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Israel-Gaza conflict fuels oil price surge and economic concerns

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2023-10-11

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Oil prices have experienced a significant surge following Israel's decision to impose a complete siege on Gaza. The escalation of tensions in the Middle East has ignited fears of a broader conflict, which could potentially drive oil prices even higher and accelerate inflation worldwide.

The Israeli military has taken an unprecedented step by calling up 300,000 reservists, raising concerns about the possibility of a ground assault. Simultaneously, the Islamist militant group Hamas has issued a chilling threat, vowing to execute an Israeli captive for every Palestinian home bombed without prior warning.

On Tuesday, Brent crude oil was trading at approximately $US88 a barrel, marking a substantial overnight increase of 4.6%, the most significant one-day surge since April. West Texas Intermediate also jumped by 4.3% and stabilized at $US86.24. These price spikes followed sharp declines last week, triggered by concerns over a weakened global economic outlook leading to reduced fuel demand.

In addition to oil, European gas futures experienced a sharp increase of 15%, the most significant gain in two months. This surge was exacerbated by the temporary shutdown of operations at a major natural gas platform off Israel's coast by US energy giant Chevron, potentially limiting gas supplies from the eastern Mediterranean region.

Rodrigo Catril, an FX strategist at National Australia Bank, remarked, "The market remains very sensitive to the risk of further ramifications from the Israel-Hamas conflict, suggesting volatility, particularly in the energy sector, is likely to remain elevated, with Iran a major concern."

Although Israel is not a major oil producer, concerns persist that a spreading conflict could disrupt Middle East oil supply, exacerbating an anticipated supply deficit for the remainder of the year. Furthermore, this conflict may hinder US efforts to improve relations between Saudi Arabia and Israel, potentially impacting future oil output. It also raises the possibility of intensified US sanctions on Iranian oil exports. Despite its historical support for Hamas, Tehran has denied involvement in the attack.

The increase in oil prices, while still 8% below their September peaks, adds to existing inflationary pressures. This has led to speculation that central banks might prolong higher interest rates.

However, David Bassanese, Chief Economist at BetaShares, argued that elevated oil prices should have limited implications for the Reserve Bank. He noted, "On the one hand, higher oil prices add to inflation, as petrol accounts for around 4% of the consumer price index, and prices rise by around 4% for every 10% rise in world oil prices. But on the other hand, rising oil prices also crimp demand, and the more households spend on petrol, the less they can spend elsewhere."

A survey conducted by the National Australia Bank (NAB) on Tuesday showed that cost pressures have cooled, providing a positive sign for the inflation outlook. This suggests that interest rates may have already peaked. Independent economist Stephen Koukoulas believes that "It's obvious that inflation will fall back to the target much sooner than the RBA is currently thinking." The Reserve Bank of Australia (RBA) forecasts core inflation to decrease to 3.9% by the end of the year, down from the current 5.9%.

Traders have adjusted their expectations, with bond futures indicating a 45% chance of an interest rate increase by May next year to 4.35%. This is down from 52% on Monday and 74% last week. Additionally, the possibility of a rate cut has re-emerged, with a 31% chance by December.

While some experts believe that the RBA will raise rates next month, following the release of key quarterly CPI data on October 25 and an anticipated upgrade of the central bank's growth and inflation forecasts, the situation remains fluid.

In the midst of these developments, the Australian dollar experienced a resurgence, reaching a one-week high of US64.33¢. This comes despite global investor concerns surrounding the Israel-Palestine conflict. The Australian dollar, which had dropped to an 11-month low of US62.83¢ last week, has experienced a 5.8% decline this year, largely due to interest rate differentials between the US and Australia.

Investor sentiment has also been influenced by a reduction in speculative short contracts by fund managers. Real money accounts trimmed net shorts in the Australian dollar to 82,100 contracts in the week ending October 3, down from 96,700 contracts the prior week. Meanwhile, hedge funds increased their negative views on the Aussie, with net shorts rising to 13,900 contracts from 9,100 the previous week. Sean Callow, a senior FX currency strategist at Westpac, noted that the overall position on the Australian dollar remained "heavily bearish," with speculators' net short positions standing at nearly $10 billion according to CME data.

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