Temporary Disruption – or the Start of a Global Supply Shock?

[MUSIC PLAYING] Welcome to PIMCO Pod. In this episode, we discussed the growing risk that prolonged Iran-related oil disruptions could shift from a temporary shock to a global supply crisis. Stay tuned after the conclusion of the podcast for additional important information. [MUSIC PLAYING] Temporary disruption or the start of a global supply shock by Tiffany Wilding and Andrew Duet. Global recession risks are rising. The conflict involving Iran and the associated disruption of energy and other cargo shipments through the Strait of Ormuz has now entered its fifth week. Global markets have remained relatively calm, despite shipping disruptions that threaten roughly 20% of the world's energy supply. That share reflects the volume of oil and energy products that typically move from Middle East producers through the Strait to global importing markets. While the markets continue to price a near-term resolution and elevated global inventories will for a time insulate economies, the economic costs will build as these disruptions persist. Eventually and perhaps sooner rather than later, the risk is that markets, which have initially focused on the temporary inflationary effects of this crisis and price monetary policy tightening across DM rates markets, will have to eventually contend with greater global recession risks and demand destruction that could weigh on equity and credit markets and increase the premium investors placed on bonds as a perceived safe store of value. Unprecedented disruption. A period of disruption on the order of 20% of global oil supplies would be unprecedented in modern history. To put the disruptions in context, the decline in global consumption of oil and energy products during the peak COVID-related shutdowns was also roughly 20%. According to data from the organization for economic cooperation and development, OECD. During the same period in the first half of 2020, global GDP contracted over 10% on an annualized basis. Both global GDP and oil consumption recovered quickly as economic activity restarted. Other large historical global oil production disruptions include the Arab oil embargo and Iranian revolution early in late 1970s. At their peak, those disruptions accounted for roughly 5% to 7% of global oil production decline, according to data from the International Energy Association and coincided with US recessions and sharp slowdowns in global growth. The early 1990s Gulf War also accounted for an 8% to 10% production disruption with real GDP growth across OECD countries falling from 3.6% to 1.4%. Pricing a near-term resolution. What explains the relative market calm of broader global financial markets in the current episode? We think a reasonable explanation is that market participants expect the disruptions to be temporary. The prices of contracts for future oil delivery illustrate the temporary nature of the shock currently priced into markets. Dispined a $125 a barrel price of physical barrels changing hands today in the North Sea, I.E. Brent dated price. Futures' contracts for December 2026 delivery were trading at $80 a barrel as of the time of this writing, a significant discount. The world was also enjoying a glut of oil inventories before the conflict. And as a result, entered this episode with inventory buffers outside the Middle East that will for a time insulated disruption in oil flows. It is also notable that Middle East storage capacity has allowed oil production to continue, despite producers inability to transport it out of the region. The blockage of roughly 20 million barrels a day of oil and energy products that previously passed through this trade has so far resulted in the shutdown of a little over 10 million barrels a day of production, with a remainder continuing and filling up storage tanks. Increasing risk of a lasting supply shock. Expectations for a relatively fast resolution combined with these economic buffers have likely limited the extent of the financial condition tightening. However, buffers do not last forever. And as the conflict and waterway closure continue, global markets must increasingly consider how long until this shifts to a genuine negative supply shock, not merely a price-driven redistribution of income between energy producers and consumers. Shipping, logistics, and storage capacity considerations are all important factors. On shipping and logistics timeframes, with the last tankers leaving the straight of our moves in late February, the final cargoes are only now reaching their destinations. According to industry experts, it takes roughly 10 to 20 days for Persian Gulf Cargoes to reach Asia. Those regions are already dealing with the immediate effects of production disruptions. Asia is followed by Europe and Africa with shipping times of approximately 20 to 35 days. And then the US Gulf Coast had roughly 35 to 45 days travel. There are inventory buffers outside of the Middle East. However, the extent of those buffers is uneven across regions. And high-quality data availability, particularly for China, adds uncertainty around precise timing. IEA estimates that oil and product inventories across OECD countries, both owned commercially and by governments, could last for roughly 140 days at last year's demand levels. But large variation exists across countries with several countries, including Mexico, Australia, Ireland and the UK, having less than two months of inventory according to the IEA. India and Australia, for example, are already implementing policies to address emerging shortages. Asian refiners have also preemptively reduced throughput and production in an effort to smooth through the disruption without fully shutting down operations. Global markets are also approaching the point at which larger Middle East production stoppages become unavoidable, as inventory tanks fill and storage capacity is exhausted. Production in the region is already downed by an estimated 10 million barrels per day. Industry estimates, based on satellite data, suggest that the Middle East had around 150 million to 300 million barrels of available tank capacity. At a pace of roughly 10 million barrels per day of stranded production, that amount of storage provides only two to three weeks before additional production must be shut down. Implications of persistent oil disruption. Some producers have been able to divert limited energy supplies through existing pipeline capacity. However, the industry is running out of time, and once production is shut down, restarting it is not as easy as flipping a switch. It can take weeks, if not months, to come back online. Increase production from outside the Middle East will take time to come online, with non-Middle East producers likely needing assurances that global oil prices will remain above the marginal cost to produce before embarking on additional investment in oil production capacity. In the US, the current domestic price of oil as of this writing, specifically the one-year forward WTI price, around $70 a barrel, is unlikely to be enough compensation for shale producers to meaningfully increase production, given the highly uncertain conditions. Finally, monetary and fiscal policy have limited ability to respond to a sustained energy shock. Monetary policy would likely be constrained, at least initially, by higher inflation, limiting central bank's ability to respond to weaker activity, and potentially higher unemployment. Central banks globally have already emphasized their commitment to keeping inflation expectations anchored. Fiscal policies that support energy demand, such as gasoline price caps, may do more harm than good. In a scenario involving a 20% disruption in global oil production, prices must rise enough to reduce global demand by 20%. Regional policies that blunt the price mechanism would only increase the price of global oil needed to balance the market. Bottom line. While the outlook remains highly uncertain, each passing week increases the global economic costs of the Iran conflict. At some point, potentially soon, as buffers are absorbed, the economic effects of persistent disruptions will start to build. Energy shortages affecting Asian manufacturing could ripple through global supply chains, leading to broader product shortages and increasing costs. Policies short of de-escalation will have limited effectiveness, and financial conditions could tighten significantly. While markets appear to be betting on a temporary disruption with resolution coming soon, the risk is that they may soon have to contend with the possibility of a more prolonged conflict with greater economic costs. [MUSIC PLAYING] Thank you for listening. That was temporary disruption or the start of a global supply shock. 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