Back in early March, in anticipation of rising jet fuel prices, I rushed to buy two air tickets to New York (August and October). The cheapest was Norse Air £500 August (very good deal) and £400 for October with a 3% discount for paying by bank transfer. I did buy with bank transfer but for a short while was worried if they went bust I wouldn’t have credit card protection. But, nevertheless, today, Norse Air sent email saying to save fuel costs, they had cancelled my October flight, and had rebooked me on a different day. The oil crisis is real, and to make it worse I still have a diesel car (I bought in the days when people said diesel was environmentally friendly, I always thank them when driving to London and pay charge -, next time I fill, could well be £2.00 a litre.
Now that is just a digression, a minor personal inconvenience against the much bigger economic shock. In fact, in a recent post I said this wasn’t really an oil shock at all— more a refining shock. Crude was around ninety dollars and all the damage was happening in the margins (diesel).
Well, that’s not true any more. Brent closed at $109. American diesel has gone past $6 a gallon, which is a record in cash terms. Put crude and the refining margin together and you’re at roughly $200 a barrel.
Oil executives, including Chevron’s chief executive Mike Wirth, say a global fuel crisis has arrived.
So we now have two shocks at once: disruption to oil supply at a time of even worse refining shortages.
The headline price is the cheapest number on the board
Here’s the odd part. Brent futures are $109, but if you’re actually buying a cargo of Murban — the UAE’s main export grade — you’re paying $131. Oman’s crude is $121. Dated Brent, which is the price of a physical North Sea cargo with loading dates already fixed, is $122.
Traders quoting paper contracts are still betting the conflict ends and things go back to normal. Refiners buying real barrels can’t afford to make that bet. When refiners pay more for oil today than traders will pay for oil next month, the shortage has stopped being a forecast.
It’s worth noting that Murban and Oman both load at ports outside the Strait of Hormuz. The market is paying its largest premium for the barrels it is confident can actually leave.
What changed: the backup route is gone
Hormuz has been effectively closed since March, but the impact was muted because Saudi Arabia could use its East-West pipeline to export through the Red Sea instead. A drone strike has now severely damaged that pipeline, blocking the escape route. At the same time, Houthi forces have seized Mayun island at the southern entrance to the Red Sea.
Saudi Arabia’s primary export route is severely curtailed, and its backup route is now impaired too.
The cost of moving oil
Cargoes are going the long way round, via the Cape of Good Hope, which adds roughly three weeks to the voyage. Freight costs have soared. Tankers are now earning in excess of $1 million a day, partly because of risk and partly because refiners are desperate to take physical delivery in case of a future supply crunch. Rates on some routes have hit record highs.
You don’t need to hit every ship. The risk alone causes insurance costs to soar and makes crews ask whether the next voyage is worth it.
The disruption has taken about 7 million barrels a day out of Gulf production — roughly 7% of world oil supply, gone in six months. Other countries have increased output, notably the US, Brazil and Canada. But it isn’t always the right kind of oil for diesel refineries.
Falling inventories, falling refining capacity
This layer of disruption comes at a time of falling inventories. The US Strategic Petroleum Reserve is around 285 million barrels, down by 130 million since March. J.P. Morgan model global visible inventories running down towards the operational floor — the level below which pipelines and refineries cannot physically function.
The double whammy is that while crude is in shorter supply, refining capacity has also been severely curtailed. It is running at about 89% of nameplate, against a usual 94%. That is the result of Ukrainian drone strikes on Russian facilities and the loss of the Jazan refinery to Houthi strikes.
China comes back to the market
After Hormuz closed, China massively reduced its oil imports and ran down its own inventories instead. That played a key role in limiting the rise in oil prices.
In recent weeks there is evidence China is starting to buy Gulf crude again, unwilling to keep depleting its stocks indefinitely. Because China is the largest buyer of crude, this is a significant factor in boosting demand.
The three shock absorbers have gone
When Hormuz first shut, three things mitigated the shock: China reduced demand, inventories were released, and Saudi Arabia made use of alternative routes.
All three have now been largely exhausted. Multiple routes are blocked, inventories are largely spent, and even if you could release more crude, there are extra shortages in refining capacity. There is nothing left to absorb the next disruption.
Why nobody is building new refineries
In response to a recent post, one reader asked why firms are not investing in more refining capacity? In fact Europe and the UK have been reducing refining capacity for years.
The problem is that nobody wants to invest billions in a plant with a thirty-year payback when, by the time it is built, fossil fuels are expected to be in long-term decline. The Economist has argued that this crisis could itself trigger an investment boom — but not quickly.
It isn’t only oil
Jet fuel and diesel move very closely together, because both come from the same middle-distillate cut of a barrel. Airline ticket prices are up 25% on the start of the year.
More worrying is European gas, which has risen 158% since January. That is a problem for countries with low gas stocks, and higher gas prices threaten to further damage European — and especially German — industry, which runs on it. UK households are likely to see a 25% jump in energy costs in January, pushing inflation towards 4%.
Disruption in the Gulf also threatens sulphur exports, since sulphur is a by-product of refining oil. Both Russia and China have announced effective export restrictions, and 45% of global seaborne sulphur passes through the Strait of Hormuz. Shortages will push up the price of fertilisers.
And don’t forget that fuel accounts for roughly 15% to 30% of the total cost of food, according to the Independent Grocers Alliance, a grouping of 7,500 supermarkets worldwide. We will see price rises across a wide range of goods.
Inflation and interest rates
The rise in oil, diesel and gas prices is causing inflation headaches around the world. US inflation has continued to run above the Fed’s target, the US has raised rates and has signalled rates will rise more. Because of the renewed disruption, markets have started to price in four interest rate rises in the UK. Though today, the Bank of England kept rates steady.
But raising interest rates doesn’t solve a shortage of crude oil or refined diesel. Rates reach demand — borrowing, spending, investment, jobs. They cannot reach supply — barrels of oil, refining capacity, shipping routes. You would have to severely deflate the economy to reduce inflation when it is caused by shortages.
Demand destruction
Prices won’t rise forever. At some point people do consume less — demand destruction. The question is how high prices must go first, and whether the fall in demand causes a recession?
Put bluntly, will we have to deal with an oil shortage by pushing the economy into a downturn? A key question is not how high prices rise, but how long higher prices rmeain.
How bad is it really?
The official statistics on Hormuz suggest very little traffic, while the US claims many more ships are being escorted by its navy. The truth is that most ships now cross with their transponders switched off to avoid becoming a target. The Economist quotes Kpler, a data firm, which says some ships are getting through but that it is volatile: on 8 September just eight transits passed through the strait, down from 23 a week before.
The case for calm
The bigger picture is that the energy intensity of global GDP is much lower than in 1980. Engines are more efficient and there has been a switch to renewable energy. This latest shock will only accelerate the move to battery and renewable technology.
And while oil prices are approaching the levels of 2022, when Russia invaded Ukraine, inflation and gas prices are both well short of where they were then. Prices have been more resilient than feared. If we adjust for inflation, the crisis looks more muted still — real diesel prices remain lower than in both 2008 and 2022, and the refining margin is still below its 2022 peak.
There is also a second equation. As oil prices rise, so does the pressure for a political solution. Should a peace deal be achieved, these blockages disappear and prices come down. We started the year with the IEA saying we had a glut of oil, and that could resurface some way down the line.
However, not everything would snap straight back. Shell’s head of gas, Cédric Cremers, says the loss of Gulf LNG won’t come back online quickly. Production takes time to restart, marine traffic has to normalise, and that could take several months.
The shortage is here
So this is definitely an oil shock, though it is more acute in petrol and diesel. And don’t forget that the crude price doesn’t reflect the higher price refiners are paying to secure oil today.
The shortage is here.
Sources
About The Author
