The Oil Price "Mystery"
Why high oil prices are a mythical red dragon - and what to focus on instead
Oil’s “oversupply” myth together with the Memorandum of Understanding has exploded violently, with bombing campaigns and drone attacks returning to levels not seen since March-April this year. The Battle of Hormuz has begun with both parties now claiming an exclusive right to control traffic in the crucial waterway. Several tankers were hit and transits through the Strait have fallen to single digits. The US Navy has reinstated its blockade of Iranian ports—with a transit fee of 20% floated briefly by the president—and Iran did the same by closing the strait again. And yet oil prices barely budged, set to gain only 12% over the week. A mystery? Hardly. A complete model collapse? All the more so.
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What supply glut?
Oil market analysts shake their heads in disbelief: why oil prices haven’t shoot through the roof yet? What is this tepid market response? The SPR is largely gone, the “gush” of oil released from the Gulf during the short lived MOU has been absorbed… ‘Prices should be up in the stratosphere! C’mon, what’s wrong with you, WTI?!’ [Sigh.] I’m not a market expert. I don’t trade oil futures. I’m just a supply chain guy, concerned with raw material availability, logistics and manufacturing plant outputs. And what I see here is not a “mystery” but a massive throughput problem, made worse by a lack of buyers on all markets. Allow me to explain.
Let’s start with throughput: according to the IEA “nearly 3 million barrels per day of refining capacity in the [Middle East] region has been shut due to attacks and a lack of viable export outlets. Refiners outside the region are also curtailing refinery runs due to concerns over feedstock availability.” As per commodity intelligence and data analytics company Kpler’s director of commodity research Matt Smith, refineries globally have already cut back production by 9 million barrels a day. That is more than ten percent of global capacity. Think about that for a minute. China’s refinery runs also crashed to pandemic lows as crude imports collapsed by more than 40% in June from a year earlier, to just 7.1 million bpd—at least according to official Chinese customs data. (S&P Global puts imports to 4.9 million bpd, as of July 5.)
Nobody buys crude oil, except refineries and storage facilities. You don’t fill West Texas Intermediate into your car’s tank, neither jets fly on Brent. All our equipment require refined fuel. And if refineries cannot buy enough crude oil to run continuously, they’re forced to shut down one distillation column after another, till supply and demand balances out or shipments normalize again. Restarting operations in these hugely complex installations is neither fast nor cost free, and thus won’t be done till traffic through the strait finally normalizes. And an unstable MOU, with long stranded tankers escaping the Gulf, was seen as anything but long term normalization.
On top of that, shippers were also reluctant to return to the Persian Gulf, quite understandably. Finding yourself being locked up in a warm bathtub onboard a multi-million dollar asset is not only hugely problematic, but also highly unprofitable, to say the least. These vessels earn money by moving goods from one place to another. Every day they have to spend idling costs a lot of money and means losing hundreds of thousands in revenues. This is especially true if the ship is being hit with a missile: while insurance pays for the damage, it doesn’t pay for lost lives, nor the lost revenue during the time of repair (or worse: incomes lost for the remainder of a ship’s useful lifetime if it ends up at the bottom of the sea).
I guess you see the point: refineries are reluctant to restart, while shippers are unwilling (and now unadvised) to risk a passage through the strait. Actual, physical demand for crude (unrefined) oil has thus remains extremely low—a temporary release of oil during the MOU notwithstanding. And according to the iron law of supply and demand: if there are no buyers, prices fall—not rise. What’s more, buyers of “paper oil” (traded on the stock market in the form of futures contracts with deliveries one, two, three months out into the future) have also disappeared. After learning the hard lesson that you cannot compete with insiders investors quietly opted out, and even though oil seemed too cheap to be true a weak ago, barely anyone bought it. Hence the tepid price action so far. (That can change anytime, for example, if panic sets in… Again, take none of this as a trading or investment advise—this information is for educational, thought provoking purposes only.)
A quick glance at the Light Crude Oil Futures Curve from Trading View explains the situation much better than a thousand words could. Simply put, what you see is a row of average contract prices with deliveries scheduled to happen in July, August, September etc. up until 2037. (Yes, apparently, you can buy a contract with a 2037 delivery date on it.) The shape of this curve, with a hyperbolic downward trend, depicts a market which expects a steady erosion in prices; favoring immediate consumption and inventory draw downs, as opposed to putting oil into storage now, then having to sell later at a discount. One more reason why everyone is reluctant to buy oil now… (Except for the Chinese who bought some 26 million barrels of crude with July / August delivery. As to whether these deliveries will actually arrive I have my doubts… But we shall see.)
As to why the rest of the world haven’t rushed in and bought up more oil while the strait was open and prices were low the answer lies in a simple cost benefit calculation. You see, in order to make a profit on storing oil, one has to buy low and sell high later.1 As of Friday, July 17th, the September contract stood at $84.81 per barrel—some $6.26 higher than contracts sold for delivery in March, 2027. Now, with all that market speculation and insider trading going on, how high is the risk that storage facilities end up buying high (even at relatively suppressed prices) and being forced to sell low? I guess you see the point: unless mandated by law (and seeing a guarantee to be compensated for losses later) no one will rush in and buy oil.
The real issue
The real issue is not the price of crude oil. Remember: the economy runs on refined products: gasoline, diesel, jet fuel etc. The cash (wholesale) price for ultra low sulfur diesel fuel, powering everything from goods transportation, agriculture, mining, construction and acting as a back up fuel for electricity generation2, has returned to $4 per gallon, or $168 per barrel. How does that compare to a ~$80 oil price?
The price difference (the so called crack spread) between crude oil and refined diesel fuel has reached absolutely epic proportions. It is yet another confirmation of refining capacity being extremely short, driven by a lack of oil, unreliable deliveries, and historic refinery shut ins. It is not oil at $150 which will kill the economy—that is a mythical red dragon “economists” scare their audience with—but record high fuel prices. Citing the cost of crude oil is thus a total misdirection.
Making matters worse, much worse—and fitting neatly into this little story we are uncovering here—are the recent and highly successful Ukrainian drone strikes on Russian refineries and shipping on the Sea of Azov and the Black Sea. Russian diesel exports were already down by 683,000 barrels a day but now they have completely collapsed to zero from 800,000 barrels a day before the war, forcing Russia to import fuel. Needless to say this comes on top of Persian Gulf diesel exports falling by more than 520,000 barrels compared to last year—a deficit which is also supposed to increase due to renewed Hormuz hostilities. And while usually the US Gulf is the main producer to fill such gaps, refineries there are already running at full bore, at 96% utilization. This would make India the world’s refining swing producer but New Delhi has recently doubled export duties on diesel and jet fuel as the government wants more of those barrels available at home before they leave for overseas buyers. This is how the world enters a major diesel fuel crunch—potentially leading to a historic economic downturn—even as oil prices stay comfortably below $100 a barrel.
The saving grace which wasn’t
In order to soften the blow from the Hormuz closure, back in March the US authorized the release of 172 million barrels of oil from the Strategic Petroleum Reserve over a period of about 120 days, as part of the International Energy Agency’s agreement to release 400 million barrels of oil from its members’ emergency reserves. According to a government report, however, US SPR stockpiles have reached precariously low levels and have been hit by major equipment failures, leaks and spills. Although we are still some way off the inventory minimum of 250 million barrels—recommended by sizing studies done in the 1970’s—daily withdrawal rates are already showing a rapidly worsening trend even at a level of 316.5 million barrels. The average rate of draw-down has fallen from a daily ~1.3 million barrels in mid June to a mere 0.43 million barrels as of the week ended July 10. If this trend continues, according to my estimates, the rate of withdrawals could fall to zero by early August, making the lifting of the remaining 72-73 million barrels highly unlikely.
Out of the nearly 100 million barrels released from the strategic reserve since late March roughly 60 million barrels were sour medium heavy crude, with high diesel yields, with the rest being light sweet crude (mostly exported abroad). This means that at May-June draw down rates (at 1 million barrels a day) the release contributed only 0.6 million barrels to the ~17 mbd inputs delivered to US refineries. Should the SPR go completely kaput in August, or were flows reduced to a mere trickle, the US would have to “source” this additional 0.6 million barrels of medium heavy crude only3 to fulfill demand—but as you will see later, America has plenty of levers to pull should push come to shove. What won’t change, however, is the pricing of refined products, as we are talking about a strictly limited global supply of medium heavy crude and refined fuels. Pushing and pulling barrels around the globe won’t replace 14 million barrels of lost production from the Middle East.
Model Collapse
The rise in diesel prices—let alone a potential scarcity of fuel in some parts of the world—also means that farmers’ costs could rise ahead of the Southern Hemisphere’s planting season and the Northern Hemisphere’s harvest, with Brazilian and US Midwestern farmers competing for the same supplies. In other words: this means not only food price inflation, but shortages as well—especially with the El Nino getting stronger and stronger by the day. This is the risk the United States establishment runs by starting, funding and fueling a number of wars around the world based on oil prices and stock market indexes: a complete model collapse. As Charles Hugh Smith summarized the issue when talking about AI:
“Our confidence that our conceptual mythologies are accurately mapping the real world is itself a source of civilizational risk because this confidence makes it inevitable that we do more of what’s failing, as the alternative—recognizing our conceptual models and mythologies are self-serving rationalizations that substitute artifice for realistic appraisals—is conceptually and emotionally impossible.”
What Charles wrote about AI is fundamentally true to all our human systems, especially to energy markets and the price of oil: crude prices have become anything but an accurate mapping of the real world. Thinking that demand could not possibly destroyed by $80 oil was probably right a year ago, but dangerously wrong in a world stripped of refining capacity and where multiple wars are being waged over energy. Basing economic, let alone military decisions on what to do next based on crude prices alone has thus become not only a bad idea, but an outright civilizational risk.
‘But, but, but… alternative routes will be found!’ Well, pipelines transporting oil out of the Middle East will take years to build—not to mention the fact that the capacity of currently planned projects and pipelines under construction / expansion seems wholly inadequate to replace shipping oil through the strait. And just as a reminder: current pipeline diversions (~7.5 million barrels a day in total) through Yanbu (Red Sea) and Fujairah (Gulf of Oman, beyond the Strait) have not started from zero, either. These alternative routes already carried 3.5 million barrels before the war, thus they now provide us with a 4 million barrels of relief… This is why Middle East loadings in April-June were ~14 million barrels a day below February levels, not because a lack of creativity. This is not a hole you plug with a 300,000 barrel Iraq-Syria oil pipeline backed by the US, or by doubling the capacity of the conduit to Fujairah… Especially not when you consider that pipes together with export terminals on their other end (and the ships going there) can be blown up by ballistic missiles whenever Iran sees fit.4
And if that weren’t enough, a newly proposed US sanctions bill authorizes tariffs of up to 100 percent targeting the top five purchasers of Russian oil and natural gas, including China and India. Russia’s shadow fleet tankers are also affected by the bill (and previous sanctions) and are thus now accumulating near Egypt’s Mediterranean coast and Indonesia’s Riau Islands, as international buyers increasingly refuse to touch sanctioned cargo due to secondary penalties. Nearly 135 million barrels of Russian crude oil are currently stranded at sea as a result. The decision who gets (and how much) of this huge buffer of oil at sea is thus entirely at the sole discretion of the sitting US president: granting waivers for nations behaving well, and slapping sanctions up to a 100 percent on those who are less “cooperative.” (India, with one of the largest refining capacity in the world is an obvious target.)
Finally, allow me to close with a quote from a fellow Substack writer on US strategy:
“The message is this: we may not be able to conquer Iran. We may not be able to bomb it into submission. But through continual bombing, sanctions, acts of terrorism, and covert action, we can create an atmosphere of permanent instability.
We can permanently damage your economy. We can hit any attempt at further economic development. We can choke off your trade with China. We can make daily life grinding, precarious, unpredictable.
And by creating this atmosphere of permanent instability and economic stagnation, we hope to break the relative unity of the Iranian masses. We hope to secure defections from the government’s side. We hope to cultivate a faction within Iran that will see compromise with the US as the only way out, as the only way forward.”
I guess this is what awaits us all outside the US, under the guise of “energy dominance:” more coercion, tariffs, and a closure of the oil tap whenever the sitting US president sees fit—whoever he may be.
Until next time,
B
Thank you for reading The Honest Sorcerer. If you value this article or any others please share and consider a subscription, or perhaps buying a virtual coffee. At the same time allow me to express my eternal gratitude to those who already support my work — without you this site could not exist.
The same goes to the SPR from where barrels are loaned as to opposed being sold: oil companies are incentivized to postpone refilling to a point where prices are the lowest. And if the futures curve suggests that prices could get lower still, then refilling those caverns will have to wait… Perhaps indefinitely.
AI data centers (too) use diesel backup generators, which have to be turned on from time to time to prevent fouling of the fuel, the breakdown of sealings in the engine, and to provide power during peak demand hours. And then there are lubricants, also made from medium heavy oil, which are actually in short supply. This is especially important for gas turbines in which oil has to be changed regularly to ensure smooth operation and 24/7 electricity.
Even if those 0.6 million barrels of medium heavy crude drawn from the SPR could be turned into diesel fuel at a world class 35% rate, we are still talking 0.2 million barrels of truck fuel a day or 5% of all diesel supplied to the US market. The end to SPR draw downs is thus not an existential question, but more of a question of pricing… Who will be left having to use their trucks less? FYI: while distillate stocks are down somewhat, they still sit at a comfortably high level—those who are waiting for the US market to collapse will have to wait a little longer.
Iran warned that in direct response to the US naval blockade on Iranian oil and gas exports, “other export routes for oil and gas which serve the interests of America and its allies” will also be closed, including the UAE Fujairah pipeline and Saudi East-West pipeline, then added: “oil and gas exports from the region: either for everyone or for no one.” As a sign of things to come the Omani route shuttle service—a key exit conduit for crude cargoes during the Hormuz crisis—has been also shut after Iran attacked three VLCCs involved in shuttling, two on Monday and one on July 7. Meanwhile, on the other side of the Arabian peninsula the Saudis have restarted (then stopped) their attacks on Yemen, and the Houthis responded by threatening a tanker with speedboats and floated the idea of closing the Saudi’s main outlet to the world market (the Bab el-Mandeb strait between Arabian peninsula and Africa). Further attacks on both outlets for Gulf oil (Fujairah and Yanbu) cannot be excluded.
This is the best energy piece published on Substack this week and the framing should end the crude-price conversation permanently. Crude at $80 while diesel sits at $168 per barrel means the number everyone is watching is the wrong number. The economy runs on refined products, not on crude. A farmer doesn't fill WTI into a combine harvester. $80 oil with $59 crack spreads is functionally $140 energy for anyone who actually uses it.
The SPR drawdown rate collapsing from 1.3 million barrels per day to 0.43 million is the data point that should be leading every energy story and isn't. If your estimate on the trajectory is right and withdrawals hit zero by early August, the last buffer disapp
I feel you're drifted from your original assessments from last year. You pointed out that the gross oil production has less energy return on investment (oil burned to extract/process). In short, net productive oil is in decline. Do you still believe that? Did you ever believe it? I do.
If that's true, that the humanity has crossed over into the depletion side of the curve (from growth), then oil does matter the most. What we're seeing in fuels is moving the furniture around--which you pointed out.
Prices are affected by the currencies they're bought/sold in. The U.S. have many financial/legal levers to affect the net prices paid by itself and friends--which you also alluded to.
If I had to boil the Ukraine war down to one economic question it's this. Russia wants Europe to pay more for its oil/gas. It's not all economic of course. It's manifests itself in Russian elite psychology blah blah.
Interesting how quickly the U.S. lightened sanctions on Russian oil when it wanted to buy time to deal with its total failure in subduing Iran.
Now the U.S. is at it with Iran over how much China has to pay for oil, or in what currency China must do it (which we can control).
It's all the same war. A war over a depleting resources or one that can't meet expectations. Rationalizing about what's good for civilization doesn't enter any discussion anywhere. It didn't during WW1 and 2 and it isn't today.
My 2-cents is China is "cleaning the clocks" of the West. Of course, it will do something stupid too, but for now, it filled its reserves with cheap oil and now watches the militaries of the West expend their military assets on missions of arrogance and hubris (inc Russia).
I agree, the price of oil is the wrong thing to look at. It's all about who controls its supply and that complicated.