The oil market isn't back to normal, not even close
Even if the strait stays open, there is more pain in the pipeline
It’s been a tough year for oil bulls. Over and over again, the traders who have bet that the price of oil is more likely to rise than fall, the “bulls”, have been proven wrong, leaving the “bears” to enjoy the majority of the profits by betting that the price will fall. The bulls may yet have their day.
To be fair to the bulls, the oil market has completely defied all sane expectations. Shutting the Strait of Hormuz and choking off the supply of one in every five barrels of oil for more than three months should have been a textbook case of acute supply shock. When you remove 20% of a vital commodity from a market, the logical result should be extreme and sustained increases in the price of said commodity.
Instead, while oil did briefly hit $118/barrel, it failed to reach even the kind of prices seen in 2022 at the start of the war in Ukraine. That oil disruption affected less than half as much oil, 8 million barrels per day (mbpd), compared to the ±20mbpd flowing through the strait before the war.
So what gives? A whole lot of things, which I won’t try to cover in detail here, but in short, the most consequential factors were:
China cut imports by around 5mbpd almost overnight 1
Saudi Arabia and the UAE ramped up their existing pipelines to the Red Sea
Asian countries implemented rationing
The whole world had an unusually large quantity of oil stored up because prices were so low before the war
Around 2 to 3mbpd snuck through the strait at night with their transponders off, often with the help of the US Navy
The USA drew down its Strategic Petroleum Reserve at an unprecedented rate, 89 million barrels in just three months
Lastly, Donald Trump “jawboned” the price downwards by announcing peace deals roughly once a week
All of these factors have combined to keep the price from the kind of stratospheric price increases that many bulls predicted. And now that the MOU is signed and the strait is “open”, oil prices have swooned all the way back to pre-war levels, and the bears are sipping poolside cocktails and chuckling over their good fortune.
All great, except that the world’s oil supply is, in no sense, back to normal. The latest drop in prices is the result of millions of barrels of pent-up crude escaping through the strait, but that effect will be transitory.
Bearish analysts blithely point to the steady increase in the volume of ships transiting the strait, but they neglect to note that outbound oil tankers substantially outnumbered inbound tankers until last Saturday, the 27th. Even now, only around 7 or 8 tankers are entering the Gulf per day.
This is significant for a simple reason: in order to move 20mbpd through the strait you must first load 20 million barrels into empty tankers every day. The vast majority of the ships serving the Gulf are “very large crude carriers2” (VLCCs), which carry around 2 million barrels of oil each. It follows that at least ten empty tankers must enter every day to enable ten ships to be filled and dispatched with their cargoes.
Once those ships are underway, it takes another 20 to 40 days for them to reach their destinations, where they must be unloaded and their cargoes of crude must be fed into refineries. This means there is an average lag of roughly 30 days between loading crude oil in the Gulf and refining it for use.
This lag is usually not a problem because of the steady traffic of ships constantly entering, being filled, and leaving. But after such a huge supply disruption there is now a huge “air bubble” in that supply. Instead of cargoes arriving at refineries every other day, you have week-long gaps, forcing refiners to rely on their emergency stores.
Normally those stores would be able to bridge serious disruptions without too much trouble, but refiners, like everyone else, have already spent two months drawing down those stores in the expectation of an imminent peace deal. By now many of them are running very close to empty.
This is where the low price of oil turns from a relief into a landmine. To understand why this is the case, you must understand that there are essentially two oil markets: paper and physical. The bulls and bears live in the paper market. They buy and sell “contracts”, which are essentially promises to buy or sell oil at a particular price on a particular day.
The paper market may seem frivolous, but it is an incredibly efficient mechanism for ensuring that oil cargoes flow to the buyers who need them the most urgently, without the shippers having to waste time haggling with each other or the refiners. But the paper market is not perfect. It can be out of sync with the physical market for all kinds of reasons.
I believe that the paper market is currently fundamentally out of sync with the physical market for three reasons:
Overly optimistic assumptions about shipping in the Gulf
A failure to distinguish between the current “mini glut” of oil escaping the Gulf and a resumption of normal supply
A reticence to challenge Trump
Time and time again, throughout this crisis, bulls have taken positions in the market based on the assumption that prices must rise, only to have Trump post on Truth Social and knock the paper price right back down. In an industry where traders make their living off making such bets, eventually you learn not to challenge the power of the Trump PR machine.
All well and good, until the price of oil on paper collides with the actual oil demand from refiners. At some point those oil contracts must move from agreements to deliveries. Right now the paper prices suggest that everything is back to normal, when this is clearly not the case.
We can see this is not the case by looking at each step of the oil supply chain. In particular, we can look at:
Crude oil storage levels
Refinery utilisation
Crack spreads (more on this below)
Petroleum, or gasoline, inventories
Gasoline supplied, i.e. how much petrol is purchased
Exports of crude and distillates
The operation of the chain is fairly straightforward: refiners need a steady supply of crude, buffered by storage, which they convert into usable distillates, like petrol and diesel, and add their premium, the “crack spread”, in order to make it worth their while. Those distillates are then distributed, briefly stored, and then supplied to customers, including drivers, truckers and farmers. I’m going to use the USA’s numbers because they are the most readily available, but this will apply to many other markets.
In the USA, over the past four weeks, we have seen:
A persistent decline in crude oil storage, i.e. in total the country is using more oil than it is producing and importing (around 2 million barrels per day)
Extremely high refinery utilisation, 97% and still increasing
Extremely high crack spreads of over $55, i.e. refiners charging a high premium for using their capacity
Falling petroleum inventories, which fell by over 2 million barrels last week
Rising levels of gasoline supplied
Strong exports of both crude, ~4mbpd, and distillates, ~1.45mbpd
So, in simple terms, the USA is using and exporting more crude than it’s making, and refining as much of its remaining crude into petrol and diesel as it can, but it cannot keep up with the rising demand as Americans begin to go on summer holiday, which means petrol storage is falling even further.
If these trends continue, as they are very likely to do, then oil and petrol prices cannot continue to fall. Demand is already outstripping supply and if any part of the supply chain experiences a hiccup then prices will rise sharply.
If, for example, gasoline demand rises well above refining capacity, as often happens for brief periods in summer, then the drawdown on petroleum inventories will increase until physical shortages start to become likely. This will drive up demand by wholesalers and retailers of gasoline and diesel, which will drive up the price. There is no slack in the refineries to accommodate this extra pressure, so the crack spreads will rise, and thus the price of gasoline.
But what if refiners manage to keep up with demand? That’s great as long as they have enough crude to refine. With crude storage levels at record lows, it’s very possible that they simply don’t have enough crude to make enough petrol to meet market demand.
Good thing the strait is open, right? Sure, except there’s still that minimum 30-day lag from the end of June to the end of July during which the mini glut has cleared but consistent supply has not, in effect, ramped up to normal levels.
This means that oil cargoes will be arriving in fits and starts for months, with big gaps between deliveries. Normally the storage built into every part of the supply chain would act as a buffer, but that storage is largely gone.
If we apply this logic to the US market, we see an almost infinite number of potential delays or gaps that could cause the supply to stall or stutter. Imagine, for example, that one region3 of the USA runs low on crude, briefly causing the refiners in that region to taper their production. Every wholesaler in that region will immediately begin bidding for petrol and diesel from other regions and other countries.
To be clear, this isn’t an apocalyptic scenario. These negative effects are going to be moderate compared to the worst-case scenario of the strait remaining closed. But the current paper price of oil is just not sustainable. We may squeak through with limited disruptions, but that seems naively optimistic given the sheer complexity of this market.
Of course, like many other amateur bulls, I may end up eating my words (yum yum) but I just cannot see how we avoid significant pain down the road. That pain is likely to be intermittent and unevenly distributed, but it will be pain.
It’s virtually unprecedented for a global crisis to be the fault of a single person4, but we all know exactly who caused this mess. It’s grimly amusing to watch that person bitching and moaning about “Big Oil” engaging in “price gouging”, or “gauging” as he spells it, because the retail price of petrol is not dropping sufficiently quickly for his ego. As is invariably the case, he refuses to recognise his own responsibility for making the world a shittier place.
This situation won’t last forever. Assuming the ceasefire holds, the number of tankers entering the Gulf will pick up significantly, but it’s already much too late. These tankers will, at least, shorten the length of time we must endure said pain, but they cannot prevent it. We all know who to thank for this.
…and did so just days after a certain president made a state visit, make of that what you will
People in the oil business are somewhat literal minded
America is so large and so diverse that there are sometimes significantly larger differences in supply between states than there are between entire countries
Why do you need a footnote for this, you silly sausage?