The economics of reopening a chokepoint that handles a fifth of the world’s oil and overseas gas supply may prove more difficult than market prices suggest.
Wester van Gaal
US vice president JD Vance exited his second day of negotiations with Iran sounding upbeat.
“The final deal is the house,” he told reporters on Monday (22 June). “We set the foundation. We haven’t built the house, but we’ve laid a successful foundation.”
Talks nearly failed on Sunday after US president Donald Trump threatened to bomb Iran and kidnap the negotiating team. But cooler minds prevailed, and the two sides now have a 60-day window to turn the interim agreement into a permanent deal.
There was good news on the energy front as well. According to US energy secretary Chris Wright, 67 commercial vessels had passed through the Strait of Hormuz in the last 24 hours, comparable to pre-war traffic levels.
Oil markets have already largely priced in the good news, with oil benchmark prices falling 20 percent (to $79 [€69]) since the US-Iran negotiations were first reported at the end of May.
But even if diplomacy succeeds, the economics of reopening a chokepoint that handles a fifth of the world’s oil and overseas gas supply may prove more difficult than market prices suggest.
“Much depends on how much oil is getting out in the next two months and there remains much uncertainty about that. Financial markets seem very optimistic about this,” Lutz Kilian told EUobserver in written answers.
Kilian is one of the world’s foremost experts on oil market shocks at the Federal Reserve Bank of Dallas. On Tuesday, the Dallas Fed will release a new working paper co-authored by Kilian, that looks at the many ways the global economy is affected by the Hormuz Crisis.
Sea mines and insurance
Giving me a sneak preview, he said that practical obstacles to restore supply are considerable.
Sea mines have to be cleared; insurers and shipowners persuaded to return and production sites — some destroyed or heavily damaged — will have to be brought back online.
His expectation is that supply disruptions will “drag on into the fourth quarter of this year easily, even in an optimistic scenario. And I can come up with many realistic scenarios that are much worse.”
One of his big concerns is inventories. The US Energy Information Administration expects oil stockpiles in advanced economies to fall to their lowest levels since 2003, even if shipping traffic resumes from now on.
According to Kilian, “we could run out of available inventories in July or August, before oil traffic is fully restored.” This would put further pressure on oil and fuel prices.
At that point, “the only remedy would be demand destruction,” he said, meaning the painful process by which high energy prices force consumers and businesses to (permanently) cut consumption.
This is decidedly not a situation currently priced in on futures markets. Kilian also cautioned that the current crisis is not just an oil-shock.
Fertiliser production, chemicals and aluminum supply chains, to name a few, are all heavily disrupted, with and ‘non-linear’ consequences on the global economy, yet still fall outside of the scope of existing economic modeling.
Markets may prove correct that diplomacy will avert the worst-case scenario. But betting on a quick return to normal as current benchmark prices suggest also appears overly optimistic.
