What we are witnessing with the Strait of Hormuz today is a once-in-a-lifetime type of event. I’ve always pondered how a nobody like myself got involved in energy and lived through 2 “once-in-a-lifetime” events in the span of 6 years: COVID and the Strait of Hormuz closure.
It’s a bit surreal to have built expertise in an area of the market that no one really cared about until... 4 weeks ago. The funny thing is that all the work we’ve put into grinding it over the last 10 years in this sector is starting to pay dividends now. Like the quote from Jacob A. Riis:
When nothing seems to help, I go and look at a stonecutter hammering away at his rock, perhaps a hundred times without as much as a crack showing in it. Yet at the hundred and first blow it will split in two, and I know it was not that last blow that did it, but all that had gone before.
With that, let’s dive straight into this week’s WCTW.
The Unacceptable Status Quo
I’ve read a lot of commentaries from very smart people about what the eventual resolution might look like. One of the more interesting “scenarios” I’ve seen goes something like this:
The Trump administration says that the mission is done and leaves the region, while the Iranian continues to control the Strait of Hormuz flow. Some type of toll arrangement will be in place.
I am here to tell you that it’s a non-starter.
To most outside observers, the logic is straightforward. A VLCC (very large crude carrier) carrying ~2 million bbls of crude oil, worth north of $200 million, should easily afford a toll fee of $2 million. The generalists argue that it’s just $1/bbl, a fraction of the cost of oil. But the misunderstanding is not in the economics of the toll fee, but in the ability to impose restrictions on the potential flow.
To better understand why the status quo is unacceptable, generalists should take the time to research OPEC’s history more extensively. In particular, with the help of Claude or ChatGPT, I implore you to understand why it is so hard for OPEC or OPEC+ to come to a production cut agreement.
From the outside view, OPEC, spearheaded by the Saudis, has every incentive to keep oil prices in a tight trading range. It has already formed a “cartel”, and so in theory, enforcing the production policies should be very straightforward. The logic is that if every producer in the cartel cuts production by 5%, everyone’s revenue goes up by 25%. Win, win, right?
Wrong, and that’s the issue with generalists in energy. Most people use the logical approach when the reality has nothing to do with logic.
The best example of this irrational behavior unfolded in March 2020 when the Saudis asked Russia for an additional 300k b/d cut.
Prior to March 2020, Russia was already responsible for ~300k b/d, so the additional 300k b/d would put the total production cut at 600k b/d. Russia refused to cut the additional ~300k b/d, despite it only being less than ~3% of its total production volume. What did the Saudis do? They unleashed hell.
Saudis took the view that if you aren’t willing to cut production, then everyone can feel the wrath. So instead of coming to the logical conclusion that the demand destruction from mandated lockdowns would inevitably reduce everyone’s oil production, Saudis forced the widespread sector shut-in that was to be infamous with the COVID fallout. A month and a half later? WTI went negative.
The moral of the story is that logic doesn’t drive policies, especially not in the oil market. Consider that if Iran implemented a toll fee, no matter how low it is, it would have an effective say in the flow of Gulf state traffic going forward. This is more powerful and effective than Saudi’s dominant role as the swing producer.
This is why, in my strong opinion, the Saudis would rather keep oil production shut-in by ~3 million b/d than to transport through the Strait of Hormuz. The ramifications are profound.