Ziemba Insights | State of the Strait: A Reprieve? But Far from a Lasting Agreement

As I write, we have entered another reprieve in the conflict with Iran, as President Trump suggested over the weekend that regional lobbying convinced him to start another round of diplomacy to try for a deal. More likely its low approval ratings, continued high refined fuel prices and other political pressure.

Market hope springs eternal. Crude oil prices sold off sharply, likely helped by light volumes in early hours of Asian trading, extending some easing from last week when a “pause” began after oil prices briefly topped $100. A pause is better than continued escalation and extension of conflict, but it’s far from clear that the perimeter of a deal or a deal to have a deal will be sustainable.

The issues with the MOU of almost two months ago remain. The challenge is that reaching a lasting long-term agreement or even a lasting short-term agreement is at least as hard as it was a few weeks/months ago. The political interest in de-escalation may be greater in the US than a few months ago as the midterms approach, but it could be harder for some others.

In some ways it may be harder than a few months ago – Iranian negotiators have even less trust that the US can or will lift sanctions allowing them not just to sell fuel but to choose how to spend those proceeds. And Iranian authorities too likely feel vindicated in their view that disruptions in the strait and associated fuel supply constraints will prompt a reaction from President Trump.

This increases the risk of an on-off conflict where economic stabilization is difficult. This is perhaps the second worst outcome for the region. The worst would be continued escalation which brings damage to energy and other critical infrastructure, makes both energy and non-energy trade and investment difficult and shifts demand for key energy products. But a recurrent risk of conflict and persistent risk premia that keeps trade dark and energy supplies from the region at a discount would be a near second. Investment activity and dealmaking locally has slowed, with projects that are going ahead linked to government investment and the longer the conflict or threat of it continues, the greater the reliance on local government pump priming.

Of course such an outcome would be bad globally, adding price pressure, encouraging hoarding and volatility and potentially extending the impact of some of the shortages on industry and agriculture through a longer season. The global economy may have been more resilient to shortages than some feared so far, not least because of Chinese demand swings, but persistent outages will

The perimeter of a deal or agreement to have a deal may well be ahead, but that would likely look like some of the elements of the MOU signed on 18 June. That assumed opening of the Strait, Iranian ability to sell fuel – and to spend the proceeds, unfreezing of assets. It also suggested some degree of Iranian oversight of the strait and some plans on a nuclear program. Will US and others be comfortable with a JCPOA-like agreement?

What’s different now than in mid-June?

• The more recent reignition brought more regional players into the conflict if through proxy conflicts, including Saudi strikes on Iranian-backed militias.
• It also put pressure on the bypass routes especially that of Saudi Arabia, which faced frictions in both its Hormuz pathways and those through the Red Sea, requiring it to use the Suez Canal and offer larger discounts.
• we were seeing other aspects of a broadening conflict including interlinkages between the conflict with Iran and Russia’s war with Ukraine. The concurrent damage to Russian refineries and additional sanctions on Russia mean that Russian trends reinforce the tightness of refined product exports, while sanctions on third country products coming from Russian crude are less available globally.

Global buffers of fuel continue to be low and couldn’t be refilled in the MOU period. Global oil markets continue to shrug off this low buffers and any demand from refilling reserves, assuming it will be gradual and offset by extensive production. But its hard to imagine the reckoning won’t eventually need to be paid, especially as some countries that lacked reserves will likely want stockpiles ahead. They may not want to pay for them and may look to regional support (Japan for some Asian trading partners, UAE and Saudi Arabia for their customers). But undeniably reserves and stockpiling will be different ahead.

I continue to watch the following signposts.

• Nature of any reopening of Hormuz – volume of vessels, oil and otherwise transiting the Strait of Hormuz and yes the Bab-el-Mandeb. What are the volumes, what are they carrying? Are they comfortable with their identifiers or are they continuing to travel dark?
• flows vs production. Will affected countries be able to scale up production not just drain inventories.
• Sanctions relief: Will the US end the blockade of Iranian vessels or followup with any further sanctions relief? Without the latter, its hard to see even a few weeks agreement. The lessons learned from the brief last MOU would keep sanctions averse buyers cautious. The last round of sanctions relief lasted only 16 days before relief was retracted. Will the US try to funnel Iranian funds into blocked accounts such as those Venezuela is chafing under? If so, its hard to see Iran being willing to sell.
• Multilateral agreements over Hormuz (and maybe the Red Sea). Has some sort of regional agreement approaching on Hormuz involving joint patrolling and environmental monitoring? A big issue with the last agreement was willful disagreement over the Hormuz reopening clauses with Iran expecting its military would be involved in communication even if no tolls were collected. The US instead steered vehicles towards Omani waters. Will the GCC live with some sort of shared ownership and fee structure? Will multilateral efforts at patrols in the Red Sea follow and reduce Houthi threats? Notably some of the most recent US sanctions targeted new Iranian insurance companies involved in implementing tolls and coordination. will relief of such sanctions be needed
• What will be the role of China? The swing in Chinese imports has helped alleviate the pressure on other countries, but its still not clear if the Chinese are drawing from their (large) strategic reserves or if there has been a larger real economy decline. How much of the import drop reflected the reduction of availability of cheap fuel and reluctance to sell on refined products. As with other countries, petrochemical demand did fall notably, but other transport and industrial demand including ethane held up more.
• Timeline of building alternate supply lines for oil, products, fertilizer and other goods.
• investment, dealmaking and fiscal response from GCC sovereigns, This will have implications for global investment flows. Areas of investment are shifting and government derisking is even more important.

What are you watching?

Overall, a de-escalation is better than continued tit-for-tat escalation and a conflict spreading across borders, but it’s far from clear that there will be a quick evolution towards a lasting deal. This risks a restart and will make it more difficult for producers to feel confident boosting production, transit passengers and tourists to return.

Compliments of Ziemba Insights – a member of the EACCNY