may be better for tax reasons). BP, 3.8%, is a more speculative investment because the company’s outlook depends greatly on what happens with its liabilities resulting from the 2010 oil spill in the Gulf of Mexico.

An attractive alternative is buying a mutual fund or an exchange-traded fund that specializes in energy stocks. The SPDR Energy Sector ETF (ticker symbol XLE), currently yields 1.5% and may well be the simplest choice.