Paper Oil Blinks While Physical Supply Tightens

• Oil market volatility is easing as traders adjust to geopolitical headlines, though prices still spike on major developments like failed U.S.–Iran talks and the Hormuz blockade.
• Despite calmer futures trading, the physical oil market remains extremely tight, with up to 10 million bpd trapped and spot prices surging far above futures.
• Ongoing blockades and supply disruptions are prolonging the crisis, pushing energy prices higher and delaying any meaningful market normalization.

Extreme volatility in crude futures prices has eased in recent days, although the market reacted with an 8% jump early Monday to the news of failed U.S.-Iran talks and the beginning of a U.S. blockade of the Strait of Hormuz. 

Traders continue to react to any signal of how the worst-ever disruption energy market would unfold, but with uncertainty still very high, oil market participants bet on and try to predict movements.

The worst of the volatility may have passed, as investors and speculators appear to have exhausted their capacity to respond to the constantly shifting narratives of the Trump Administration, analysts say.

Past Peak Fear?

It appears that the oil market is gradually becoming used to the price swings in either direction that follow each post of U.S. President Donald Trump regarding Iran, the state of negotiations, or the navigability status of the Strait of Hormuz, the key oil chokepoint which handled about 20% of daily global oil and gas flows before the war.

Some say many of President Trump’s public posts are negotiation tactics and traders may have already moved from peak fear and peak panic and into calmer trade awaiting real outcomes.

“Markets have reached peak uncertainty,” Billy Leung, investment strategist at Global X ETFs, told CNBC earlier this week.

“The reaction function is no longer as extreme as before.”

These comments came hours after President Trump announced the U.S. Navy would blockade the Strait of Hormuz. The blockade has now begun.

But while it is part of whatever negotiating tactics the U.S. President is using, the U.S. blockade only exacerbates the real physical constraints to crude oil flows. These have already been severely hampered by the seven-week-long de facto closure of the world’s most important shipping lane for oil, gas, fuels, and fertilizer.

The blockade on top of the blockade and the Iranian threats that no port in the Persian Gulf would be safe if Iranian ports are blocked further push back the time when the Strait of Hormuz may reopen to free traffic and begin easing the increasingly tightening physical oil supply.

This would take months, even if the Strait of Hormuz opened to free traffic today.

As a result of the blocked traffic, global oil and fuel supply is shrinking and energy prices are soaring, including U.S. gasoline prices that are now more than $1 per gallon more expensive than seven weeks ago.

The U.S. blockade now poses a key question to analysts, policy makers, and war decision makers: “does a closed Strait hurt Iran faster than it hurts the global economy?” Erik Meyersson, Chief EM Strategist at SEB Bank wrote in a Monday note.

Moreover, the U.S. blockade raises the value of keeping the Iran-aligned Houthis in Yemen out of the war, Meyersson said.

The Houthis in the past two years have hit commercial vessels in the Bab el-Mandeb Strait – the only route for Saudi crude to bypass the Strait of Hormuz and for the Suez Canal to remain open to traffic.

So far in this war, they have kept a low profile and have not moved to impede vessel traffic off Yemen’s coast. But no one can predict with any certainty that the Houthis will stay out of the mess in the Middle East.

“Both the US and Iranian sides have once again signalled the extent of their respective entrenched positions,” Meyersson noted.

“As such, given the time constraints and likely ongoing military preparations on both sides, absent a diplomatic breakthrough, the road to continued warfare remains open.”

Geopolitics Vs. Supply Crunch

Oil futures traders are betting on how they believe the conflict would unfold, hoping for the best but wary of the worst. Still, they are a bit better prepared to handle all the conflicting signals they are being given by the hour.

Not prepared are the physical crude markets, where prices have soared to near all-time highs or record-highs, including compared to the 2008 price rally just before the financial crisis.

The sharp decline in crude futures last week was likely primarily driven by an overcrowded long position, rather than any meaningful easing in underlying fundamentals, which continue to point to a tightening physical market, Ole Hansen, Head of Commodity Strategy at Saxo Bank, said on Monday.

Crude futures were trading slightly lower than $100 per barrel as of Tuesday morning. But the price of physical crude for immediate delivery has soared amid the supply constraints and is about $40 per barrel more expensive than the futures.

Brent futures may have sunk below $100 per barrel, but constraints are intensifying amid the supply shock, with the physical price of a key North Sea blend, Forties, surging last week to a record high of as much as $147 per barrel.

The surge in physical crude prices reflects the massive supply shock, with about 10 million barrels per day (bpd) of crude trapped in the Strait of Hormuz and unable to go to refiners.

The huge $50 a barrel premium of the physical crude over the futures prices signals that the real oil supply shock is enormous, even if the sentiment on the futures market is tentatively hopeful that there is still a way to resolve the Middle East crisis soon.

Related: Trump Signals High Gas Prices Through November Midterms

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