Saudi Arabia and Iran Are at Each Other’s Throats. Why Are Oil Prices Falling?

So much crude is sloshing around the globe that even the prospect of growing Mideast unrest isn’t enough to spook oil traders.

By Keith Johnson, a senior staff writer at Foreign Policy.

Saudi Arabia and Iran, OPEC’s two biggest powers, are at each other’s throats in an escalating war of words that is already spreading to other countries in the Middle East and Africa and spooking diplomats from Moscow to Beijing. Yet crude oil prices fell on Monday, a reminder of how dramatically awash the world still is in cheap oil.

Oil traders had initially panicked after Saudi Arabia broke off diplomatic relations with Iran on Sunday amid fears that the growing tensions sparked by Riyadh’s execution of a prominent Shiite cleric could further escalate and potentially threaten oil supplies. That sent crude prices sharply higher in early trading in Asia, Europe, and the United States on Monday.

The political crisis has intensified further, with other Persian Gulf countries joining Saudi Arabia in downgrading or cutting diplomatic ties with Tehran. Oil traders, though, don’t seem to care: Oil prices began falling within hours of markets opening as traders digested gloomy economic news from Asia, including the 10th straight month of falling Chinese factory orders. The dismal data is being seen as a sure sign that the engines of the global economy are sputtering and unlikely to gobble up much of the excess crude sloshing about.

The global oil glut, in other words, weighs more heavily on prices than even the prospect of open conflict between two rival, regional powerhouses.

“Until oil production is actually compromised, risk can’t swing prices on its own for too long,” said Matthew Reed, vice president at Foreign Reports, an energy consultancy. “The glut is too great.”

Despite the growing unrest — which included the sacking of the Saudi Embassy in Tehran and moves by an array of Persian Gulf countries to downgrade their diplomatic ties with Iran — actual oil production is not at risk in either country. On the contrary, Saudi Arabia is still pumping flat out, and Iran is gearing up to boost oil production and exports in the coming months as Western sanctions are lifted.

“The Saudi-Iranian confrontation is very significant for regional politics but poses a limited direct risk to oil supplies from either country or their Middle East neighbors,” said Richard Mallinson, a geopolitical analyst at Energy Aspects, a London-based consultancy. “The market would react to developments that directly threatened supplies from a major producer, but that does not seem to be on the horizon at present.”

The spat between Saudi Arabia, the most powerful Sunni state, and Iran, the standard-bearer of Shiite Islam, has been brewing for decades and has only intensified in the wake of the landmark nuclear deal Tehran inked last year with Western powers. Riyadh and its Sunni neighbors worry that the deal, by freeing Iran to export more oil and earn more money, will allow a rejuvenated Iran to expand its regional influence at their expense.

Tehran, for its part, feels slighted by Saudi Arabia, which took advantage of Iran’s global isolation in recent years to increase its own role in the region and in global oil markets. Saudi Arabia has tried to push back against Iranian influence in countries like Iraq and Yemen. The two countries’ primary battleground is Syria, where Tehran has been one of President Bashar al-Assad’s staunchest supporters while Riyadh has pumped money and weapons to the rebel groups working to oust him.

Oil is just a part of the broader rivalry between the two countries, both of which rely heavily on income from exporting crude — and both of which have suffered as crude prices plunged over the last year and a half. Crude prices have fallen from about $110 a barrel in the summer of 2014 to the mid-$30s a barrel today. Annually, that costs Iran about $25 billion in foregone revenues and costs Saudi Arabia almost $200 billion.

But Saudi Arabia, emboldened by much deeper pockets than Iran, has been able to withstand the price decline better. As the biggest oil producer and dominant voice inside OPEC, Riyadh has ignored calls from other OPEC members, including Iran, to throttle back its oil production to prop up falling prices.

At the same time, Iran is angling to jump back into global oil markets with a vengeance and claw back market share as sanctions are lifted. Since 2012, Iranian exports have been limited to about 1 million barrels a day, compared with 2.5 million barrels a day before Western sanctions were imposed because of Iran’s controversial nuclear program. But under the terms of the deal reached last year, those oil sanctions will soon come off, potentially freeing Iran to dump up to 1 million barrels of additional oil into an already glutted market.

The simmering tensions between the two countries came to a head over the weekend after Saudi Arabia executed a prominent Shiite cleric, prompting an angry response from Iranian leaders and irate reactions in the Iranian street. On Monday, Sunni states including Bahrain and Sudan joined Riyadh in severing diplomatic ties with Iran; the United Arab Emirates “downgraded” its diplomatic relations with Tehran but didn’t cut them completely.

The escalation prompted concern far and wide, especially since it could torpedo floundering talks for a resolution to the five-year-old Syrian civil war and the broader fight against the Islamic State.

State Department spokesman John Kirby on Monday urged leaders in the Middle East to take steps to calm the escalation. Russia reportedly offered to act as an intermediary between Saudi Arabia and Iran. China, whose need to secure large amounts of oil from the Middle East has made the region an increasing source of worry, said on Monday it is “concerned that the relevant incident may sharpen regional disputes.”

With a more impetuous Saudi leadership than in years past, and Iran’s leaders torn between hard-liners and relative moderates, there are real prospects for significant escalation. That could extend to proxy fights in places like Yemen, where Saudi Arabia has battled to push back against Iranian-backed rebels, or Syria, where Riyadh has backed rebel groups fighting the regime of Assad, an ally of Iran.

But despite the relative calm on oil markets Monday, the conflict could also spread to the oil patch itself, Reed said. Saudi oil installations in the eastern, heavily Shiite part of the country are potentially vulnerable to sabotage. And in 2012 hackers, reportedly from Iran, planted malware on Saudi Aramco computers in a high-profile attack that wiped out thousands of computers and crippled the oil company’s corporate operations for weeks.

Although that hack did not affect Saudi oil output, “it was a wake-up call for Riyadh, and Tehran certainly learned from it too. A second wave can’t be ruled out,” he said.

Photo credit: AHMED FARWAN/AFP/Getty

Keith Johnson is a senior staff writer at Foreign Policy. Twitter: @KFJ_FP