Now that Iran and the United States have reached a memorandum of understanding to end direct hostilities, especially in the contested Strait of Hormuz, the big question is how quickly inflated oil prices will come down.
Benchmark crude prices were still trending lower on Monday on news of the agreement, with Brent contracts for August trading at $83 a barrel. That’s still a lot higher than benchmark crude was before the war but far less than the triple-digit prices reached during peak moments of the conflict.
Announcing the deal late on Sunday, U.S. President Donald Trump wrote on social media: “Ships of the World, start your engines. Let the oil flow!” He later amended that to note: “With the opening of the Strait upon the signing of the Deal on Friday, for purposes of mine removal, oil will flow on both ends again for the Region, and the World!”
One complication is that the exact terms of the MOU are not entirely clear and won’t be until its publication sometime this week. Reports suggest that Iran will allow unhampered and toll-free traffic through the strait during the 60-day follow-on negotiations but may seek to charge fees for traffic after that. But Trump has also threatened to renew hostilities and the U.S. blockade if Iran proves recalcitrant, so there remains uncertainty over exactly how open the strait will be and how soon.
But many of the same factors that drove up prices in recent months are likely to persist to some degree for months to come, oil analysts said. That means oil production, oil flows, and oil inventories, which have been badly depleted during the more than three months of economic upheaval.
Start with production. The issue is less about physical damage to Persian Gulf oil production facilities (natural gas plants are a different matter) than about the fact that many big producers, including Iraq and Kuwait, had to throttle back output because they had no tankers to cart away their accumulating tanks of crude. Estimates vary, but most analysts figure between 11 million and 13 million barrels a day of oil production was taken offline during the conflict.
Much of that can snap back relatively quickly. But the last bit of recovery is tricky, as a Kuwaiti oil official told a conference hosted by the Atlantic Council in Washington last week. Nawaf al-Sabah, the CEO of Kuwait’s state-owned oil corporation, warned that as many as 4 million barrels a day of the total Gulf oil and petroleum product output of 20 million barrels a day could be sidelined for months yet. Some of that shortfall has been and will continue to be made up by increased oil production, especially in the United States, Guyana, and Brazil.
But that adds up to nowhere near the supply glut that was facing the global oil market at the end of last year. As ClearView Energy Partners, an energy consultancy, said in a research note on Sunday, “a positive supply-demand balance might not arrive” before the later part of the year.
The other big hurdle to normal oil markets is to load the oil tankers that remain trapped, get empty tankers back to the Gulf from the far corners of the world, and get them both moving with confidence through what was until this weekend a war zone.
“Sailing through the strait will remain riskier and more costly than before the war,” Oxford Economics said in a research note on Monday. “As a result, physical flows are still likely to recover gradually rather than immediately, even if prices respond more quickly to signs that a credible reopening deal is in place.”
As U.S. Energy Secretary Chris Wright said at that same energy conference last week, “I think it’s many months to get back to normal flows of energy.”
News of the U.S.-Iran agreement is unlikely to immediately change the calculus of shipowners, seafarers, and maritime insurers. First, everybody in charge of a ship has to be sure that the strait is clear of mines. Then the tankers inside have to be unfouled (all sorts of things can grow on the hulls and propellers of idle ships after three months), and the stray sheep have to be gathered back to the flock. Then they have to load and take their cargo to distant markets.
“[A]lready depleted global petroleum inventories are likely to draw further pending mine removal, facility restarts, and unladen tankers’ travel to the region,” ClearView said in its note. Oil prices have calmed down, but they are still $20 a barrel higher than last year—and those futures prices are for deliveries at the end of the summer, not right now. “That could suggest traders think a return to status quo ante market balances and stock levels might still be months to years away.”
And then there are the drawdowns. One big shock absorber during the last three months was the historic release by some countries of strategic oil reserves (both government and commercial stocks). The run on the tanks may ease up in July now that the framework for peace is in place, but the damage has been done. According to the U.S. Energy Information Administration (EIA), oil inventories in OECD countries are already at their lowest level in more than 20 years.
“Because of the size of the drawdown in global inventories, we forecast that oil prices will remain elevated until global oil flows return to normal levels and oil inventories are replenished,” the EIA said in its June short-term energy outlook.
So unless there are several big surprises—producers bounce back quicker than expected, tankers return to the Gulf with no-worries nonchalance, and rapidly declining inventories don’t spook anyone—it is likely that oil prices will stay stubbornly high for a while yet. That certainly includes the 60-day period set aside for serious talks, including over the ostensible reason for the war in the first place, but it could be even longer.
A related question is why oil prices remained relatively restrained during the largest energy shock in history. While crude oil futures prices flirted with $120 a barrel at times, they never came close to the $150- or $200-a-barrel doomsday predictions.
The answers boil down to China, diversions, drawdowns, and jawbones.
China is the world’s largest oil importer, hoovering up about 11 million barrels a day in normal times. That fell to well under 8 million, and possibly as low as 6 million barrels, due to the crisis in the Gulf, where China gets most of its oil from. Beijing made up the difference by drawing on its ample stocks (China’s 1.4 billion or so barrels of oil reserves dwarf any other country) and by curtailing the export of refined products. China’s hunker-down defense was the demand destruction that helped keep oil prices from spiking.
Pipeline diversions were another big help. Saudi Arabia piped half its oil output across the desert to avoid Iran’s chokehold on the strait; the United Arab Emirates did something smaller but similar. That amounted to something like 7 million barrels a day that didn’t have to go through the Iran-controlled chokepoint.
At the same time, even though the United States gave up on escorting ships to force open the strait after a single day, it did help shepherd cargo ships and many tankers through a safer, non-Iranian route. The latest estimate by U.S. officials suggests that as many as 3 million barrels a day may have snuck out of the double-blockaded strait by flying almost literally under the radar. (Tankers turned off their transponders, like “shadow fleet” tankers going dark.)
The other thing that helped was the release of strategic oil reserves, though that was a double-edged sword. The United States and Japan, as well as Europe, together released as many as 2.5 million barrels a day from storage to ease shortages. The problem is that those reserves, especially in the United States, will need to be restocked. That means there will be months of extra buying to fill those back up, adding to the usual summertime global demand for oil.
Add up the 3 million barrels a day at least from China’s forbearance, 7 million from alternate pipelines, 3 million from shadow fleets, and 2.5 million from reserves, and you’re well on the way to making up the 20 million barrels a day of prewar traffic through the Gulf. Those are four reasons the physical market didn’t implode.
The reason the paper market—the oil futures where contracts for months ahead are traded every day in the world’s largest commodity market—didn’t explode is because Trump jawboned the market down every time prices got scary. Repeatedly, almost 40 times before this weekend’s apparent peace deal, Trump assured markets that the war was over, and oil traders believed him every time.
That play of words didn’t add any physical barrels to a tighter market, but it did keep markets from panicking and played a big psychological role in keeping the war’s costs, both political and economic, within manageable limits, until his jawboning caught up to reality.
This time, the assurances that the war is over (for now, at least) are coming not just from Trump but also from mediator Pakistan and Iran itself, so hopefully it will stick. If not, energy prices will.
