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- [00:01]
A
Welcome to Thoughts on the Market. I'm Andrew Sheets, global head of fixed income research at Morgan Stanley.
- [00:06]
B
I'm Martin Ratz out of Commodity Research at Morgan Stanley.
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A
Today on the program, we're going to talk about why investors everywhere are tracking ships through the Strait of Hormuz. It's Wednesday, March 11th at 2pm in London. Martin, the oil market, which is often volatile, has been historically volatile over the last couple of weeks for following renewed military conflict between the United States and Iran. Now, there are a lot of different angles to this, but the oil market is really at the center of the market's focus on this conflict. And so I think before we get into the specifics, I think it's helpful to set some context. How big is the global oil market? And where does the Persian Gulf, the stir Hormuz, fit within that global picture?
- [00:51]
B
Yeah, so the global oil consumption is a little bit more than 100 million barrels a day, but that splits in two parts. There is a pipeline market and there is a seaborne market. And when it comes to prices, the seaborne market is really where it's at. If you're sitting in China, you're buying oil from the Middle east, all of a sudden it's not available. Sure. If there is a pipeline that goes from Canada into United States, that doesn't really help you all that much.
- [01:13]
A
So it's the oil on ships that really matters.
- [01:14]
B
Oil on ships, that is the flexible part of the market that we can redirect to where the oil is needed. And that is also the market where prices are formed. And the seaborne market is in the order of 60 million barrels a day. So only a subset of the hundred. Now, relative to that 60 million barrel a day, the Strait of Hormuz flows about 20. So the Strait of Hormuz is responsible for about a third of seaborne supply, which is, of course, very large and therefore very critical to the system.
- [01:44]
A
And I think an important thing we should also discuss here, which we were just discussing earlier today on another call, is this is a market that could be quite sensitive to actually quite small disruptions in oil. So can you give just some sense of sensitivity? I mean, in normal times, what sort of disruptions in terms of barrels of oil kind of move markets get investors attention?
- [02:06]
B
Yeah, look, this is part of why this situation is so unusual. And oil analysts really sort of struggle with this. Look, normally relative to the 100 million barrels a day of consumption, we care about supply, demand imbalances off a couple of hundred thousand barrels a day. That becomes interesting if that increases to, say, a million, a million barrel a day, over or under supplied, you can expect prices to move. You can expect them to move by meaningful amounts. We can write research, the clients can trade. You have a tradable idea in front of you. When that becomes 2 to 3 million barrels a day, either side, you have major historical market moving events. So in 0809, oil famously fell from over 100 down to something like 30 on the basis that the oil market was 2, 2.5 million barrel day oversupplied for two quarters. In 2022, we all thought this actually never happened, but we all thought that Russia was going to lose about 3 million barrel a day of supply. And on that basis, just on the base of expectation alone, brent went to $130 per barrel. So two to three, either side, you have historically large moves. Now we're talking about 20.
- [03:18]
A
And I think that's what's so striking. I mean, again, I think investors, people listening to this, they can do that arithmetic too. If this is a market where 2 to 3 million barrels a day have caused some of the largest moves that we've seen in history, something that's 20 is exceptional. And I think it's also fair to say this type of closure of the Strait is something we haven't seen before.
- [03:41]
B
No. Which also made it very hard to forecast, by the way, because the historical track record did not point in that direction. And yet here we are, the historical track record. Look, you can look at other major disruptions historically. The largest disruption in the history of the oil market is the Suez crisis in the mid-1950s that took away about 10% of global oil consumption. This is easily double that. So really unusual. If you look at supply and demand shocks of this order of magnitude, you can think about COVID in April 2020 for one month, at the peak of COVID when we're all sitting at home, nobody driving, nobody flying. Yeah, we lost, very briefly 20 million barrels a day of demand. Now we're losing 20 million barrels a day of supply. So, look, the sign is flipped, but it's in the same order of magnitude. And yeah, these are unusual events. You wouldn't naturally sort of forecast them that easily, but that is what is in front of us at the moment.
- [04:34]
A
So I think the next kind of logical question is if shipping remains disrupted. And I'd love for you to talk a little bit about, you are sitting there with satellite maps on your screen tracking shipping, which is a development, but what are the options that are available in the region, maybe globally, to Temporarily balance this supply and create some offset.
- [05:01]
B
Yeah. So of course, when we have a big disruption like this one, of course the market is going to try to solve for this. There are a few blocks that we can work with. I'll run you through them one by one, including some of the numbers. But very quickly you arrive at the conclusion that this puzzle, we can't really solve it. Like in 2022, the market was very stressed. We thought Russia was going to lose 3 million barrels a day of supply. But we could move things around in our supply demand model. Russian oil goes to China and India. The oil the day by we can get in Europe. We can move stuff around to kind of sort of solve a puz. This puzzle is very, very difficult to solve. So through the strait of Hormuz, 15 million barrels a day of crude, 5 million barrels a day of refined product, 20 million barrels a day in total. What can we do? Well, the biggest offset is arguably the Saudi east west pipeline. Saudi Arabia has a pipeline that effectively allows it to ship oil to the Red Sea at the port of Yanbu, where it can be evacuated on tankers there. That pipeline has a capacity of 7 million barrels a day. We think it was probably already flowing at something like 3 million barrels a day. So there's probably an incremental 4 that can become available through that. That's the biggest block that we can see of workaround capacity, so to say after that the numbers do get smaller. The UAE has a pipeline that goes to Fejara that's also beyond the Strait of Ramu. We think there is maybe half a million barrel a day of capacity there. Then you're basically sort of done within the region and you have to look globally for other sources of oil. If there are sanctions relief, maybe on Russian oil you can find a half a million barrel a day there, here, there and everywhere. 100,000 barrels a day, 200,000 barrels a day. But the numbers get very strong.
- [06:44]
A
It's still not. So if you kind of put all of those almost in a best case scenario, relative to the 20 million that's
- [06:51]
B
getting disrupted if you add another one or two from a massive SPR release. The fastest release from SPR ever.
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A
Strategic Petroleum Reserve.
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B
Yeah, exactly. Earlier today we got an announcement that the IEA is proposing to release 400 million barrels from Strategic Reserve across its member countries. That is a very large number and that is important. But more important is how fast can it flow, because the extraction rate from these tanks is not infinite. The fastest ever rate of SPR Release is only 1.3 million barrels a day. Now, maybe the circumstances are so extraordinary we can do better than that. Then we can get it to two. But beyond that, you're really in very, very uncharted territory. So maybe in the region, workaround, sanctions relief, SBR release, we can probably find like 7 million barrels a day. Out of a problem that is 20, you're left with another 13. The 13 is four times what we thought Russia would lose. So you're left with this conclusion like this really needs to come to an end.
- [07:54]
A
And the other rebalancing mechanism, which again, when we come back to markets and forecasting this, is obviously price. You talk about this idea of demand destruction, which I think we could paraphrase as the price is higher, so people use less of it, and then you can rebalance the market that way. But give us just a little sense of, as you and your team are sitting there modeling, how do you think about the price of oil where it would need to go to, to potentially rebalance this the other way?
- [08:25]
B
Yeah, that price is very high. So what is a really interesting analysis to do is to look at the historical frequency distribution of inflation adjusted oil prices. You take 20 years of oil prices, you convert it all in money of the day, adjusted for inflation, and then simply plot the frequency distribution. What you get is not one single bell curve centered around the middle with some variation around the midpoint. You get sort of two partially overlapping bell curves. There is a slightly larger one which is sort of the normal regime lower prices. 60, 70, 80 bucks. There's a lot of density there in the frequency distribution. That's where we are normally. What's interesting is that actually if you go from there to higher prices, there are prices that are actually very rare in inflation adjusted terms, like 100, 110 in nominal terms, we might feel that that has happened. In inflation adjusted terms, these prices are extremely rare. They are way rarer than prices that live even further to the right. 130, 140. The oil market has this other regime of these very high prices. If you go back in history, when did those prices prevail? They always prevailed in periods where we asked the same question, what is the demand destruction price? And to erode demand by a somewhat meaningful quantity, you end up in that regime, these very high prices, like 130. And it's not a gradual scale. You sort of at one point shoot through these levels and that's where you then end up.
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A
It's quite serious stuff.
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B
Yeah. Also because we can casually say in the oil market, oh, Demand erosion has to be the answer. But we don't erode demand in isolation. Like diesel is trucking, jet is flying, NAFTA is petrochemicals.
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A
These are real core parts of economic activity.
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B
It's all gdp.
- [10:19]
A
Maybe. Martin, in conclusion, let me give you a slightly different scenario. Let's say that the conflict goes on for another couple of weeks, but then there is a resolution. Traffic goes back to normal. Walk us through a little bit of what that would mean. How long does it take to get back to normal in a market like this?
- [10:39]
B
Yeah, so if you say weeks, I would say that is an uncomfortable period of time.
- [10:44]
A
Actually, feel free to use a slightly different scenario.
- [10:46]
B
Yeah, if you say days, let's say next week, something happens, the whole thing comes to an end. Look, then we will have logistical supply chain issues. But look, we can work through that. There is at the moment somewhat of an air pocket in the global oil supply chain. There should be oil tankers on their way to refineries for arrival in April and May that currently are not. So we'll have hiccups and things need to be rerouted and we draw on some inventories here or there. And that will keep commodity prices tense. I would imagine the equity market will probably look through it. We'll have a month or six weeks, not more than two months, I would imagine, of logistical issues to sort out. Look, of course, if that doesn't happen, then we're back in the scenario that we discussed. But yeah, that's equally true. If it's short, we can live with the disruption.
- [11:35]
A
But it's fair to say that this is a situation where days really matter, where weeks make a big difference.
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B
Oh, totally. Look, the oil industry has built in various sort of compensatory measures, I think inventories along the supply chains, but nothing of the scale that can work with this. I mean, this is truly yet another order of magnitude.
- [11:56]
A
Martin, thank you for taking the time to talk.
- [11:58]
B
My pleasure.
- [11:59]
A
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