The Persian Gulf is fast becoming the next major flash point in the Middle East. The problems began with the US imposing sanctions on Iran break the economic backbone of Iran by cutting off their oil export routes. That was with a couple of years of Obama having signed the special pact with Iran. The US has alleged that Iran had failed to abide by its side of the agreement.

In the last few weeks, the area has almost come to the brink of war with sabre rattling from the Iranian side and the American side. The problems began a couple of weeks back when the UK seized an Iranian tanker off the coast of Gibraltar for carrying oil to Syria. Since Iran was under sanctions, the tankers were seized. Iran retaliated by threatening British tankers near the Strait of Hormuz before backed off after warnings from the Royal Navy. The situation took a turn for the worse in the last week when the US shot down an Iranian drone. In response, Iran seized two tankers under a British captain and having a Swedish flag and is holding the crew captive. The seizure of tankers by Iran has already been declared as an act of war by the US. The big question is whether the Strait of Hormuz will be shut or not?

The fate of the Strait and the oil movement will largely depend on the gravity of the war situation. It would depend on whether it is a limited confrontation or a full-fledged war. In a limited confrontation, the regular flow of traffic through the Strait of Hormuz will continue with a caveat that some flags might be in danger when they passed through the Strait. However, a full-fledged war could be more serious. In the event of a full-fledged war, the Strait of Hormuz could be shut and landmines could make it hard for ships to pass by.

The impact on commodity prices in general and on India in particular could be quite serious if the situation takes at turn for the worse. Even a limited confrontation could be mean that oil prices could increase to $90/bbl. This would be driven by futures buying before falling demand starts to pull down oil prices. However, more than crude oil, it is the flow and price of LNG that could be hit harder by the conflict because the Strait remains central to LNG transportation. Japan, South Korea and India have major reasons to be worried. India imports 85% of its daily oil needs and 70% of these imports come from the Middle East. Even a limited conflict could be highly inflationary for India and worsen its current account deficit. In fact, economists estimate that a 10% increase in oil prices widens CAD by 0.40% of GDP. That could have negative implications for the rupee value and the external ratings.