Introduction
One fifth of the world’s crude oil usually moves through the Strait of Hormuz, and for most of this year it has been all but closed. A disruption of that scale would once have been enough to trigger a recession, but the financial market response has been remarkably orderly throughout. Crude oil prices rose well above their pre-war levels but never approached the catastrophe a literal reading of the supply loss would imply. Longer dated energy futures moved substantially less than the front month and the premium for physical cargoes, having spiked dramatically in April, collapsed back to almost nothing through May. That collapse, it now appears, was the market correctly anticipating what has since arrived. The US/Iran peace framework is expected to lift the blockade and reopen the Strait, albeit gradually. The spot price of Brent, which peaked near $120, has since fallen back below $80.
This composure was never confined to oil. Equity markets held up, and in places extended gains, credit spreads fell through the episode, and the inflation premium priced into bond markets rose only modestly. A geopolitical shock that closed one of the world’s most critical energy chokepoints registered, in the end, as a manageable inconvenience rather than a systemic event. That broader calm was itself revealing, as financial markets appeared relaxed not only about oil but about the macroeconomic consequences they expected it to cause. As we will argue, the forward curve that anchored much of that serenity read the direction of travel correctly, but is now likely too sanguine about where oil ultimately settles.
The explanation for the modest reaction has two halves and the apparent resolution of the conflict has tested both. The calm was partly earned, as the world economy is far less oil dependent than it was in the 1970s. This means a shock of this size hurts less than it once would have. But the calm was also partly borrowed, as much of the disruption was absorbed by drawing down inventories. This cannot be repeated indefinitely. In the event, the borrowed portion was repaid before the loan was called, since the US/Iran peace deal arrived before inventories reached the floor that would have forced a disruptive price spike.
Going forward inventories are likely to be replenished. This is likely to hold oil prices above the current forward curve rather than returning them to pre-war levels. The macroeconomic damage is real, but it is largely already reflected in the data, especially for inflation. The peace deal accelerates an anticipated disinflation process rather than triggers a fresh disinflationary shock.
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