History offers mixed guidance on how deteriorating relations between Iran and Saudi Arabia might affect the oil market. According to the standard analysis, movement toward armed conflict between two major oil producers should create worry about physically threated supply and raise the price of crude. Historic evidence certainly supports this view. In some past clashes between producers, though, prices moved the other way.
To the surprise of many analysts, crude prices rose only slightly and briefly on news of developments leading to a diplomatic crisis between Iran and Saudi Arabia. High oil inventories and signs of Chinese economic weakening were said to more than offset whatever worries traders harbored about disruption to supply.
Yet the crisis, however limited its immediate effect might be on the oil market, is escalating. To expect its longer-term influence to be minor would be a mistake. The question remains whether that influence will be upward or downward.
Saudi-Iranian relations have been adversarial for decades, of course, shaped by the Sunni-Shia schism within Islam. Especially since the US withdrawal from Iraq and nuclear negotiations with Iran, old, formerly subdued antagonisms have become overt competition for regional hegemony. Even before the latest escalation, Saudi Arabia was fighting rebels backed by Iran in neighboring Yemen, opposing support by Iran and Russia for President Bashar al-Assad of Syria, and balancing worry about Islamic State jihadists in Iraq and Syria against concern over upstart Shiite influence in Baghdad.
Still, the Jan. 2 executions of 47 prisoners identified by the Saudi government as terrorists was unusually brazen. Among those killed were four Saudi Shiites, including a well-known and outspoken critic of the royal family whose links with terrorism are in question. News of the slaying of Nemer al-Nemer inflamed Iranians. Protesters sacked and set fire to the Saudi embassy in Tehran and attacked the Saudi consulate in Mashhad. In response, Saudi Arabia severed diplomatic relations with Iran in a move matched by Bahrain and Sudan. The United Arab Emirates downgraded its diplomatic relations with the Islamic Republic without breaking relations.
The main worry has to be what the oil market most fears: violent hostility spreading throughout the region. Indeed, there were reports of a rocket having been fired at the Saudi embassy in Baghdad. And on Jan. 6 the Bahraini Interior Ministry said it had foiled plans for a series of bombings by a group called Al-Basta. It said the group received support from the Iranian Revolutionary Guard and Hezbollah and had ties to a Bahraini terrorist group called Saraya Al-Ashar.
Even if the crisis stays within diplomatic constraint, a different type of war is possible. Saudi Arabia clearly intends not to cede market share when Iran escapes international sanctions and rebuilds production. The kingdom's goals, though, might be more strategic. Saudi Arabia has enough spare production capacity to match any feasible Iranian increase. That would crush prices. If the Saudi government can't keep Iranian oil out of the market, it might settle for keeping dollars out of Iranian coffers. Other gulf producers have overproduced in times of stress to weaken neighbors—Kuwait before the Iraqi invasion in 1990, for example, and Iraq when then-President Saddam Hussein sought regional support against United Nations sanctions on his country.
How desperate?
Is Saudi Arabia that desperate? To some yet-uncertain degree, things have changed fundamentally in Riyadh. The killing of Nemer al-Nemer in a mass execution was as provocative as it was brutal. Days earlier, the kingdom had announced sensitive austerity measures. Days after the killings it cut prices on crude sold in Europe. When the US didn't impose sanctions it initially announced against Iran for testing ballistic missiles in December, Saudi Arabia might have decided it had to act preemptively to keep its Shiite rival financially weak.
It's too early to call this a price war. When sanctions on Iran end, however, the market's most important metric will be Saudi production.
