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- [00:01]
A
Welcome to Thoughts on the Market. I'm Andrew Sheats, global head of Fixed Income Research at Morgan Stanley.
- [00:06]
B
I'm Martin Rantz, head of Commodity Research at Morgan Stanley.
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A
And today in the program, oil flows through the Strait of Hormuz remain restricted. The implications for global energy markets and what may lie ahead. It's Wednesday, April 1st at 2pm in London. So, Martin, it's great to sit down with you again. Three weeks ago we were having this conversation, a conversation that was a little bit alarming about the scale of the disruption in the oil market with the closure of the Strait of Hormuz and how that could have ripple effects through the global economy. Three weeks later, oil is still not flowing. What is happening and what is maybe surprised you or been in line with expectations over the last couple of weeks?
- [00:53]
B
Yeah, many things have been in line with expectations in the sense that we're seeing the effects of the closure of the straits, that the earliest in regions that are physically the closest to the strait. So we saw the first examples of physical shortages in, say, the west coast of India. From there on, it's reverberated throughout Asia. Also in Asia, we're seeing the type of prices that you would expect. Bunker fuel for shipping somewhere between $150 to $200 a barrel. Jet fuel over $200 a barrel. NAFTA going into Japan. NAFTA normally trades well below the headline price of Brent. Now $130 a barrel. That's more than double of what it was in February. So those things tell the story of this historic event. What has been surprising on the other end is how slow the reaction has been in many of the oil prices that we track the most.
- [01:46]
A
The numbers people will see on the news. It's $100 a barrel, maybe as we're talking.
- [01:51]
B
Yeah, it's strange to see jet fuel cargoes in Rotterdam, more than $200 a barrel. But then the front month, Brent future only trading at 100. That spread is historically wide and very surprising. But look, there are some reasons for it. The crude market had more buffers. There are a few other things. But how slow Brent futures have rallied, that has been somewhat surprising.
- [02:13]
A
But from those other prices you mentioned, those prices in Asia, those prices in Rotterdam that are maybe higher than the numbers that people might see on the news or on a financial website. Is it fair to say that in your mind that's sending a signal that this is a market that really is being affected by this and being affected maybe in a larger way than the headline oil price might Suggest.
- [02:34]
B
Oh, clearly. Look, the oil market is full with small price signals that tell the story of the underlying plumbing of the oil market. So you can look at price differentials of physically delivered cargoes versus financially traded futures. West African oil versus North Sea oil, Brazilian oil versus North Sea oil, oil for immediate physical delivery versus the futures contract that trades a month out. And many of those spreads have rallied to all time highs. That is no exaggeration. And so in an underlying sense, the stress in the market is clearly there. It is just that in front of Brent Futures, which is the world's preferred speculative instrument to express a financial view on oil. Yeah, there the impact has been slower to come, but you're now seeing a lot of Asian refineries bidding for crudes that are further away in the Atlantic Basin. So demand is spreading to further away regions and that should over time still put upward pressure on Brent.
- [03:32]
A
In our first conversation you had this great walkthrough of both just putting the scale of this disruption in the straight or four moves into the global context. How many barrels we're talking about, how that's a share of the global market. Maybe it just might be helpful to revisit those numbers again. And, and also some of the mitigation factors we talked about. Well, maybe we could release reserves, maybe some pipelines could be rerouted. Based on what you're currently seeing on the ground, what is this disruption looking like?
- [04:00]
B
Yeah, so to put things in context, global oil consumption is a bit more than 100 million barrels a day. That number lives in a lot of people's heads. But if you look at the market that is critical for price formation, that's really the seaborne market. You can imagine that if, say you're in China and you have a shortage, but there is a pipeline from Canada into the United States, that pipeline is not really going to help you. What you need is a cargo that can be delivered to a port in Shanghai. So the seaborne market is where prices are formed. That is roughly a 60 million barrel a day market, of which 20 million barrels a day flows through the Strait of Hormuz. So for the relative market, the Strait of Hormuz is about a third very, very large. Now, out of that 20 million barrel a day, that is in principle in scope, there is still a little bit of Iranian oil flowing through that continues. They let their own cargo through. Then Saudi Arabia has the east west pipeline. They can divert some oil from the Persian Gulf to the Red sea. That's about 4 million barrels a day incremental on top of the flow that already exists on that pipeline. The UAE has a pipeline that can divert half a million barrels a day, but you are still left with a problem that is in the order of 14. Is million barrels a day going to have some SPR releases to offset that a little bit? But global SPRs can flow maybe 1 to 2 million barrels a day. You're very quickly left with a double digit shortage. And that is historically large.
- [05:24]
A
And just to take it to history, I mean, again, if we were placing a 14 million barrel a day disruption in the context of some of these historical oil disruptions that people might have a memory of, what is the relative scale?
- [05:38]
B
Yeah, this is at the heart of why this is such a difficult period to manage. Normally we care about imbalances of half a million to a million. That gets interesting for oil analysts. At a million, you can expect prices to move if you have dislocations in supply and demand of say, 2 to 3 million barrels a day. You have historically epic moves that we talk about for decades, literally. Like in 2008, oil fell from $130 a barrel to 30 on the basis of 2 to 3/4 of 2 million barrel day oversupply. In 2022, around the Ukraine invasion, oil went from 60, 70 bucks to something like 130 at the peak. On the basis of the expectation, but not realized. It was just an expectation that Russia would lose 3 million barrels a day of productive capacity. And so 2 to 3 million barrels a day normally already gets us to these outsized moves. And so this event is four or five times larger than that. That means we don't have a historical reference for what's currently happening.
- [06:45]
A
I guess I'd like to now focus on the future and maybe I'll ask you to summarize two highly complex scenarios in a overly simplified way. But let's say tonight we get an announcement that hostilities have ceased, that the strait is open, that oil can flow again, or a second scenario where it's another three weeks from now, we're having this conversation again and the strait is still closed. Could you just help listeners understand what the energy market could look like under each of those scenarios?
- [07:21]
B
Yeah, so maybe to start off with the latter one, because from an analytical perspective, that one is, is perhaps a bit easier. Look, if the strait stays closed, at some point consumption needs to decline significantly. Yeah, significantly. We need demand destruction. Now that's easier said than done. Who gets to consume in those type of environments are those who are willing to pay the most. And that means that certain consumers need to be priced out of the market. We tried to answer this question in 2022 and the collective answer that we all came up with is that you need prices for Brent in money of the day, $150 or something, thereabouts. That is not an exaggeration. Now let's all hope we can avoid that scenario because that is, you know, that looks like a spectacular price, but that is not a beneficial scenario for anybody in the economy. The other scenario is more interesting and it can actually be split in sort of two sub scenarios.
- [08:22]
A
And this is the scenario where actually stuff starts flowing tomorrow.
- [08:27]
B
Exactly, exactly. If it completely flows like it always did, sure. We go back to the situation we had before these events. Brent can fall substantially 70 bucks. Before these events. We thought the oilmark would be oversupplied. Who knows, True freedom of navigation, maybe even lower. But at the moment that doesn't quite look like that. That will be the scenario that's in front of us. What seems to be emerging is an outcome whereby this could de escalate, but leave the Iranian regime structurally in control of the flow of oil through the Strait of Hormuz. And if the Iranian regime continues to manage the flow as they currently do, cargo by cargo, because there are some cargoes trickling out and there is a process that seems to be established for it, there seems to be a toll that seems to be paid, given that that will then manage 20% of global oil supply. That is not the same oil market that we had before. Like all of OPEC's spare capacity would be behind this system. Would that spare capacity be available in the case of an emergency? Maybe, maybe not. This is only one of many questions, but if the Iranians stay in control of the Strait, we will not return to the oil market that we once knew.
- [09:42]
A
And is that fair to say? We might need a higher long term oil price, a higher risk premium in future oil prices to offset some of that?
- [09:50]
B
Yes, I would say that that is very likely. First, a lot of the supply would be fundamentally less reliable. Second, we would have de minimis effective spare capacity in the system. Thirdly, if this is the scenario we are left with, that creates an enormous incentive for countries to start expanding their strategic storages. And building strategic inventories is like exerting demand. China has built a lot of strategic storage over the last two years. They are now in better shape than if they hadn't. In the west we've historically had strategic storage, but India for example, has none. And so the rest of Southeast Asia, no strategic storage. A Lot of strategic storage. Buying that is price supportive. And also look, the, the prices that we care about are the price of Brent and Double Ti and they are not behind the Strait of Ramus. They have higher security of delivery. You can totally see how refineries would be willing to pay a premium for those crudes relative to others. So when you add all of that up, it leaves you with a higher risk premium that people would pay, particularly for the crudes that form our perceptions about the oil market.
- [10:58]
A
Martin, one final question I'd love to ask you about is how the US fits into all of this. You do counter this perception that the US is energy independent, it produces a lot of oil, it's net energy neutral in terms of its imports, exports. You can correct me to the extent that that's correct, but to what extent do you think it's true that the US is more isolated, energy wise from what's going on and to what extent do you think that that could be a little bit misleading given a global interconnected market?
- [11:28]
B
Look, the United States is in a better position than many other countries, that's for sure. But the practical reality is also that that is, I have to say, mostly sort of a volume argument, but not the price argument. The United States is a net exporter of oil, but that is a net effect after very large imports and very large exports. It's just that the exports are a little bit bigger than the imports.
- [11:52]
A
So it's a lot of flow in both directions.
- [11:54]
B
There is an enormous flow in both directions and that connects the United States with the rest of the world. In the end, in the seaborne market there really is only one oil price and we all pay it, including the United States. But nevertheless, relative to other parts of the world. Yeah.
- [12:09]
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Better positioned, but still not immune from what's going on.
- [12:12]
B
No, no, we're all connected.
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A
Martin, it's been wonderful talking with you and while I hope to catch up with you again soon, if we're not talking again in three weeks, it maybe is a good sign.
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B
Might be. Thanks Andrew.
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A
And thank you as always for your time. If you find thoughts of the market useful, let us know by leaving a review wherever you list and also tell a friend or a colleague about us today.
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C
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