The Oil Shock Is Here. And We’re Just Beginning to Feel It.

As the third week of the U.S.-Israel war against Iran grinds on, the effect the war might have on the global economy is still unclear. At the center of that question is oil. Iran’s closure of the Strait of Hormuz has stopped the flow of nearly one-fifth of the global oil supply. While fuel prices have already spiked, the full consequences of a prolonged closure of the Strait could be much more disruptive. To understand what’s happening now—and where we may be headed—HBR spoke with oil analyst Rory Johnston, founder of Commodity Context, a newsletter that distills data on the energy industry, and a lecturer at the University of Toronto’s Munk School of Global Affairs and Public Policy. We spoke on Tuesday morning, March 17. (This conversation has been edited for length and clarity.) We’re just over two weeks into the U.S.-Israel war on Iran, and Iran has locked down the Strait of Hormuz, basically corking the pipe that 20% of the world’s oil supply flows through. How would you contextualize how much oil has been taken out of the market so far and what its effects might be, even if the situation were resolved tomorrow? So, there are two ways of thinking about this. The first is production. We’ve seen production cuts across the region, because once you lose the Strait of Hormuz, countries like Iraq and Kuwait don’t have anywhere else to put their crude and are forced to shut in production—that is, they’ve temporarily taken the wells offline. By my estimate, the total supply that has now been shut in in the Gulf is around 8.5 million barrels a day, which is 8% or more of global supply. That is a humongous volume of crude. Even if the Strait reopened today, that would probably take weeks to a month or two to get back up and running to be shipped out. Then you have supply: the 20 million barrels a day, give or take, that has actually been blocked from leaving the Strait and is not being supplied to the global market. At 20 million barrels a day and 15 days in, you’re looking at 300 million barrels of oil products that have not been exported from the Gulf. This is like building up an air pocket in the normal flow of oil out of the Gulf, largely to Asia. Now, the important thing to remember about the global oil system is that it’s essentially a flowing chemistry set. It needs to keep flowing at a steady pace, and any big changes in that flow rate cause a bunch of chaos all through the system. That air pocket is important because we still had tankers leaving the Gulf three weeks ago, and it’s probably going to take another week, week-and-a-half for those to finally hit land. After that, the air pocket starts really actually hammering local available supply. That’s when we’re going to start drawing down inventories very quickly. Then we have anticipatory action from refineries in Asia. It’s complicated and expensive for them to shut down, and they could be down for weeks or a month if they do. So, they’ve preemptively reduced their operating rates to extend their runway of how long they can keep going with limited feedstock crude coming in. But that gives us a preview of what happens when that air pocket hits in a week or two. We’ve already seen jet fuel in Asia, as an example, hit over $200 a barrel equivalent. Fuel oil, the sludgy product that fuels global shipping, normally trades at a decent discount to crude, but it’s currently trading at a premium. So, if this drags on, we have a domino effect where the fallout gets bigger and bigger. For instance, if we run out of the feedstock, eventually the refiners are going to shut down. When you think about some of those big dominoes falling, what might those be? And when might they potentially start to fall? The first domino is that air pocket finally hitting. From there, I think the next big domino is going to be the market reaction, because once that physical scarcity starts to rapidly draw down inventories, there’s kind of no escaping what we are facing. Global financial markets, and particularly the paper [financial] side of the futures market, seem like they’re still in a little bit of disbelief. There’s a well-entrenched belief that, even if it is happening, [U.S President Donald] Trump’s going to wrap this up at any second. What we’ve seen from the president’s foreign policy style—particularly when it comes to military interventions—is that he tends to do something big, flashy, and kind of cinematic that’s made for the front page, then declare victory very quickly and it’s over in two or three days. To be completely honest, that was my expectation as well. I did not expect us to be in our third week of this war, a third week of an actual outright stoppage of traffic to the Strait. I never thought I’d see this in my lifetime. There’s a lot of alarmism in the oil market. I like to think of myself as a non-alarmist oil analyst. I’m usually the person who talks about how the system is so impressive and so dynamic in its ability to adapt to shocks. But this is just such a big shock that rather than bending, I fear it will break the system. Only I think a lot of generalist observers aren’t accepting that because, very frankly, people in the oil sector always say that everything is an existential threat. Now, we’re in a boy who cried wolf situation. What do you mean by “break”? In this context, “break” fundamentally means demand destruction. Typically, higher prices can incentivize suppliers to realign logistics and trade routes to allow more supply, even with the same amount of production behind it. But all of those things are insufficient for the loss we’re currently facing. If we continue down this path, prices will need to rise to such a level as to actually force a physical, volumetric reduction in demand. That’s not something we’ve typically seen in these types of crises. What you would often see is a high price level that over a longer period of time saps consumer spending and causes all the recessionary issues that we usually talk about. But rather than a price elasticity demand destruction [where consumers choose not to buy], it’s an income elasticity demand destruction [where they can’t afford to buy]. It’s not that you don’t drive to work because the price of gas is too high, it’s you don’t drive to work because you lost your job. That is the more common way we see demand destruction manifest. In this situation, if the Strait remains closed, the price is just going to keep rising and rising and rising until you get fewer planes in the air and fewer people driving. And I think that is the kind of situation we’re kind of looking at now. Here in the U.S., there’s been a focus on rising gas prices. But I’m curious, what are other possible ramifications of an oil shock, and how will this affect other commodities? Just lingering on fuels for a second before we get into the other stuff, the markets for diesel, heating oil, and jet fuel—what we call the middle distillate products—are under far greater idiosyncratic stress than gasoline. These markets have been very, very tight basically since 2022 when Russia invaded Ukraine. And they’ve kind of been the leading source of tightness in the petroleum products market ever since. For instance, during the 12 Day War last year, crude prices spiked but diesel prices spiked much more. Diesel crack spreads—the premium of diesel to crude oil—were around $30 a barrel at the beginning of February, and are currently almost $70.00 a barrel. Gasoline is going to hurt household budgets, and it’s very politically sensitive. But middle distillate products are actually much more important for the economy because that’s shipping costs, that’s freight, that’s groceries, that’s Amazon boxes, that’s airfare, everything else. So, I think that is a much more economically and structurally important fuel, particularly when we’re talking about potential inflationary pressures. If central banks are trying to look at inflationary pressures, they’ll be looking at gasoline for a view on consumer expectations. But I think they’ll be looking primarily at diesel for the kind of structural, inflationary impact it can have. In terms of the delayed impact of some of these increases, how quickly do you think that this shows up in higher shipping costs, higher cost of goods, etc.? It goes back to this idea of when everyone thinks this is going to end. Right now, people are not acting as if this is a durable shock yet. A lot of people are saying, “Maybe I don’t increase rates quite yet, maybe I swallow this.” But I think if this goes on for one to two months, people will be forced to pass costs down the supply chain. This first month, I expect you’re largely going to see this as an erosion in, say, shipping margins. Going into the second or third month, they’ll try and claw back margins by increasing rates on clients. So, let’s say roughly three months is when I would expect the impacts to really start showing up. I think if these prices remain high—and if, say, the Federal Reserve is very aware that these prices remain high—you can see where the puck is going, right? The Central Bank of Australia raised interest rates this morning. In the United States, they’re maybe not raising rates, but we’re thinking there are no more cuts, right? Central banks were slow to raise rates after Russia’s invasion of Ukraine, and some felt a little bit burned in terms of not getting ahead of the inflation. I think the 2022 experience is really illustrative here. Now, typically central banks ignore swings in energy and food prices because they don’t actually paint a picture of the underlying inflationary pressure that central banks are trying to target. But in 2022, you had inflationary pressure growing and then you had this price shock on top of it. The fear was that they can’t ignore gas prices anymore because they might unmoor consumer inflation expectations—a revisitation of the 1970s. Most people don’t know the price of copper or wheat on a given day, but we all know the price of gasoline because we see 18 signs for it on the way to work. So, even if everything else is only rising at 2%, if gasoline is rising at 25%, you’re much more likely to think things are rising by 25%. And that’s terrifying for central banks because that’s the classical explanation of the 1970s: you had an unmooring of inflation expectations and then Volcker needed to over-tighten the market and prompt a fairly painful recession in order to re-anchor those expectations. We hadn’t seen an unmooring of those expectations in 2022. We still haven’t yet. But that’s the central banker’s worst nightmare. How instructive do you think 2022 is? How are the situations similar and how are they different? The main similarity is panic, but most of the underlying fundamentals are actually very different. Going into 2022, we had a very, very tight oil market. OPEC had cut a bunch of production in 2020 [during Covid-19] to balance the market, which I think was the right call by OPEC at the time because it saved us from an even more extreme bullwhip effect. But you saw this massive loss in supply as demand cratered. Thankfully, demand and the global economy recovered much more quickly than people expected, but we didn’t have the supply to keep up with it. Inventories were being drawn down and even before Russia’s invasion of Ukraine, and prices were heading back toward triple digits. Then Russia invaded Ukraine. The big scare was that the International Energy Agency’s April report said that the combination of import bans and restrictions from the West would create a 3 million barrel a day loss of Russian supply. I remember thinking like, “Wow, that’s a crazy big supply loss.” In the end, though, we lost a million barrels a day and then it basically came back. Right now, going into this, the market was quite loose. We actually were staring down a 2–3 million barrel a day surplus. OPEC had hiked a bunch of production. The global demand was good, but not stellar. And overall it looked like inventories were building and were going to press prices lower. If anything, we didn’t see lower prices last year because of the aggressive sanctions policy from the White House toward Venezuela, Iran, and Russia. What’s happening today is about the difference between the fear of losing 3 million barrels from Russia and the 20 million barrels actually lost in closing the Strait of Hormuz. We’re talking about a seven-fold increase in the supply loss. And again, we never lost the three million barrels [after Russia’s invasion of Ukraine], but we have in fact lost the 20 million barrels per day from the market right now. So, this crisis is really just on a completely different scale. Right now, I think a lot of people are saying, “Well, we dealt with Russia really well. That ended up being kind of a nothingburger. The system showed how amazing it was at adapting to these types of shocks.” I think there’s a sanguinity in the market right now of, “Surely they’ll figure it out again.” And the system is attempting to reroute. There’s the east-west pipeline in Saudi Arabia, which can move—although we haven’t seen this proven yet—upwards of 5 million barrels a day of that 20 million from the Gulf to the Red Sea. Now there, the Houthis could become an issue again as we saw a few years ago. But that’s the single biggest offset. Then you have all of that sanctioned oil from Russia and Venezuela floating around. Right now, Russia is the single largest beneficiary of this war. The Trump White House, to its credit, had actually done a very good job at tightening restrictions around Russia, and prices were getting much, much worse for Moscow. That was accomplished over eight months, and in two weeks of this war, all of that’s already been undone. India’s been scrambling for Russian barrels. Everyone’s been scrambling for Russian barrels to the point that even Eastern Europe has been clamoring to Brussels saying, “Can we ease some of these restrictions on Russian imports into the EU?” Because the massive pipeline that used to supply us would be really, really handy in this global oil shock. Then the International Energy Agency (IEA) announced a major Strategic Petroleum Reserve release: 400 million barrels over roughly 120 days. That’s roughly 3.3 million barrels a day of flow back into the system—which, if we were in 2022, would be a staggeringly large number, but still very small relative to the loss we have. How is this affecting middle-income countries? And how might that affect the global economy? Obviously Europe and the U.S. can absorb high prices in a different way than, say, countries like India or Vietnam. This is a really important point, because while we can talk about how the market is going to solve this, there is a human element here, and people will have to go without. There is not enough supply to meet demand. Someone’s going to need to cut back. The question is who? Markets are going to solve this by saying that the people with the highest price sensitivity—another way of saying this is the poorest people on the planet—are going to be the ones who have to cut this demand back. For me and you in North America, or those in Europe or wealthy Asia, it will be a debilitating price shock. We’ll have recessionary concerns, everyone’s going to complain, it’s going to be very unpopular for politicians. But at the end of the day, we likely won’t see material shortages because we’re able to incentivize imports to our shores. Whereas in the developing world and the global South, even if there are people in those economies who could pay those prices, the average consumer can’t. They’re not going to be able to incentivize those imports to their shores, so they will experience outright physical shortages. We actually saw a bit of this in 2022 when the natural gas price crisis in Europe shot up. There was this now very infamous example of a contracted LNG tanker headed to Pakistan, and it broke its contract and sailed to Europe instead. Sure, there was a breakage fee, so they had to pay that, but it was so insubstantial relative to the arbitrage opportunity between Pakistan and Europe. But yeah, the market solved this by the ship going to the place where it demanded the highest price for its cargo. Now some people will say good, that’s how markets are supposed to work. But the other side of this is that Pakistan didn’t have gas, and that’s important for power generation, for heating, for wherever else you need. That’s not a good thing. As this plays out, those who can pay the highest prices will still get fuel. As long as global trade remains free, wealthy economies will get their oil at a very, very steep price, but the global South will have to do without. What, if anything, can businesses do to insulate themselves from what’s coming? Or are they just at the mercy of the markets and geopolitics? If you’re a business consumer of these fuels, it’s still very clear to me that the market is not yet pricing in this lasting a long time. You can pick up cargos for future delivery much cheaper than current spot prices because the main clamor right now is for prompt or spot available supplies. But again, I also thought this was going to be short-lived, and thus far I’ve been wrong. If this continues, things will get worse, prices will get higher, and you will not have the same opportunities to hedge at such a low price. So, there is an opportunity to do that now. The challenge here is the bidirectional risk, which is part of why a lot of people in this market are frozen. Last Monday markets shot up coming out of the weekend, hit almost $120 a barrel for Brent, and then dropped back down to like $85. There was like a $35 spread on the day. If you’re a business trying to hedge into that volatility, you could protect some upside, but you could also be holding a massive liability. If the White House decides tomorrow that this war is done and traffic does resume, prices are going to dump very quickly. We’re in a deeply uncertain moment right now because so much of this comes down to the specific policy decisions, arguably of a single man. And even if Trump decided to end the war tomorrow, what does Israel do? What does Iran do after that? There’s a saying I like: “Risk lubricates the gears of the global market. Uncertainty grinds it to a halt.” We’re in this, we’re in this moment right now where we’re grinding to a halt because people are just saying, “I don’t know when this will end.” As a great example of this, ships trapped in the Gulf can pay astronomically high war insurance to get out, or potentially they can wait a day or two and get out for basically nothing. All of these things come down to how long the market has set this to last. The more the market expects this to be a short-term episode, the less the rest of the market and economy can prepare for if this isn’t short-lived. I think that’s the trap we currently find ourselves in. It’s a completely untenable situation. I think that markets are treading water, waiting for the physics of these markets to force people’s hands. Because I think at that stage there’s no amount of jawboning that the White House can do that can counteract 10 million barrel a day draws in Asia. I think that the markets coming to terms with the physical reality of what’s happening is what people have to wait for now.

The Oil Shock Is Here. And We’re Just Beginning to Feel It.

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