Oil and the International Market

With Brent closing last week at above $100 for the first time since 2022, I thought it might be interesting to delve a bit deeper into the murky world of international oil markets and try and work out what is driving that price spike?

It might seem there is an obvious answer to that question: deprive any market of 20% of its volume and the price is going to go up, surely?  Yes, but…international oil demand is finite and predictable.  In energy terms, oil still supplies around one-third of global primary energy and the world consumes around 105 million barrels of oil a day (to break that down into an even more depressing statistic, given the imminent threat of climate change, the world burns about 1.2 million barrels every 15 minutes - approximately one barrel for every 80 people on Earth every day – or 38 billion barrels per year).  And there is actually plenty of oil available – either in storage, or at sea or in strategic reserves.  China holds a total of around 900 million barrels of oil (plus commercial reserves of around 300 million barrels) – enough for 140 days.  The G7 holds around another 2 billion.  Oil at sea adds around another 600-700 million barrels and reserves held at refineries another 600 million barrels (though refined products are a separate and perhaps more worrying problem).

Around 20 million barrels pass through the Strait of Hormuz every day (or did before 2 March, at least).  Saudi and the UAE can push up to 7.5 million b/d through pipelines to the Red Sea.  So the world is at most 12.5 million b/d short on a daily basis.  That does not seem so much when the stocks and reserves are so comparatively high.

So why the price shock – especially when the futures curve looks so flat?

Spot prices react to immediate physical supply constraints, whereas futures prices look forward over periods measured in months or years, enabling the impact of short (or even medium-term) supply disruptions to get smoothed out over time. Since the global oil market is more a network of regional physical markets, than a perfectly integrated global market, a disruption in one region can cause ‘local’ spot cargo prices to spike, even if global supply looks comfortable. Futures on the other hand, tend to reflect global balance, rather than regional bottlenecks.

The spot market is easily spooked by a period of tight supply. This is particularly the case for refineries which operate continuously and need to be reassured that they will have reliable supply. If refiners perceive that supply is, or may become, tight, competition for supplies increases and they bid for spot cargoes immediately, causing a price spike. This same phenomenon applies to short-term inventory levels.  If they drop below expectations, buyers will be prepared to pay a premium for immediate delivery, even if overall production remains stable.

Trading also has a major impact on spot prices.  Geopolitical risk or severe supply constraints can cause traders to close their positions.  If a trader bets that the price of oil will fall, but it actually rises, they will rush to buy oil contracts at the higher price to cover their loss and avoid it getting worse.  That process itself drives the price of oil higher on the stock market and quickly becomes a cycle.

The Supply-Demand Balance

But the biggest problem that global oil markets face is the very tight supply/demand balance.  As noted above, global oil demand is around 105 b/d.  If supply was significantly above that, then the market could weather short-term supply shocks.  But in fact, current global oil supply (of all liquids, including crude oil, condensates, natural-gas liquids, biofuels, etc.) is only around 107 million b/d.  That means the system normally runs with around only 2 million b/d of spare supply, which is only 2% of the total market.  So, if 13% of the total global market supply is removed, the market becomes tight immediately even when the long-term balance looks comfortable and despite the existence of strategic reserves. 

The supply tightness will manifest in prices differently over a period of weeks. The immediate market reaction is likely to be measured in minutes or hours, with traders responding almost instantly once they believe supply may be disrupted as the market reprices risk. Physical supply effects manifest after one to three weeks. This is because there are significant oil supplies either already in transit (on tankers) or storage (in refineries, pipelines, or commercial storage tanks).  The real supply shock occurs once refineries have run through their reserves (normally three weeks).  At that point the impact is felt in fuel markets as refineries reduce their runs or switch their crude grades.

What can be done?
International organisations can release their oil reserves onto the market.  It takes a few weeks before the global market becomes so tight that policy makers are forced to move.  In this crisis, the IEA has responded remarkably swiftly, announcing the largest ever coordinated release of oil stocks onto the global market – over 400 million barrels of oil – on 11 March.  Although that seems a huge amount of oil, in practice, it will cover the loss of Hormuz transport for only 26 days and it cannot all be released at once. Even if all participating countries released the maximum they could every day, only around 3 million b/d would actually reach global markets, leaving a continued shortfall of around 9 million b/d every day.

So what stocks are actually available?

As noted above, the world has large commercial inventories and oil in transit that act as a buffer. Excluding most strategic reserves, global oil inventories are between 7.5-8 billion barrels (approximately 75 days of global demand).  In addition, there are significant volumes on tankers at sea (between 250–350 million barrels) and in floating storage (between 150–250 million barrels) making a total of up to 8.6 billion barrels in non-strategic storage. That feels like a lot of oil.  But in practice, much of that oil is not freely deployable either because it is tied to refinery operations (using that oil would result in refineries shutting and the world quickly running out of refined products); is sanctioned; is stored in Russia or China and so not readily available to global markets; is already contractually committed; or is a quality mis-match for demand.  In addition, there is a physical constraint of transport – either pipeline flows or availability of tankers – in getting the oil from where it is stored to where it is needed.

So, from the 8.6 billion barrels of oil in storage, only 10–20% is sufficiently ‘flexible’ to be able to respond quickly to a supply shock. That is made up of the 400-600 million barrels which have already left the Gulf (the oil at sea or on floating storage noted above) and between 1-1.6 billion barrels in flexible commercial inventories, making a total of between 1.4 – 2.2 billion barrels of flexible supply.

Production shut-ins

But behind these figures, there is a much more worrying, longer-term and growing concern. Normal Gulf production is around 27–30 million b/d and Hormuz normally ships around 20 million b/d with a further 3-5 million b/d transported through pipelines. Gulf producers, unable to export their crude have to put their crude into storage. The seven main Gulf producers (Saudi Arabia, UAE, Iraq, Kuwait, Qatar, Oman, Iran) together have about a total of around 343 million barrels of onshore crude storage capacity – Saudi has the largest storage capacity of around 200 million barrels.  Given the above production figures, it is likely that Gulf storage will be full after around 28 days. Once there is no more storage, producers will have to begin ‘shutting in’ production.  If a shut-in is carried out properly and the well is not closed for an extended period of time, then re-starting production normally takes a week to 10 days. 

However, for older wells, or those that were poorly shut-in, restarting production can take much longer, since shut-ins can result in pressure loss, water intrusion, or, in extreme cases, reservoir damage.  Although, because its fields are engineered for swing capacity, Saudi Arabia could return to 70% production within days of operations restarting, the majority of fields are not engineered for on-off production which means that a return to full production in the Gulf after an extended shut-in could take two to three months: that is genuine cause for concern because it suggests that, even if the Hormuz were to re-open tomorrow, the effect of the shut-ins means that the international oil market will continue to feel the impact of the closure for some time after the re-opening.  And that fact is pushing much of the price inflation the market has witnessed over the past week.

Which is where Geopolitics comes back in.

To flip from economics to geopolitics for a second, this leads us to the key question. Iran will be calculating how long it needs to hold the Strait shut in order to ramp up the economic pain on consumers (in particular US consumers) to such a degree that it becomes politically intolerable and Trump (with mid-terms looming and poll numbers falling) is forced to concede.

And that question is: if the ordinarily tight supply and demand curve in international oil markets is stressed by the loss of 13 million b/d; flexible storage can only replace a certain amount of that demand on a daily basis and is not infinite; production is being shut-in as storage fills up; and production restarts will lag behind a re-opening of Hormuz (even if some of that production re-start lag will be covered by draining down Gulf storage) how long until the supply crunch really hits the consumer’s pocket?

The time-line from extracting crude oil to selling a refined fuel product (gasoline, diesel, jet fuel, etc) is fairly complex. Oil moves from the well-head to a separation unit on-site where gas and water are extracted.  It is then stabilised and stored, before being sent into pipelines, trucks, or tankers.  This process takes anything from a few hours to a few days. Depending on the transport mechanism (pipeline, lorry or tanker) and where the destination refinery is located, transport can take between one day and a few weeks – this is generally reckoned to be the longest part of the production chain.  Once the oil arrives at the refinery, it is generally stored for around a week before use – since refineries operate continuously, they are obliged to store large volumes of crude before processing.  Once the oil enters the refinery units, the actual processing is relatively quick, taking between 12-48 hours from crude input to finished product streams.  The finished product is then shipped to market, which can take a further 1-10 days depending on market destination. A total journey from well-head to refined product sold on the market of between 14 -31 days.

Assuming that markets are rational and respond to actual supply shortages, rather than predicted shortages, this means that, if oil stopped being shipped through the Strait of Hormuz on 2 March, the effects of the closure will begin to be felt by refineries and passed on to consumers on 16 March and from then on, the effects will only increase.

Conclusion

I should state very clearly, I hold no candle for the theological dictatorship that has brutally ruled and repressed Iran for the last half-century.  But I equally do not support the reckless and ill-advised assault on Iran. Anyone who has ever run any sort of scenario-planning on an Iranian response to an attack would have ended up at the conclusion that Iran would respond exactly as it has because such an attack would inevitably be viewed by the Iranian regime as existential. So it is odd that, before launching his misjudged attacks on Iran, the US President expressed his surprise that Iran had not folded when faced with the growing US military arsenal off its shores. 

The coalition may have overwhelming military superiority, but the economic power levers are increasingly shifting to favour Iran.  The longer it can keep the Strait closed, the tighter the global oil market becomes.  Offers to escort tankers through the Strait are a distraction – it would take around 10 naval vessels to escort a convoy of 5 tankers/day: given that there are 150 vessels upstream of the Strait, it would take a minimum of 30 days just to clear those tankers, before beginning to drain down the storage backlog. 

The more that prices respond to the supply/demand mis-match, the more the balance of international economic leverage swings in Iran’s favour.  This economic pressure is beginning to lap up on US shores, which is why we are seeing cracks emerge in the Republican front, with luminaries such as David Sacks, the White House AI and crypto tsar calling for the US to “declare victory and get out” of the Iran war. I assume that someone has briefed the US President about this – hence his sudden conversion to believing in the importance and role of allies and international coalitions to achieve solutions and his call for assistance in re-opening the Straits.

But I think this conversion has come too late.  Iran is now ‘locked in’ for a long war.  The regime believes it can take the domestic pain and suffering of daily bombing runs (which increasingly appear to have as their objective levelling Tehran and major Iranian cities) for longer than the rest of the world can take the economic pain of the consequences of those attacks. In the meantime, the economic consequences of this ill-advised war are only going to grow: and as usual, it is the poorest in society who will suffer the most.