Oil prices fall as traders realize Israel strike on Iran was limited

Oil futures are on pace for a weekly loss as traders see limited risk that Israel’s retaliatory strike on Iran will trigger a wider war that disrupts crude supplies.

U.S. crude oil and global benchmark Brent have fallen 3% and 3.4%, respectively, since last Friday, erasing gains made when investors bid up prices on fears that Israel and Iran were on the brink of a major war.

Market sentiment has shifted from fear to relief this week after Israel and its U.S.-led allies thwarted Iran’s unprecedented drone and missile attack on Israel last weekend. The Netanyahu government appears to have submitted to international pressure to avoid escalation, waiting days to retaliate and ultimately launching a limited strike against the Islamic Republic on Friday.

West Texas Intermediate futures were last trading 0.66% higher at $83.28 a barrel, while Brent gained 0.49% to $87.54 a barrel. The two contracts have largely erased the risk premium built into prices after Israel hit an Iranian diplomatic building in Syria at the start of the month, the event that triggered the current round of hostilities.

“The energy market has been through this before,” John Kilduff, founding partner at Again Capital, told CNBC’s “Squawk Box. “It’s hard to get your head around the fact anymore how high the bar really is in the Middle East these days for all out war to break out and for oil supplies to be impacted.”

Israel’s retaliatory strike on Friday was “very muted and carefully calibrated” using small packages of explosives and drones rather than manned aircraft, said Admiral James Stavridis, the former Supreme Allied Commander of NATO.

“Both capitals, Jerusalem and Tehran, are downplaying the events — de-escalating,” Stavridis told CNBC’s “Squawk Box” on Friday.

“We are therefore ready to cautiously conclude that the cycle of escalation between Israel and Iran is over, at least as far as direct attacks against each other are involved,” Marko Papic, chief market strategist at the Clocktower Group, told clients in a Friday note.

Explosions were heard near the airport in Iran’s third-largest city Isfahan, Iran’s Fars news agency reported. Isfahan is also the location of one of Iran’s major nuclear sites. Iran’s armed forces said nuclear facilities in the Isfahan province were “in complete security.”

The oil market has been most worried about a strike on Iran’s nuclear facilities because the Islamic Republic would be forced to respond to such an attack, Kilduff said.

A Telegram channel affiliated with the Islamic Revolutionary Guard Corps said that there were no explosions on the ground in Isfahan and that the explosive sounds were caused by Iran’s defenses.

Israel on Sunday vowed to “exact a price” from Iran in response to the weekend’s large-scale aerial assault on the Jewish state.

A day earlier, Iran struck military targets inside Israel, launching more than 300 missiles and drones, in retaliation for an Israeli strike on its embassy compound in Damascus, Syria.

“With Israel’s apparent strikes on Iran today, retaliating for Iran’s attack on Israel last Sunday, we now have a direct nation-on-nation hot war,” said Rapidan Energy’s Director of Global Oil Service, Clay Seigle.

“The ‘shadow war’ chapter has come to an end,” he added.

While Washington has pledged an “ironclad” commitment to Israel, President Joe Biden has also told Israeli Prime Minister Benjamin Netanyahu the U.S. will not join any offensive operations against Iran, a senior administration official told NBC News.

“The U.S. should avoid further entrapment in Israel’s efforts to drag U.S. military forces into a broader war with Iran,” said Sarah Leah Whitson, executive director of Democracy for the Arab World Now, or Dawn.

Israel’s decision to attack Iran in spite of pleas from its primary backers is a “clear indicator of how irresponsible and unaccountable the Israeli government is,” she added.

Seigle maintained that’s it’s still too early to determine what could happen next.

However, Seigle pointed out that the “big risk” for oil markets in the expanding Middle East war is that oil exports from the Arabian Gulf will be cut off. The region is responsible for more than 20 million barrels of oil per day.

A disruption or closure of the Strait of Hormuz, a key chokepoint which sits between Iran and Oman and through which one-fifth of global oil production flows daily, would also cause oil prices to shoot higher.

“A Hormuz disruption would be very serious for the world economy, potentially driving oil prices well into the triple digits to levels that induce demand destruction,” he added.

Symbolically, the Jewish state’s attack on Iran is also “bigger than anything Israel has carried out in the past,” given how it is a direct strike against targets inside Iranian territory by the Israeli military, Eurasia Group said in a note. That being said, the political risk consultancy said such a response suggests the escalatory pressure will likely be contained — Iran has not acknowledged that a missile strike took place, blaming the explosions instead on air defense systems.

“The response from the Islamic Republic has been to downplay the attack, suggesting that the regime will feel little need to respond immediately,” said Eurasia Group.

— CNBC’s Sam Meredith contributed to this report.