Oil ETFs spiked 3% Wednesday morning before paring gains following Iran's largest-ever direct missile strike, involving over 180 ballistic missiles.

The largest exchange-traded fund to track WTI crude prices, the United States Oil Fund (USO), was down slightly in afternoon trading after rising 3% earlier in the day, following a 3% gain Tuesday on the rising Middle East tensions.

The conflict further escalated as Israel deployed more troops into Lebanon to confront Hezbollah, an Iran-backed militant group, with no signs of easing tensions despite international calls for de-escalation.

The morning’s spike in oil eased on news that Iran stated its missile strikes would cease unless further provoked.

Oil ETFs and Rising Middle East Tensions

The price of oil and oil ETFs typically rises during wars and conflicts in the Middle East due to the region's critical role in global oil production and supply.

Here are some key reasons for this reaction:

• Supply disruptions: The Middle East, especially countries like Saudi Arabia, Iraq, and Iran, is home to a significant portion of the world’s oil reserves. Any conflict in the region threatens to disrupt oil production or transportation, leading to fears of reduced supply. The possibility of infrastructure damage, embargoes, or sanctions exacerbates concerns about availability, driving prices higher.

• Risk premium: Markets add a "risk premium" to oil prices during periods of instability. This reflects the uncertainty about future supply levels and potential price shocks. The risk of conflicts spreading or escalating heightens this premium, as investors expect tighter supply and higher prices in the near term.

• Strategic chokepoints: The Middle East contains key shipping routes like the Strait of Hormuz, through which a substantial portion of global oil flows. Any military conflict or geopolitical tension in these areas can disrupt oil flow, amplifying fears of supply shortages and leading to price spikes. This also increases the volatility of oil ETFs tied to crude oil futures.

• Speculation and investor behavior: Investors tend to buy oil and oil ETFs during periods of geopolitical conflict to hedge against the risk of rising oil prices. The anticipation of supply issues or market instability often leads to a speculative surge in oil-related assets, further pushing prices upward.

As a result of these factors, oil ETFs, such as USO and the iShares U.S. Oil & Gas Exploration & Production ETF (IEO), which track oil’s price, tend to receive increased demand and price appreciation during conflicts in oil-producing regions.