Middle Eastern events have had a very significant impact on oil prices in the first quarter of the year. The almost total closure of the Strait of Hormuz has significantly disrupted energy flows to a degree that has never been seen before. 20 million barrels per day (mb/d) of oil is normally transported via the Strait but this has fallen to two to three mb/d – mostly Iranian oil going to China.
Not being able to export oil, affected countries first filled up domestic storage, and once this was full they had no choice but to shut in production. At the time of writing, we have seen 10mb/d of oil market production closed. The figure is smaller than the pre-conflict Strait volumes as some pipelines have been used to bypass the Strait, in particular by Saudi Arabia.
The disruption has seen oil prices rise to around $120 per barrel (bbl), with Middle Eastern barrels and refined products trading at levels never seen before. Singapore jet fuel reached $220/bbl at one stage compared to $82/bbl pre-conflict.
As of 8 April, Iran and the US seemed to have stepped back from the brink and agreed to a two-week ceasefire and the re-opening of the Strait of Hormuz. Both sides are claiming victory.
What does this mean for the oil price?
The situation is complex and could change at any time, but a few things are known. The volume of ships passing the Strait needs to surge in the coming two weeks for the oil market to be convinced that the crisis is over. It is not enough if vessel numbers increase to 20 or 30, given that pre-war numbers were in the region of 130-150.
If the vessel number surges to 75% of pre-war levels, then that represents a near normalisation of flows given the current use of pipelines that were not previously running at full capacity.
However, while shipping levels could return to normal quickly, it will take weeks or even months for production levels to return to normal given the 10mb/d of shut-in production and damage to some facilities. This should mean that front month oil prices (i.e. oil for near-term delivery) are unlikely to fall to pre-conflict levels quickly. The uncertainty about when production will return should support prices. And the outcome of any talks is unknown; we have had two rounds of unsuccessful talks before so there is no guarantee they will work now.
Rebuilding strategic reserves will provide price support
In the longer term, the conflict has highlighted both the vulnerability of the energy supply system and the lack of strategic reserves for many countries. This is a long-term positive for oil prices. The US Strategic Petroleum Reserve (SPR) alone would need to buy 1mb/d for 18 months before it approaches normal levels. Given global oil demand has averaged 1mb/d growth for the past few years, this represents a significant increase in demand.
We do not know if the US will refill the SPR at this pace, but this conflict has highlighted the vulnerability for many. It would not be surprising if Asian and European countries, which have been more impacted and have limited reserves, try to address this in the coming years. These long-term factors should support oil prices in the medium term.
Oil price likely to retain a Middle East premium
The most bearish outcome for the oil market would be a complete removal of all sanctions on Iran while keeping the Russian sanctions off. If the market was confident that Iran had a West leaning government then the Middle East risk premium would evaporate. The future supply picture for oil would improve significantly as Iran has the ability to increase supply in a way that Venezuela does not.
We will continue to adjust positions as the Middle East conflict evolves. Whatever the outcome, we strongly believe that these events have raised the long-term floor for the oil price in all scenarios, apart from one where Iran is now a Western leaning country, an outcome we think unlikely.
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