What's next for oil and gas prices as Middle East tensions heat up?

Oil prices climbed this week as tensions in the Middle East escalated. Iran launched missiles at Israel and the Israelis threatened retaliation, raising the possibility of a disruption to the flow of oil from the region. A jump in oil prices automatically spurs fear of a spike in gas prices, but experts see reasons that may not happen.

Here's a look at the current situation and the outlook for oil and gas prices:

Familiar tensions, different times

Oil prices rose than $6 per barrel (5.47 euros) this week and prices at the pump moved higher as well. The average price for a gallon of gas rose 5 cents from last week. Any major escalation of tensions in the Middle East conjures up memories of the oil embargo that followed the start of the Yom Kippur war in 1973, which quadrupled oil prices.

However, the global supply of oil has been altered radically since the 1970s, with the U.S. becoming the world's largest oil producer. Months of war between Israel and Hamas and Hezbollah, two Iranian proxies, did little to boost prices for OPEC and its 12 oil-producing nations. Only the possibility of a direct confrontation between Israel and Iran moved the needle.

Gasoline prices are up, but cheaper than last year

U.S. gas prices typically rise along with crude because the price of oil makes up half the cost of a gallon of gasoline.

The national average for gas has risen to about $3.18 per gallon, according to AAA. But that’s still 13 cents less than a month ago and 60 cents less than a year ago. The record national average high of $5 per gallon was reached in June 2022.

“Despite the threat of war and a hurricane season that is still percolating, domestic gasoline prices are edging lower,” AAA spokesperson Andrew Gross said in a statement on Thursday. “There are now 18 states east of the Rockies with averages below $3 a gallon."

AAA also estimates that approximately 1.2 million of its members live in households with one or more electric vehicles. The organization believes that tepid gas demand and low oil costs will likely keep prices at gas pumps sliding.

It's the fundamentals

The long-term expectation is for oil prices to move lower, not higher. That's because the balance between supply and demand has tilted toward supply, a dynamic that typically weighs on oil prices.

In its most recent update on the energy markets, the International Energy Agency said demand for oil in the first half of this year rose by the smallest amount since 2020. Meanwhile, supplies have continued to increase and the OPEC+ alliance, made up of members of the producers cartel and allied countries including Russia, has said it plans to release more oil into the market starting in December.

“Geopolitical tensions have soared of late and yet fundamentals seem to be moving in the opposite direction with Iranian oil exports trending close to the highest level in years,” Barclays analyst Amarpreet Singh said in a note to clients. “The jury is out on the primary driver of the geopolitical drift, but it warrants caution against taking a strong view on a sustained disruption.”

State of Iran's oil sector

The country produces 3.99 million barrels per day, which is 4% of the world total. By comparison, Saudi Arabia produces about 9 million barrels a day.

Despite sanctions imposed by the West that have hampered production and export levels, Iran continues to find ways to maintain its oil sector, sometimes using creative methods like blending and re-labeling oil for sale to markets like China. As of the middle of this year, Iran was exporting about 2 million barrels of oil a day, up from 500,000 in 2020 but below the 2.5 million barrels it exported each day in 2018.

Export terminals like Kharg Island in the Persian Gulf could be a target for an Israeli strike. They play a key role in shipping crude oil abroad, primarily to Asian countries, including China.

Oil prices rose Thursday after President Joe Biden said U.S. and Israeli officials were discussing a possible Israeli strike on Iranian oil facilities. On Friday, Biden said the exact nature of any retaliatory action by Israel was “under discussion.” But he added, "I think if I were in their shoes, I’d be thinking about other alternatives than striking oil fields.”

What's next for oil prices?

Tom Kloza, global head of energy analysis with the Oil Price Information Service, believes oil prices are approaching a top, with U.S. crude oil at $74.38 and Brent crude, the international benchmark, at $78.05. “Perhaps Brent may have a cup of coffee at $80 a barrel or higher,” he wrote in an email, but the long-term outlook is for lower prices.

“As soon as things calm down, oil traders will concentrate on 2025 and 2025 looks very problematic for high prices with supply almost certainly outpacing demand by 500,000 to 1 million barrels a day,” Kloza said.