Oil and financial markets’ default assumption seems to be that the Strait of Hormuz will reopen to traffic soon. Yet, that is not the status quo. If there is no major action from one of the concerned parties, the near-total strangulation of the waterway continues.
Commentators focus mostly on crude oil, its dwindling stocks, and the alleged “disconnect” between the moderate paper prices for futures contracts and the much higher prices for prompt purchases of physical crude. But what really matters for the economy are end-prices to consumers.
In normal times, about three million barrels a day of refined products and 1.5 million bpd of liquefied petroleum gas (LPG) were exported through the strait. Unlike for the bypass pipelines that are used to export crude through Fujairah in the UAE and the Saudi Red Sea, there are no such diversions for products. Maybe smaller amounts can go by lorry or rail, and some from refineries along the Saudi west coast.
Middle Eastern refining capacity has also been physically damaged by Iranian attacks, and some plants might take months to repair.
The aspects of the crisis interact. The cut in LNG exports because of Iran’s strikes against Qatar may force consumers to turn to heavy fuel oil, LPG or diesel for electricity generation and industrial boilers. The loss of methanol and products such as polyethylene creates further competition for alternative petrochemical feedstocks.
Other factors may tighten the market. Ukrainian attacks on Russian processing plants and terminals are likely to continue, particularly as Kyiv seeks to limit Moscow' windfall from higher prices.
There have been several accidental explosions and fires at refineries elsewhere in recent weeks, such as the Geelong refinery near Melbourne, one of Australia’s only two, and Valero’s Port Arthur refinery in Texas. As plants are run harder and longer, the risk of breakdowns from lack of maintenance grows.
In recent analysis, investment bank JP Morgan correctly diagnosed the huge deficit in crude oil supply – but admitted that we have only a very hazy idea of the size of the world’s refined product inventories.
Geography matters – large imbalances could cause local shortages that cannot be fixed quickly. China, Russia, Kazakhstan and Thailand have already banned exports of some products, while India has introduced a tax on exports of aviation fuel and diesel. If restrictions spread, nations with insufficient domestic refining capacity could run short even if global supplies are adequate.
Stress in refined fuels might appear in any and all of the five main demand segments: jet kerosene for planes, heavy fuel oil for ships and industries, petrol and diesel for ground vehicles, and LPG and naphtha for petrochemicals.
Aviation fuel is the most exposed. It is generally not stored in large quantities because it requires special logistics and degrades over time.
South Korea, which has no oil production of its own, is the world’s biggest exporter of jet fuel because of its advanced refineries. Seoul has already capped exports of aviation kerosene, petrol and diesel, and banned shipments of the petrochemical feedstock naphtha entirely for five months. The UK, Australia, New Zealand, Vietnam and even California all look at risk. Some airlines, such as Lufthansa, have begun cutting unprofitable flights.
Worldwide, jet fuel supplies on their way to customers averaged just over 30 million barrels since 2017 and were never less than 20 million; now just 15 million barrels remain. While Brent crude futures are currently about $105 a barrel, US petrol futures are at $146 and diesel is $166 a barrel. Meanwhile, jet fuel sells for nearly $200. Fuel accounts for a quarter to a third of an airline’s operating costs in normal times, a share which will nearly double.
Airlines use the futures market to protect against unexpected rises in fuel prices, but because jet futures are illiquid, they often hedge against crude oil instead. In normal times, the two are closely related. Now, the divergence ruins this hedging strategy and will leave some carriers facing heavy losses.
Jet fuel and diesel are chemically similar; refineries can switch between making more of one or the other. But that does not help when both are in short supply. The typical medium-gravity Middle East crudes that are now cut off produce high yields of kerosene and diesel.
The diesel market was already tight even before the war erupted. Hauliers, farmers and miners rely heavily on it, and Ireland was swept by protests against high fuel prices earlier this month. Agriculture faces twin pressures, battered also by impending fertiliser shortages.
Lower-income countries, unable to pay up or to offer subsidies, will be particularly affected. East Africa has very little oil production of its own, and almost no operating refineries. It relies heavily on fuel imports from the Middle East. Diesel shortages could badly dent its important mining industry.
Petrol, whose price is even more politically sensitive, has been less affected so far, and prewar global stocks were higher. US exports of refined fuels have jumped as the rest of the world clamours for supply; that will pump up prices for American motorists. As summer approaches, holidaymakers will face an uncomfortable choice between paying more to fly, or drive - or staying at home.
Finally, the cost of petrochemical and oil derivatives – plastics, artificial fibres, paints, lubricants, road bitumen and many others – will also rise.
The turmoil in the refined product market will play out in different ways. Sharp price rises may ration demand. But the required reductions are similar to, perhaps even greater than, those of the Covid era. What price is high enough to force people to stop flying and to sit at home - $200 a barrel?
Logistical problems or government price caps may cause outright shortages in some places. As in Ireland, the authorities will face discontent. But if they placate it with subsidies or cutting fuel taxes, that just postpones the necessary adjustment and forces it on to others, probably poorer or politically weaker consumers.
There are no quick or easy answers to the refining crisis. Its effects will linger even after normal crude oil production is restored. For now, governments and companies can only plan, avoid panic, and try not to worsen the crisis with meddling.
