Before the temporary ceasefire in the Gulf, the world had been experiencing the biggest oil price shock ever, surpassing even the crises of the 1970s. The scale and speed of movements were comparable to some of the most disruptive episodes in modern energy markets.
At the centre of the disruption was the US-Israel conflict with Iran and the effective closure of the strait of Hormuz. The strait is a choke-point through which roughly one fifth of the global oil supply typically flows. Under the terms of the ceasefire, it is now expected to reopen.
The use of energy as a geopolitical weapon is not new. Sanctions imposed by the US and its allies on countries such as Cuba, Venezuela, Iraq, Russia and Iran have long contributed to oil market volatility. These measures reduce the pool of freely marketable oil and increase uncertainty.
More recently, European, UK and US sanctions on Russia also reshaped trade flows and pricing dynamics. And the G7 has imposed its own price caps on Russian crude.
When it comes to the Gulf, there are alternative export routes out to open sea but their capacity is limited. Saudi Arabia’s east-west pipeline can transport around five million barrels of oil per day to the Red Sea. And the UAE’s pipeline to the city of Fujairah can move around 1.5 million barrels per day, bypassing the strait. Throughout the hostilities, Iran continued to export an estimated 1.5 million barrels of oil per day.
But even accounting for these alternatives, any disruption in the strait implies a loss of roughly 10 per cent of the world’s oil supply. In comparison, the oil shocks of the 1970s represented around 5-7 per centof the world’s supply.
The effects of this supply crunch propagated rapidly through global markets. They initially hit Asian buyers before spreading to Europe and beyond. Price premiums for physical crude have surged, and prices for the three main benchmark crudes (Brent, Dubai and West Texas Intermediate (WTI)) have all risen sharply.
At the same time, volatility in the market has also increased dramatically. Implied volatility in Brent futures has climbed from below 30 per cent in December to around 90 per cent more recently. Put simply, this means the price of oil was expected to change by no more than 30 per cent in December last year, but this expectation rose to 90 per cent recently.
In part, it reflects a fundamental imbalance between scarce physical supply and a largely unchanged volume of financial (“paper”) trading and hedging activity.
About the author
Adi Imsirovic is a Lecturer in Energy Systems, University of Oxford, England. This article is republished from The Conversation under a Creative Commons license. Read the original article
In the spot market (where purchases are made “on the spot”), prices have reflected the acute scarcity. Here, prices for physical Brent reached US$140 (£106) per barrel. Some grades have been trading at premiums exceeding US$10 above this.
Saudi Arabia’s official selling price for its flagship “Arab Light” crude has risen steeply for Asian buyers. This underscores the tightness in markets for immediate delivery and the extent of short-term pressure on demand.
But futures markets tell a different story. As the name suggests, these are where buyers agree a price for later delivery. These prices are significantly lower. This suggests that traders still expected the disruption to be temporary, with the possibility of a relatively rapid price correction should geopolitical conditions stabilise.
These expectations are not without foundation. While some refining infrastructure (such as Ras Tanura and Samref in Saudi Arabia, Ruwais in the UAE, Mina Al-Ahmadi and Mina Abdullah in Kuwait and Bapco in Bahrain among others) have been damaged, much of the core oil production capacity in the region remains intact. In theory, exports could resume within days or weeks.
In addition, a large number of tankers known as very large crude carriers (VLCCs) have been stranded in the Gulf. This deescalation should quickly release significant volumes of oil back on to the market.
Optimism or caution?
This gap between short-term panic and longer-term expectations is a key feature of the current market. It reflects the wide range of possible geopolitical outcomes.
But there are reasons to be cautious about such optimism. Control of the strait of Hormuz is one of Iran’s most powerful strategic tools. Further disruption may serve both Iran’s economic and political objectives, particularly after it has suffered such significant infrastructure damage.
The cessation of hostilities and reopening of the strait should ease immediate supply concerns. But it could also signal a deeper shift in the global security architecture that has underpinned energy markets for decades. In particular, a reduced role for the US as a security guarantor in key shipping lanes could introduce a more persistent risk premium into oil prices. This would raise consumer costs across the world for a huge variety of goods.
In such a world, the primary constraint on energy markets may shift from the availability of resources to the security of production and transport infrastructure. This could potentially embed higher volatility into oil markets over the longer term.
The negotiations will be difficult, and diverging objectives among the key actors complicate the outlook. For Iran, the conflict has been existential. For Israel, weakening Iran may be a long-term objective. And US policy goals remain less clearly defined. The widening regional dimension just adds more uncertainty.
A pause in the conflict does not mean the end of hostilities. The temporary truce may enable the oil tankers to leave the Persian Gulf, but will they dare to go back in? The uncertainty only amplifies the market volatility.
There is still the option of more releases from strategic petroleum reserves – and governments may choose to do this. However, this would be a temporary relief and would risk leaving global reserves depleted, creating vulnerabilities to future shocks. Markets would be likely to anticipate this and it would limit the effectiveness of the move in stabilising prices.
A renewal of the conflict represents the worst scenario. Sustained high prices would bring back the spectre of inflation, high interest rates, economic slowdown and growing unemployment. In a global economy already burdened with debt from the COVID crisis, there are few levers left for central banks to tackle this predicament.
