The end of the beginning - the state of global energy markets after ten weeks of war

Discussion of the impact of the conflict in the Persian Gulf on the international energy market is clouded by the fog of war; by uncertainty about the intentions of President Trump and the new Iranian leadership  and by the reluctance of many Governments to admit the scale of the challenge .  This is therefore a good moment to lay out a fact based summary which will help readers to draw their own conclusions about the consequences of what has happened since February 28th.

1.        In normal times around 100 to 140 vessels including 50 to 55 tankers carrying oil, liquefied Natural Gas, fertilisers, petrochemical feedstocks and refined oil products passed through the Straits of Hormuz each day.  Since early March that flow has reduced to a trickle.  One recent estimate suggests that some 1900 to 2,000 vessels including between 100 and 200 tankers  are stranded in the Gulf.

Because of the journey times involved the last of the tankers and other ships which passed through the Straits before the war began have only recently arrived at their destinations in Asia and Europe.  Following their arrival the flow of supplies has now dried up.  This means that we are now at the end of the beginning and that economies around the world are starting to feel the impact not just of the fears and speculation reflected in rising prices but also of physical shortages.

 1.        The problems we now face are not simply the result of the closure of the Straits.  The Iranian response to the attack by the US and Israel has amplified the impact of the closure by targeting energy related infrastructure located in areas around the Gulf.  These attacks have continued since the nominal ceasefire came into effect on April 7th/8th causing damage to facilities such as the petrochemical plant at Ruwais, the Habshan and Shah gas plants in Abu Dhabi and the alternative transit routes - the East West pipeline in Saudi Arabia and the port of Salalah in Oman. The overall extent of the damage done is unclear but in some cases is obviously substantial.  At least eight significant Gulf refineries are fully or partially out of action.  So is the Ras Laffen LNG facility in Qatar.  The Qatari Government has said that that reconstruction of the facility could take 3 to 5 years.  Repairs to the refineries, which are complex modern industrial plants, is likely to take many months at the very least.  Facilities in Iran, including the refinery at Laban Island, have also been hit but there is no clear evidence of the extent of the damage they have suffered.

2.        In contrast to the energy crises of the 1970s the shortages now developing are not focused on crude oil but on oil products which are created through the refining process.  An excellent detailed explanation of this is available in the Substack  Crack the Market.   (https://crackthemarket.substack.com/ )Those managing the crisis or wanting to understand the challenges of the next few months should read that analysis. 

3.        The main shortages which are now evident are in products such as jet fuel and diesel.  Before the war Europe imported 60 per cent of its jet fuel needs from the Gulf region.  The UK was overwhelmingly reliant on jet fuel supplies from the region.  The refineries of the  Gulf states in Saudi Arabia, the UAE and Kuwait also supplied a large proportion of Europe’s requirement for diesel - the main source of fuel for freight lorries and other key transport uses including crucial links in the extended food supply  chain. The shortage of jet fuel and diesel is global and the intense competition for supplies is pushing up prices which are rapidly passing through the chain to the end consumer.

 4.        The impact of what had happened so far has been softened over the last two months by the drawdown of stocks – in total worldwide amounting to some 400- 500 million barrels - but stocks can only be drawn down once and will need to be rebuilt (if supplies are available) over coming months  – an issue which suggests that the optimistic forward price curve which currently forecasts a fall in prices to around $ 80 by this time next year is over optimistic.

5.        The normal response to disruptions in any market is a search for alternative sources of supply.  In this crisis, however, the availability of substitutes is limited.

The only available alternative export routes for oil from the Gulf are the East West line across Saudi Arabia from Abqiaq to Yanbu on the Red Sea coast and a small pipeline running across Oman from Nahdah to the storage and export terminal at Raz Marqaz on the Arabian coast.  In both cases the scope for increasing capacity is limited. There is no alternative export route for  Natural Gas. Most of the world’s spare capacity in oil production is concentrated in the Gulf States – that is behind the barrier of the Straits and therefore unavailable. Some other producers around the world have increased production by modest amounts.  Canada has promised to increase oil production by 140,000 barrels per day;  Khazahstan by 100,000 – much of which was already planned before the war began.  The largest immediate increases in supply of both oil and natural gas have come from the United States but recent reports say that there are infrastructure limits to the amounts,  particularly of shale gas, which can be produced and exported.   Beyond the Gulf the largest volumes of additional resources are in Russia – but the scope for adding to the current level of supply is limited both by sanctions and by the lack of development over recent years.  At best, and with all sanctions removed, Russia could not provide more than a few hundred thousand extra barrels per day. The NordStream 2 gas line across the Baltic to Germany is still unrepaired after the explosions of September 2022.  The line which in theory could provide some 55 bcm of gas is reported to be partially intact but has yet to certified or permitted to operate.

6.        There is also a shortage of the refining capacity necessary to replace what has been damaged or destroyed.  Over recent years refinery capacity in Europe has declined with many ageing facilities dating back over the last century closed.  By contrast the Gulf states have built a series of large scale world class refineries over the last 15 years.  In addition to the loss of output from the Gulf refineries, the wider problem is being driven by  the mismatch between the existing configuration of the remaining refining capacity in Europe and the mix of products now required.  For instance there is very little readily available capacity capable of producing the volumes of jet fuel which have been lost .  The result has been the development of exceptional pricing for cargoes travelling long distance – for instance from the US to Asia where the jet fuel shortage is for the moment most evident.  The problems in the product markets have been compounded by the decisions of China and India to restrict exports of scarce products from major refineries such as the  Jamnagar complex in India in order to protect domestic supplies.

7.        The shortages being caused by the conflict in the Gulf are not limited to the energy sector.  The Gulf was also the main source of 70 to 80 per cent of Asia’s supply of naphtha for the petrochemical sector.  Major chemical processors in Indonesia, Singapore and Korea have been forced to declare force majeure and to halt production.  Japan has also suffered a break in supplies of methanol from Saudi Arabia while the Zhejiang joint venture between Saudi and China has had to close part of its operations. These closures have a knock on effect across the world because of the importance of petrochemical products throughout the economy. Plastics, packaging, textiles, vehicle production, electronics and pharmaceuticals have all become dependent over recent years on supply chains linked to the dramatic growth in the Asian petrochemical sector.   All these sectors and many more are also vulnerable to price increases.  The world’s largest producer of condoms, the Malaysian firm Karex has announced that it expects to increase prices by 20 to 30 per cent because of the rise in feedstock costs for the plastics and other products on which their business depends.

 8.        The Gulf was also the source of around 30 per cent of the raw materials shipped to the farming industry around the world  including nitrogen based phosphates, urea, ammonia and sulphur – all critical input to global food supply.  The reduction in trade has led to sharp increases in fertiliser prices and fears of  much reduced crop yields especially in areas where higher prices are simply unaffordable.  A series of international organisations including the UNFAO and the World Food programme have warned  that reduced use of fertilisers could translate into significantly smaller harvests in areas such as Africa, South Asia and Latin America and higher prices around the world both this year and next.  Numerous international agencies have warned of a major risk of famine in some areas over the next year.  The continuing  increase in food prices seen around the world for products such as wheat, fruit and vegetables over the last two months is early evidence of the problems to come.

9.         The looming shortage of jet fuel poses a significant challenge for both travellers and the airline industry. Travel to and via the key airport hubs in the Middle East remains severely disrupted.    In April Lufthansa cancelled 20,000 short haul  European flights through the summer.  They and many other  airlines including Air France and BA are beginning to impose surcharges to reflect the increased cost of fuel .  SAS cancelled 1,000 flights in April and both they and Lufthansa are reducing regional flights within Europe. Over the last ten weeks the price of jet fuel in Europe has increased by up to 100 per cent and by more in Asia because of the high transportation costs of bringing in back up  supplies from the US.

10.  For the shipping industry the immediate impact of the closure of the Straits has been a substantial loss of normal trade with hundred of ships trapped by the blockade.  The sector has also had to deal with a sharp increase in war risk insurance premiums and the rise in the cost of fuels. The rerouting of ships  via the Cape of Good Hope typically adds a week to the time involved in deliveries  leading, according to the Chief Executive of Maersk, to an increase in freight rates of between 15 and 20 per cent.  The cessation of normal trade has affected the flow of basic commodities such as iro-ore pellets and other bulk commodities important to manufacturing supply chains and the steel industry.

11.  The crisis serves to remind us all of the extent of dependence of the modern economy on hydrocarbons.  One example of this is CO2 which has become an essential element in a number of key sectors.  For instance ready meals and sealed products such as fruit and salads depend for their shelflife on the use of purified CO2 in the process of packaging.  When speaking to an audience of public sector leaders last week I was reminded by the head of one of the UK’s leading NHS Trusts that medical grade CO2 was essential for anaesthetics and other medical procedures including surgery.  He said that there was a serious concern that a fall in supplies of the gas which is a by-product of specific industrial process would hamper the normal working of the health service.

12.  Many other sectors of the economy – from hospitality to advanced manufacturing and construction -  face a period of rising fuel prices, reduced consumer demand and increased costs of debt. Some will not survive and we can expect a Darwinian process of consolidation in the worst affected sectors.   Individuals also face an increased cost of living and potentially a significant increase in the cost of mortgages and other personal debt. 

13.  The cumulative effect of inflation, lower growth and rising unemployment will also affect public finances especially in countries which are already endebted. France, Italy Belgium and Greece all have debt to GDP ratios of over 100 per cent.  At 93 per cent the UK’s figure is lower but the cost of servicing the debt is significantly higher because the yield on UK gilts at 5 per cent or more is so much greater than in Germany – at 2.7 per cent or France at 3.4.  

 14.  Much of the commentary over the last few weeks has been based on the assumption that the conflict in the Gulf would be strictly time limited and contained by a combination of factors including resistance in the US to a long and drawn out war; a shortage of munitions on both sides and the collapse of the Iranian regime. The expectation has been there would be a stable and enduring ceasefire which would then be followed by a reopening of the Straits and the resumption of normal service.  These expectations explain the wide gap which developed in March and April between the price of oil for future delivery and the substantially lower forward price for 3 or 6 months ahead. In the event the ceasefire has remained fragile and as we approach mid May the Straits are still closed.  The gap has narrowed but the future market prices for the end of the year and into 2027 still look low and will clearly increase if the current ceasefire does not hold.

 15.  The sense of complacency which has enabled stock market valuations to remain high has been compounded by the absence of detailed Government plans for handling the looming shortage of supply and the insecurity created for consumers by rising prices. While Fatih Birol the Executive Director of the International Energy Agency  was declaring several weeks ago that we were entering  “the biggest energy crisis in history” with a loss of supply far greater than in previous oil shocks and saying in mid April that Europe had just six weeks of jet fuel supply left, the official message from the British Government was that there was no shortage of petrol  and that motorists should keep driving as normal. In early May that advice appears to remain in place.  What has changed is that in private  Governments have begun to prepare detailed plans for a deteriorating situation.   In the UK for instance the management of energy security appears to have moved from the Departmental level to the centre of Government with regular meetings of the emergency response process known as COBRA.  Plans for prioritising the delivery of supplies to key sectors such as the food supply chain and the health service are reported to have been agreed but not announced. A complex system to “consolidate” air travel which means concentrating would be passengers on a more limited number of flights has been announced but not yet been implemented.  Nothing has yet been announced on the prioritisation of supplies to businesses or on the question of direct financial support for any category of consumers.  A similar gradualist approach is being taken across the European Union and beyond. In Germany there are plans for targeted schemes to assist vulnerable households and energy intensive firms. Spain has announced a € 5bn fund to support specific groups of consumers and small businesses. In Australia the Government is spending A$10 billion to increase stocks of petrol, diesel and jet fuel to be held in a centrally controlled Fuel Security Reserve. The Government in Canberra is also taking steps to protect it’s trade routes and to shield vulnerable consumers.

These measures, however sensible, do not indicate a real sense of urgency in the public policy response to the immediate challenge posed by events in the Gulf, but the rhetoric of some political leaders indicates a much greater sense of seriousness about the risks.    Friedrich Merz, the German Chancellor has said that parts of the German economy are in “a critical condition” because of high energy costs and warned of the risks of “large-scale, uncontrollable migration” if there is a breakdown of the Iranian state.  The British Prime Minister Kier Starmer has described the war as “a long lasting strategic and economic shock for the UK which will shape our future for a generation”. One can only assume that there is a wave of substantive short term measures to come over the coming weeks.

16.  As spring turns to summer and we pass the end of the beginning it is clear that the impact on consumers will be very different from one country to another. Although rising fuel prices set by international markets will push up bills and inflation, the physical impact of shortages will vary. The level of dependence on imports of both oil and natural gas is over 90  per cent in Germany, France and Italy, with the French position somewhat mitigated by the reliance on nuclear power for most electricity generation.    China on the other hand has built extensive oil stocks and can continue to  rely on coal as main source of power generation and industrial energy use, including in the petrochemical sector. China also has a growing mix of sources of low carbon power generation from wind, solar and nuclear.  The US is self sufficient in oil and gas removing any fear of shortage.  For Americans the key issue, as so often before is the high price of gasoline.  Even at 4 to 5 dollars per gallon – the average in the US in early May, however,  the gasoline price is still more than 40 per cent lower than the price in the UK or Germany.  Inflation aside, with increased military spending the war is undoubtedly good for the American economy. Among the developed countries the UK, Germany and Japan seem likely to be the most seriously affected.

17.  The hardest impact will undoubtedly be felt by the world’s poorer countries which typically are dependent on imports and do not have the resources to pay the increased prices. Bangladesh for example which imports  95 per cent of its energy requirements, mostly from the Gulf, has suffered not just from inflation in fuel and food prices but also from a loss of earnings. Exports of clothing depended on trade through the Red Sea have seen a damaging increase in shipping costs while remittances from the estimated 3 to 5 million Bangladeshi citizens employed in the Gulf countries have fallen sharply.

These of the facts of the current situation. What happens next remains unknown. Over the next few weeks we will see in more detail the impact of what has happened since the war began on February 28th. The success or otherwise of mediation will determine whether trade through the Straits of Hormuz is restored or remains constrained.  The post ceasefire negotiations – in particular on the future of Iran’s nuclear ambitions – will take longer and their progress will determine the extent to which the Gulf remains a war zone, with continuing physical risks to commercial trade.  By the autumn we should know whether the war will produce no more than a temporary if uncomfortable economic downturn as stock markets seem to be assuming or a serious global recession.

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In a future post I will discuss the longer term consequences of the conflict.  The first and most obvious conclusion is that the status quo ante will not be restored.  US and Israeli action against Iran has opened up new fissures in the  Middle East. This will not be the last war in the region.  Governments and energy dependent businesses across the world must adapt to a situation in which supplies from the Gulf  cannot be guaranteed or taken for granted.  In the energy sector there is much talk of a surge in the development of renewables and nuclear to achieve something fancifully called “energy independence” but the unavoidable present reality of reliance on oil and gas for at least three quarters of daily energy use which will take decades to eliminate.  Perhaps the most important consequence of all will be the realisation that open market globalisation – the main economic trend of the last 30 years – cannot provide the security of supply on which modern economies have come to rely.