Why the market shrugs off the mother of all oil shocks (2024)

When Israel invaded Lebanon in July 2006, oil prices jumped nearly 10%, rising to about $80 a barrel. Fast forward to the present day, and the price reaction has been remarkably similar. The fighting, though, is worse. Far, far worse. For evidence, look at the exploding walkie-talkies, the assassinations of the leaders of Hezbollah and Hamas, and the barrage of Iranian ballistic missiles hitting Tel Aviv just days ago.

Back in 2006, the energy market mulled whether oil supply was at risk. That mere speculation, which few thought was probable, was worth a 10% price rally. Now we know oil supply is under threat. So much that US President Joe Biden publicly admonished Israel last week. “I think if I were in their shoes, I’d be thinking about other alternatives than striking oil fields,” Biden said Oct. 4. Shockingly, the confirmation by the White House of a live discussion about an Israeli oil attack is worth the very same 10%.

Rightly or wrongly, the oil market isn’t reacting to Middle Eastern risk as strongly it once did. The “war premium” is smaller, and it fades away faster. The muted response is part of a much wider trend in financial markets: Generally, volatility is lower.

In the past, the energy market used to price in a what-if storyline that almost always involved the worst possible scenario for oil. The institutional memory of trading desks was firmly anchored in the oil crisis of the 1970s and large supply disruptions of the 1980s (Iran-Iraq war) and 1990s (invasion of Kuwait). That institutional memory is gone. Walk into a modern oil trading room and no one under 35 years old (or perhaps even 40) has firsthand experience of a long-lasting Middle East oil supply shock. If anything, the lived experience is the opposite: For the last two decades, disruptions had been small and short-lived. In fact, the most recent supply interruptions had been the choice of oil consumers: sanctions against Iran, Venezuela and Russia.

If the market were currently pricing in a worst-case scenario, it would look very much like the “mother of all oil supply shocks.” The plot would go as follows: Israel strikes the Iranian oil export terminal of Kharg Island, from where the Islamic Republic ships 90% of its production; Tehran, in turn, retaliates by bombing oilfields in Saudi Arabia, Kuwait and the United Arab Emirates, affecting a large chunk of global output. Immediately, an all-out regional war has broken out, closing the Strait of Hormuz, the shipping lane for most Middle Eastern oil. That’s worth a lot more than a 10% price jump.

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    Why traders are so sanguine? The four most dangerous words on Wall Street are “this time is different.” At the risk of tempting fate, it does feel different. There are five good reasons why geopolitical risk is priced differently now than yesteryear:

    1) The US is the world’s largest oil producer, and thus its dependence on Middle Eastern petroleum has collapsed. Back in July 2006, the country pumped 6.8 million barrels a day of total oil liquids. Today, it pumps more than 20.1 million barrels. In 2006, US net petroleum imports ran at an all-time high of 12.5 million barrels; America is now a net exporter to the tune of 1.5 million barrels. The American oil hegemony doesn’t mean Middle East outages don’t have a real impact, but it certainly changes the psychology of the market.

    Why the market shrugs off the mother of all oil shocks (46)Bloomberg

    2) The West has shown the will to do “whatever it takes” to minimize supply shutdowns, including using strategic petroleum reserves earlier than what had been the case — and in greater amounts. Western countries have also loosened oil sanctions against producing nations, sometimes risking the loss of political credibility, to keep petroleum markets well supplied and prices lower. In some ways, it’s the oil equivalent of the “central bank put” that has calmed equity and bond markets in recent years. Much like central banks have done in financial markets, oil policymakers from Washington to Tokyo will also deploy their bazookas against any petroleum shutdown.

    3) Over the last two decades, oil-producing countries have demonstrated a remarkable ability to recover from supply shutdowns. In particular, the 2019 attacks against the Saudi oil facilities in Abqaiq and Khurais, which cut the kingdom’s supply by about 50%, lasted only a few days rather than the months many had feared. The Libyan oil industry also reemerged from the 2011 uprising against leader Moammar Qaddafi largely undamaged, and so did the Iraqi oil infrastructure from the 2003 American invasion. All those events have created a sense of security that perhaps is false but is shaping how traders see potential disruptions and their likely impact.

    4) The oil options market is far more liquid, allowing traders to buy insurance, at reasonable cost, instead of taking outright directional bets. Back in 2006, the average daily volume of call options — which provide upside price protection — for Brent crude was around 10,000 lots; it averages 150,000 lots now, reaching peaks of 350,000 lots a day recently. The extra liquidity gives the market better and cheaper tools to hedge risk without pushing prices significantly higher. Brian Leisen, an oil strategist at RBC Capital Markets LLC, says traders had largely bought “short duration protection” of late “as opposed to outright abandonment of bearish positioning.”

    5) The fog of war is thinner thanks to the availability, at reasonable price, of commercial satellite photographs that allow traders to observe in near real-time what’s happening instead of guessing. Satellites have also improved the tracking of tankers departing ports. Simply put, the oil market can trade more on information, despite imperfections, and less on rumor.

    But past performance doesn’t guarantee future returns. If a wider regional war explodes in the Middle East, the oil market will be shocked to its core, forcing everyone to reprice. The five reasons listed above provide resilience but don’t eliminate risk. If anything, they can fuel a “this time is different” complacency that could bite the back of the market at the worst possible time. Just hope cooler heads prevail.

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    Why the market shrugs off the mother of all oil shocks (2024)
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