Oil prices up nearly 3% as Israel-Iran conflict escalates, US response remains uncertain

CALGARY (Reuters) -Oil prices jumped almost 3% on Thursday as a week-old air war between Israel and Iran escalated and uncertainty about potential U.S. involvement kept investors on edge.

Brent crude futures settled up $2.15, or 2.8%, to $78.85 a barrel, its highest close since January 22.

U.S. West Texas Intermediate crude for July was up $2.06, or 2.7%, to $77.20 at 1330 EST (1730 GMT).

Trading volumes were light on Thursday due to a U.S. federal holiday.

Israel bombed nuclear targets in Iran on Thursday, and Iran fired missiles and drones at Israel after hitting an Israeli hospital overnight.

There was no sign of an exit strategy from either side, as Israeli Prime Minister Benjamin Netanyahu said Tehran's "tyrants" would pay the "full price" and Iran warned against a "third party" joining the attacks.

The White House said on Thursday that President Donald Trump will decide whether the U.S. will get involved in the Israel-Iran conflict in the next two weeks.

That prospect has crude prices grinding higher, said Rory Johnston, analyst and founder of the Commodity Context newsletter.

"Consensus (in the market) is increasingly forming that we will see U.S. involvement in some way," Johnston said.

Iran is the third-largest producer among members of the Organization of the Petroleum Exporting Countries, extracting about 3.3 million barrels per day of crude oil.

About 18 million to 21 million bpd of oil and oil products move through the Strait of Hormuz along Iran's southern coast, and there is widespread concern the fighting could disrupt trade flows. 

The risk of major energy disruption will rise if Iran feels existentially threatened, and U.S. entry into the conflict could trigger direct attacks on tankers and energy infrastructure, said RBC Capital analyst Helima Croft.

On Thursday, JP Morgan said an extreme scenario, in which the conflict widens to the broader region and includes a Strait of Hormuz closure, could result in oil prices surging to $120 to $130 per barrel.  

Goldman Sachs said on Wednesday that a geopolitical risk premium of about $10 a barrel is justified, given lower Iranian supply and risk of wider disruption that could push Brent crude above $90.

Even if Middle East tensions were to cool off in the coming days, oil prices are probably not headed back to the low $60 range they were trading at a month ago, said Phil Flynn, senior analyst at the Price Futures Group.

"I think this (conflict) knocks oil out of its complacency," said Flynn. "I would argue that the market has been underplaying geopolitical risk."

But DBRS Morningstar said in a note on Thursday that it expects any sudden oil price surge to be temporary. A higher oil price will exacerbate tariff-related headwinds to the global economy and oil demand, so as long as the conflict recedes, the war premium will deflate and prices will cycle lower, DBRS said.

Russia's top oil official said on Thursday OPEC+ oil producers should proceed with plans to increase output, noting rising summer demand. Russian Deputy Prime Minister Alexander Novak said at an economic forum in St. Petersburg that OPEC+ should calmly execute its plans and not scare the market with forecasts.

(Reporting by Amanda Stephenson, Enes Tunagur, Colleen Howe and Sam LiEditing by David Goodman, Deepa Babington and Rod Nickel)