Persian Gulf Exposures
Hi, it’s Chicken Little again.
It is my primary job to alert my customers to exposures in transport markets. Thank goodness most of them do not materialize. However, when the potential effects are serious, and the probability is greater than zero, the prudent business person thinks through the implications and takes steps to protect his or her assets. If there is a hurricane coming up the coast, it is time to put up the plywood. Should, as is usually the case, the storm keeps out at sea, one bears the cost of taking down the protection. But, in that once-a-decade event, when the storms hit hard, one saves the cost of new windows and other damage to the interior.
It’s the Middle East again.
In September 2019, we have one such economic hurricane in the escalating violence in the Persian Gulf. An accident of geology has concentrated 25% of the globe’s oil supply in less than .2% of its surface. Unfortunately, the naturally hyper-competition for those riches makes it a politically volatile region ravaged by wars during two-thirds of the years since 1980. Remarkably, oil supply and pricing have been affected as little as they have been by such problems. Still, we will see that market has reacted strongly to events there. The good news had been that the center of Persian Gulf oil production in Saudi Arabia has been spared violence, keep the largest production source online despite the problems. But that was before last weekend when somebody – accusations are flying – executed a successful cruise missile and drone strike on one to the Saudi’s two major production centers, taking out, temporarily about half of their capacity. One would be a fool not to look closely at the economic implications of this act – one that has idled 5% of global production capability.
The first response has been positive.
The immediate result was a 10% jump in crude oil prices. However, news from the Saudis about the releasing of reserved stockpiles, and the restoration of two million barrels per day (mbd) of production have calmed markets. Prices dropped 5% amid experts’ assurances of adequate supplies. Those assurances have a ring of legitimacy, given the ability of the global market to withstand such shocks before. So, is this a crisis after all?
Major war in the Gulf has happened before.
Part of the answer can be found in the 1980’s Iran-Iraq war. That conflict pitted two of the major OPEC producers who together produce nine MBD. Markets reacted strongly to the risks to that production, bidding the price of crude up to $365/B at the peak of the fears. That number gives us a useful benchmark in estimating an up-side price exposure. The 1980s also help us understand the market’s ability to adjust to such risks. Increases in production elsewhere, conservation and the Iraqi’s and Iranian’s ability to sustain production eventually convinced buyers that supply would continue. By 1988 prices had fallen below $15/B. Again, one asks, “Is there a problem?”
 Stated in inflation corrected dollars. The nominal price of the 1980 full-year average $117/B.
A one-time punch in the gut is likely.
The answer depends on one’s time horizon and risk tolerance. The time horizon issue is easy to see. Market do react strongly to stimuli; they over-react. Even during the politically mild oil years since 2000, average annual prices for crude have ranged from $24 to $117 per barrel. We see that despite the market’s ability to adjust quickly, in the short run bad things happen. Let’s use the $117 to quantify a U.S. trucking risk of such a short-run ‘bad thing”. $117/B crude is equivalent to $4.84/gallon diesel, assuming no adjustment of refiners’ margins. That’s a $25/mile increase in costs from now. Clearly this is a great time to make sure your fuel surcharges are properly constructed. It is also a good time to build cash reserves because rising oil prices strain cash. Pump prices rise before the fuel surcharges adjust.
There is lots of room for pessimism here.
The risk tolerance is harder to quantify because of the uncertainty involved and of the need to understand each firm’s situation. I write on this issue, however, to emphasize the very substantial upside to the current risk. The initial evaluations of the attacks of last weekend indicated that the cruise missiles involved attacked from the north on a route through Iraq and Kuwait. That route avoided the bulk of the air defense assets protecting Saudi Arabia, assets oriented towards the Persian Gulf and the direct routes from Iran. The facts seem clearly to refute the claims of responsibility by Houthi rebels in Yemen. The attacks came from the wrong direction and used assets of longer range than those possessed by the rebels. It seems likely that the weapons were launched in Iran, and almost certain that they were supplied by the Iranians. If true, we have a blatant act of war between two actors that sit on 15MBD of oil and who control shipping access to another 3MBD. 21% of the globe’s oil exits through the straits of Hormuz. If oil prices jumped to $365/B in response to the Iran/Iraq war, what could they do in response to an Iran/Saudi war? A jump to “just” $200/b equates to $7.18/gallon diesel. That’s $.58/mile above today’s fuel cost. Of course, a threat to 21% of global supply, even for a short while, raises costs of supply adequacy, something all the more critical given the impending pressure on distillate supplies from the maritime move away from high-sulfur bunker fuels. This is a great time to be building diesel reserves. History also tells us that the biggest threat to fuel availability is simply a simultaneous move by consumers to top off their tanks. We see this before snowstorms and hurricanes. Were diesel users to top off nationally, there would be a one-time 66% increase in demand – a lot of trucks without fuel or waiting in long lines at the pump. Think about it. At peak times trucks already wait for a spot at the pumps.
A worst-case scenario.
It is highly likely, should proof arise of a definite Iranian connection, that the U.S. will be involved in any military response. It is certain that Iran and a host of its jihadi allies will assume an American involvement. If, even the Yemeni Houthi rebels have short-range cruise missiles, what is to prevent someone from launching such missiles at U.S. production facilities, most of which are close to saltwater. I bring this up to emphasize the fragility of American insulation from the violence of its global war fighting commitments. If we can control drones strikes in Afghanistan from an office in Virginia, cannot our opponents do something similar? Launch a cruise missile from a boat in the Gulf of Mexico. I spin these scenarios to emphasize the vulnerable interconnectedness of the global energy economy. Should full-scale warfare breakout at the center of that economy, spillover to other production units is likely.
Let’s sum up the situation.
We have in the Persian Gulf the biggest threat to global economic stability since the banking crisis of 2008. It is time for all us to be reading, watching, and listening to the media on this issue. The certain results will be increased volatility of fuel prices, with the possibility of annoying lines at the pump. We also know that the system has impressive adaptability which will relatively quickly offset the most likely threats. There is no need to head for the bunkers yet. You just need to make sure yours is full of provisions. Finally, this issue has frightening possibilities that could push events beyond the boundaries of easy fixes: big jumps in fuel prices, actual, if only temporary, shortages of fuels.
What to do?
- Get informed and make plans
- Top off your tanks now, before possible panic buying.
- Review your fuel surcharge formulas.
- Build up cash reserves.
- Review fuel economy savers (speeds, idling, park your old equipment)
- Decide what lanes to serve in the event of real shortages.
Maybe the indirect effects will be bigger.
This threat comes at a touchy time in global economics. My long-publicized prediction of recession will come true if crude oil price move over $100/B. Out of work Americans waiting in long fueling lines will be looking for someone to blame. History says they will find a scapegoat (deserved or not) in the incumbent president – in an election year. A change in leadership in the midst of crisis would make big changes in policy likely. People remember the shift from Carter to Reagan much more than the recession of 1980 that eased Mr. Reagan’s arrival to the White House. In that highly political vein, consider the question of global rivalries, especially that of the U.S. and China. One would hope that China, a major oil consumer, would side with the Saudis against Iranian “aggression”. Alternatively, would they blame the tensions on President Trump’s aggressive policy against Iran, setting up a much larger conflict than one between two mid-sized oil powers? One hopes for cool heads. Donald Trump’s legacy may well turn on his handling of this challenging situation. The low-risk option would be to step back from the brink, hoping to avoid recession. But this President is a high-risk player who may feel that an aggressive use of American power will reverse the current polls that suggest a 2020 defeat.