Despite US President Donald Trump’s on-again off-again mercurial policy, equity markets want to move on
from the Iranian war and its impact on oil and energy prices. However, when the war will be over is still
uncertain. Odds still favour the US ending the conflict soon and focusing back on the domestic economy to
prepare for the upcoming mid-term elections in November. This paints a picture of short-term caution (risk
neutral or risk-off) and medium-term positive (risk-on) for risk assets.
It’s all about oil
While the general attention is focused on the US-Iran war and its impact on oil prices, equity markets (as
represented by the S&P500) want to move beyond the war impact. This can be seen from the S&P500’s
positive performance despite soaring oil prices (Exhibit 1).
History shows that that every major surge in oil prices is often followed by a subsequent crash of 20%-30%
(Exhibit 2). This should help negate the concern about sustained elevation of oil prices due to the war’s
destruction of oil production facilities. A similar boom-bust outcome could unfold when the US-Iran war
finally ends and/or the Strait of Hormuz reopens. Why?
Demand destruction
The cure for high oil prices is high prices themselves due to the demand destruction that high prices have
inflicted on demand. In other words, oil supply disruption leading to high oil prices will force global demand
to adjust to the high-price low-supply structure. The world has already cut down on oil consumption, with
the global oil intensity – the amount of oil required to produce a unit of GDP – falling by about 60% over the
years (Exhibit 3).
Supply increase
History shows that supply disruption due to war did not prevent a sharp fall in oil prices. This is because oil
producers always have a strong incentive to ramp up production, capacity allowing, to recoup the loss of oil
revenues during the war.
For example, the US-Iraq war in 1991 destroyed Iraqi’s oil production, removing more than three million
barrels a day from the market for more than five years. However, this did not help oil prices recover after
the war (Exhibit 4) as other producers boosted production to recoup the lost oil revenues during the war.
The UAE’s decision to leave OPEC in May 2026 reveals fractures among member countries. This may
pave the way for OPEC to ramp up production once the war is over. Other than Saudia Arabia, the UAE is
the only other nation with the largest spare capacity. Its decision could encourage more countries to quit
the cartel or increase their incentive to boost production. Note also that Qatar, Ecuador, and Angola had left
OPEC some time ago, and they have strong incentive to increase oil output too.
The US pressure
As I argued in my last note, Trump is under pressure to end the conflict and re-focus back on the domestic
economy because domestic support for the war and his approval rating are falling quickly, and rising
inflation (because of the Iran war) is breaking his anti-inflation promise and making the Republicans’
position precarious in the mid-term elections.
Democrats lost the presidential election to Trump in 2024 largely because voters were angry about rising
price levels, even though inflation was on a declining trend. So, Republicans could lose the House, or even
both the House and Senate, if rising inflation, especially gasoline prices which are highly visible to
households, continues to hurt voters economic wellbeing.
So what?
When everyone is focusing on high and rising oil prices, the underlying macro dynamics argue for a sharp
decline once the war ends if oil producers follow past practice and boost output to maximise market share
and revenue. Post-war oil prices could correct by as much as 30% or more, depending on how much
damage the war has done to the oil production facilities.
Should this scenario materialise, it would be positive for almost all asset classes and the broader economy,
as lower oil prices would act as a tax cut, benefiting businesses and consumers, while also driving down
inflation expectations and long-term bond yields.
A caveat is of course that no one knows when the US-Iran war will finish. The markets are not going to fully
embrace progress in US-Iran talks due to Trump’s erratic moves. Despite his noisy announcements on a
peace agreement, before the “ink is dry” market sentiment and positioning on risk assets should remain
cautious.
