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Strange Economics of Mideast Oil Shield Trump From Iran’s Bite

Strange Economics of Mideast Oil Shield Trump From Iran’s Bite

(Bloomberg Businessweek) -- A third of the world’s seaborne crude and fuels pass through the Strait of Hormuz at the mouth of the Persian Gulf. So it’s no surprise that as skirmishing in the Gulf between the U.S. and Iran has intensified this year, the price of oil has … wait … fallen?

Anyone betting that troubles in the area would push up the price of oil has lost a barrel of money. The prices of Brent crude and the U.S. benchmark, West Texas Intermediate (WTI), are each down about 26% from their highs of last October, which was before hostilities ratcheted up.

The stability of oil prices is fortunate for President Trump, who’s been able to tighten the screws on Iran without provoking an increase in gasoline costs that would be unpopular with voters. It’s also a plus for the global economy, which benefits from a reliable supply of affordable crude. Shocks to the supply of oil have been causes of global economic downturns in the past. Not so happy are the leaders of Iran, who are (still) hoping to get relief from Trump’s sanctions by making the U.S. and its allies feel some pain.

Strange Economics of Mideast Oil Shield Trump From Iran’s Bite

Given the importance of the oil market, the placidity of prices is a crucial mystery to unravel. After all, four tankers were sabotaged in the region in May and two in June. On July 10 a British warship had to intervene to stop Iranian vessels from impeding a BP Plc tanker. On July 18, Trump announced that the U.S. had shot down an Iranian drone that approached the USS Boxer near the Strait of Hormuz. And on July 19, Iran’s Revolutionary Guard Corps held a U.K. tanker and stopped a Liberian-flagged, British-operated ship in the strait, leading Trump to say, “This only goes to show what I’m saying about Iran: trouble, nothing but trouble.”

The tension has captured the attention of marine insurers, if not oil traders. The price of insurance against war risk has risen about 1,000% since earlier this year, to $500,000 or more for a single voyage of a standard oil tanker and its cargo through the Persian Gulf, according to people familiar with the market.

The stress echoes the early days of the 1980s tanker war between Iran and Iraq, which began as a skirmish but ended with significant damage. Fifty-five commercial ships were sunk or declared total losses. The U.S. Navy eventually formed convoys to protect ships from attack, but that exposed American sailors. In 1987, Iraqi missiles killed 37 crew members of the USS Stark. A year later the USS Vincennes shot down an Iranian commercial airliner with 290 passengers after misidentifying it as a military jet.

The question is why oil traders seem to be whistling past the possibility that today’s scuffles could turn into an ’80s-style tanker war. “It is amazing” that “a tanker has been seized, and we’ve barely moved” the price of oil, says Richard Fullarton, founder of the oil-focused fund Matilda Capital Management in London, who’s traded energy derivatives for more than 20 years. Salih Yilmaz, a London-based energy analyst for Bloomberg Intelligence, says the risk of worsening conflict “is definitely there, and it may be underplayed by the market.”

Traders and other observers can cite a string of reasons the Gulf strife doesn’t justify a rise in price. A smaller share of the world’s oil passes through the Strait of Hormuz now than in the ’80s, Caitlin Talmadge, a professor at Georgetown University’s Walsh School of Foreign Service, wrote in an email. In addition, she said, “Markets believe the U.S. will intervene militarily if needed to secure supply.” If tensions do push up oil prices a lot, she wrote, that incentivizes the people involved in shipping the region’s oil to send more ships “so they can fetch a higher price for their cargo,” and that supply pushes the price down.

What happened in the ’80s is instructive. The attacks by warring Iraq and Iran initially led to a 25% drop in commercial shipping and a rise in the price of crude, but fears faded as it became clear that only about 2% of ships’ passages were disrupted, according to the Robert Strauss Center for International Security and Law at the University of Texas at Austin. Despite the tanker war, oil prices fell sharply in 1986 because of a supply glut.

As in the early ’80s, the price of crude surged this spring over Mideast tensions. But this summer, fundamentals of supply and demand are having a bigger impact on the market than headlines out of Washington, Tehran, and the Gulf. Growth in global demand was the slowest since 2011 in the first quarter and has continued to be soft, so there’s little risk of a shortage even if there were a temporary interruption in Gulf supplies. The story that’s influencing the oil market these days is one of surplus, not shortage. Crude prices would be even lower if not for the Gulf conflict, says Caroline Bain, chief commodities economist at Capital Economics. “What it has done,” she says, “is put a floor under the prices.”

Bearish forecasts have weighed heavily on oil prices. On June 14 the Paris-based International Energy Agency predicted that global oil supplies will increase far more than demand in 2020, with the continuing boom in U.S. shale augmented by new fields in Brazil, Canada, and Norway. The Organization of Petroleum Exporting Countries agreed in July to continue output curbs into the first quarter of 2020, but that may not be enough to prevent a glut: OPEC estimated on July 11 that the amount of crude required from the cartel will slump sharply next year as non-OPEC supply surges.

Not only is stronger supply suppressing oil prices, but weaker-than-expected demand is, too. For a dramatic illustration of how a slowdown in demand can kill the price of oil, look back to the last recession. The price of WTI plummeted from $145 a barrel to $34 a barrel in just five months, from July to December of 2008, the worst period of the global financial crisis.

Although nothing as extreme as the financial crisis is in the forecast, demand for oil is growing more slowly than supply. For decades, China was a reliable source of demand for oil and other commodities, but its economic growth rate is on a downward trajectory. Its second-quarter gross domestic product expansion, 6.2%, was the slowest in almost 30 years, and economists are expecting it to dip to 6% in 2020. China has also been making massive additions to its oil inventories, which has had conflicting effects. On the one hand, the purchases have added to global demand and thus put a floor under the price. On the other, the existence of the huge stocks is putting a ceiling on the price, because traders know that if there’s a supply disruption, China can draw on barrels it already has in storage. “In 2016 China had roughly 50 days of coverage. Today they have 100 days of coverage—more than the U.S.,” energy economist Philip Verleger wrote in an email.

It’s often assumed that the price of oil determines the price of refined products such as gasoline, diesel, and jet fuel. But Verleger says the opposite is often closer to the truth. If the prices of refined products fall because of a glut, refiners reduce how much they’re willing to pay for crude oil, the main input, so the price of crude falls. That’s what’s happening now, he says. China is a leading culprit because it has excess output from new refineries and is dumping it on the Singapore market, Verleger says.

The price of oil is notoriously volatile because both the supply and demand for it are inelastic. They don’t change much in the short term in response to changes in price. On the demand side, drivers need to fill their tanks whether gas is cheap or costly. On the supply side, producers aren’t able to increase production rapidly in response to stronger demand, and they tend to keep producing even when demand declines. They’ll dump oil on an oversupplied market as long as the price exceeds the cost of getting it out of the ground.

At least that’s the way it’s always been. The shale revolution is changing the equation, making supply more responsive to price changes. In contrast to, say, a deep-water well off the coast of Brazil, a shale-oil project is relatively cheap to get started, so nimble shale producers can quickly increase production if the price rises, putting a ceiling on the price. The downside of shale is that while it’s easy to find, getting it out of the ground is costly—more like mining than traditional oil production. If oil is too cheap, shale becomes uneconomical, and shale operators can and do quickly shut in production, reducing global supply and putting a floor under the price.

Strange Economics of Mideast Oil Shield Trump From Iran’s Bite

This, in a nutshell, is why the shale revolution bedevils OPEC. It tends to moderate the price of oil and limits the organization’s power to engineer the market. Shale particularly confounds one OPEC member: Iran. It can’t credibly threaten to induce a global recession by harassing tankers, because if the price of crude starts to jump, U.S. shale production will rapidly increase—out of producers’ self-interest, not out of patriotism. The Permian, Bakken, Eagle Ford, and other sources of shale oil are as valuable to U.S. foreign policy as the U.S. Navy’s Fifth Fleet.

Iran isn’t completely without leverage. An all-out assault by it on tankers, loading platforms, and other oil facilities in the Gulf would wreak havoc. That could happen if hard-liners in Iran control policy and conclude that nothing short of such an action will get the country relief from U.S. sanctions, which have produced double-digit unemployment and reduced its oil output to the lowest since 1986. This may be a stretch, but it’s worth recalling that Japan’s sneak attack on Pearl Harbor in 1941 came after the U.S. punished the country economically with an embargo on oil and gasoline exports to it. But a major action by Iran in the Gulf would anger China, a huge customer of Mideast oil, and could provoke a military conflict with the U.S. In an interview with Bloomberg TV in New York on July 17, Iranian Foreign Minister Mohammad Javad Zarif said Iran has the ability, but not the desire, to shut the Strait of Hormuz. Said Zarif: “The Strait of Hormuz and the Persian Gulf are our lifeline.”

That leaves Iran with a strategy of sporadic but comparatively low-level harassment of Gulf shipping. “It’s almost like they benefit by dragging it out,” says John LaForge, head of real asset strategy for Wells Fargo Investment Institute. But as in the ’80s, the effectiveness of such a strategy—call it unconventional warfare—diminishes over time. Says LaForge: “The market may just be falling asleep with it.”

Then again, this is the Middle East: You never know what will happen. Prices did pop a bit right after the July 19 incident involving the two U.K.-linked ships. Before that, Georgetown’s Talmadge ran through a series of reasons why there’s not much to worry about, and then, in her email, pivoted to this: “All that being said, a major, unanticipated military conflict in the Strait would almost certainly cause at least a temporary spike in the price of oil.” For now, the oil market is Trump’s friend and Iran’s enemy. Let’s see how long that lasts.

To contact the editor responsible for this story: Howard Chua-Eoan at hchuaeoan@bloomberg.net

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