Why oil hasn’t ruined the global economy. With Rory Johnston

0:01When the Strait of Hormuz first closed, some analysts predicted that oil prices would rise to astronomic levels. Brent crude oil had been around$70 a barrel. Could it rise to$150 a barrel? $200 a barrel? And with those crazy prices, could the global economy experience a major shock? Those predictions never came to pass. The worst never happened. Prices rose to over$100 a barrel, but then inventories were drawn down. China reduced its demand, and over May and June, prices of Brent crude oil fell, almost back down to their pre-crisis levels. Crisis over. Or not. Since the beginning of July, prices have been climbing again.

0:52At the time of recording, on Wednesday, October 21st, they are close to the highs reached when the Iran war first started, of over$100 a barrel. Is the crisis back on? Is the oil-pocalypse still coming? Or has the world gotten used to a new oil regime?

1:20This is The Economics Show with Samaya Keynes. I'm joined today by Rory Johnston, founder of the Commodity Context Substack, host of the Oil Ground Up podcast, and a lecturer at the University of Toronto. Rory, hello. Thanks so much for having me. Oh, thanks for joining me. Okay, so on this show, we always start with a question where the answer has to be on a scale of 1 to 10. So on this very serious scientific scale, how freaked out are you about where oil prices are heading right now? So 0 is looking at the charts as something that soothes you to sleep. 10 is you are losing your mind, reaching for those anxiety meds, given the fear out there.

2:01I would say right now we're probably between a 7 and an 8. I think that I no longer have the complete anxiety apocalypse now kind of situation that I would have been in in March. And we'll talk about that in a second. But the market still remains very precarious. And prices reflect that. And I think we are at a far more dicey period of this, even as things are starting to improve. If you had to make a kind of best guess of how bad things could get, do you still think it's possible that we could get to$150,$200 a barrel? or do you think the peak is a bit lower than that? It's not my base case, but we can still get there.

2:38I think the benefit right now is we're seeing more oil out of the Middle East, thankfully. So the deficits are starting to shrink, but inventories remain very, very low. So should we see a new escalation of conflict, let's say after the US midterms, we could very easily see that deficit reemerge and now with far less buffer. So we can still get to those very, very high prices, but I do think the current trajectory of the market is not to 150, 200. is probably more hanging at the$100 a barrel level for a while and then maybe even sinking back to maybe$90,$80 next year if the current supply dynamics persist.

3:13Okay. All right. So cause of a concern, but don't completely freak out just now. So now let's go backwards, though, right? Because obviously, thinking at the beginning of the Iran war, there were those warnings that oil prices were going to go super, super high that never materialized. Which camp were you in? Okay, so I was very openly out there saying we could see$200 crude here. And I want to be clear, I am not normally one to make big, outrageous kind of inflammatory price calls. But the logic was essentially that we needed to destroy huge amounts of demand in a scenario where we had an unmitigated loss of Hormuz's supply.

3:57Analysts knew that we were going to see rerouting flow out of the East-West Pipeline to the Red Sea and the ADCOP Pipeline through the United Arab Emirates to the Gulf of Oman. On top of that, we had other predictable responses from the market, like the largest release of strategic petroleum reserves from the IEA member states. But even with all of those levers pulled, we were still gonna have six, eight million barrels a day of unmitigated supply loss through the Strait of Hormuz. In prior markets, like when we're talking about really, really high prices, let's say in 2008 or the early 20-teens or in 2022, we were talking about deficits in the market of one to two million barrels a day, maybe three in the most extreme.

4:39Now we're talking about six to eight. So when the market previously managed to balance itself in those prior supply crises, we were able to destroy, let's say, one to two million barrels a day of demand with prices of$120,$130 crude. We needed to destroy two, three times that volume. which is where these calls for$200 a barrel came from. But the thing that I missed and many analysts missed was China and what I call the Beijing swing in hindsight, which is China reduced its crude oil import volumes by about 5.5 million barrels a day, or roughly 45 % of its pre-war normal import levels. It reduced those between, say, the quarter before the war started and the bottom of their imports in June and July.

5:29That is a gargantuan, unprecedented swing in the seaborne demand for oil from China or any other country. And if you ask me, like people were like, can China do more early in the war? And of course, China can do more. But the rationale was, why would China do more? Why would China bail out President Trump in an unpopular war that risked China's source of oil supply The expectation was that you would want market pressure to press the president off a ledge. Right. But I suppose the question is, how did China do this? How did they implement this massive swing in their demand? My estimation is a large combination of pulling every energy security lever they have.

6:15So they've diversified their feedstocks and petrochemicals to coal and gas-based things. They pulled back petrochemicals. They've likely released strategic stockpiles of crude and even more interestingly, likely released refined products as well. Now, to be clear, I want to clarify that there is no evidence of this. There is no official document or announcement saying that China has released stocks. That's actually what's really interesting about this entire thing is China said almost nothing at all. So all of this is essentially by looking at the data and saying, OK, well, China's, for instance, its available supply of diesel was down by 20 % year over year in June and July of this year.

6:5770 % of Chinese diesel is used in road freight, but road freight activity is up three and a half percent. So like, where's that massive delta? And the easiest answer is that China has quietly, in order to maintain domestic supplies and stability, released stockpiles that we always assumed they had into this market. Okay. And now picking up your point from earlier, why do you think the Chinese government did this? The answer, again, there's a debate here, because no one knows Beijing is not sharing its rationale. I think there's two main explanations. I think one is that this is a very over-exuberant demonstration of a prioritization of domestic energy security.

7:41So we saw, for instance, that China capped the prices of some domestic products. So diesel at its high point only rose, say, 30 percent in Beijing versus more than doubling globally. I think the other explanation, this is the side that I'm probably on, which is they did more than just necessary to maintain domestic supply stability and prices. they, again, balanced a huge chunk of the market. Why would they do something that's seemingly altruistic? Because I wouldn't argue that Beijing is an altruistic kind of government. The other simple explanation here is that it wasn't altruism, it was still self-interest, that historically when Beijing wanted to stimulate its economy, it always historically looked at construction, real estate.

8:28That over the past half decade has slowly been petering out. So they needed other things. And the only other lever that they have is export markets. So if you had a bunch of Asia and Europe where they were trying to diversify trade, it was going to take the brunt of this economic hit from an unmitigated Hormuz shock. And that would have really done a number on demand for their exports. But I think a part of this is domestic supply stability. But I think another part of this is maintenance and kind of defense of their own export markets because countries in acute economic recession are not going to be buying Chinese imports.

9:02Mm-hmm. Okay. Well, that was China. There were some other participants in this oil supply crunch. Can we talk about the US? Because, you know, they obviously were pretty key in starting the crisis, but they also, you know, the government tried to do other things to ease the pressure. The government suspended the Jones Act, effectively, you know, relaxing rules governing which ships can bring oil to US ports. There has been a relaxation of restrictions on sales of Russian oil. They also drew on the SPR or the Strategic Petroleum Reserve. Did any of them actually work? Yeah, it's a great question.

9:43And obviously, I think the political backdrop to all of this is that you have this major Middle Eastern war that has spiked inflation going exactly against, I think, the mandate that President Trump was brought to office with, which was affordability and ending wars in the Middle East. Now they're kind of trapped heading into this midterm. So they've been trying to do everything at their disposal to bring these prices down, particularly given the fact, you know, diesel is particularly expensive right now. And that's really important to farm states, which are really important in the balance of congressional control in this election.

10:13So overall, the SPR release was real barrels. That was a huge increase in supply to the market, probably at its peak over a million barrels a day, but still small on the scale of the overall crisis. Most of the other stuff we've seen has largely been window dressing. And even this latest Russian diesel deal that President Trump announced on True Social a couple of weeks ago, it sounds like a lot. Putin pledged 500 ,000 tons of diesel for November, but in oil terms, that's only 125 ,000 barrels a day. And Russia, in a normal non-war market, is the world's second largest diesel exporter at nearly a million barrels a day.

10:56So at most, Putin is pledging 10 % of what it would normally export in a market where it's not being bombed by, where its refiners are not being bombed by Ukrainian drones. Going beyond the US then, I want to ask about demand destruction elsewhere. And, you know, there were lots of reports of countries like the Philippines, Morocco, Zambia having to really cut back on consumption, rationing fuel, making people work from home, that sort of thing. How important has demand destruction in those other, I guess, poorer countries been to balancing the market? The one help here, and it helps to just dwell on what demand destruction is for a second, because it's not just one thing.

11:39We can talk about price elastic demand destruction, which is, you know, you go to the gas pump and you see, you know,$4 or$5 a liter for gasoline. You're like, oh, wow, that's really expensive. Maybe I'll take the bike or the bus or not drive today. Then there's income elastic demand destruction, which is the high oil prices to stabilize the global economy. There's a recession. You lose your job and you don't have a job to drive to anyways. And then this crisis, we've seen this third element, which is this kind of forced, almost like COVID era demand destruction of like work from home policies or at the kind of country level, even if you can afford the gas price, maybe your country or your city can't.

12:21And then you just have shortages that emerge. I think initially I had expected with this unmitigated Hormuz market, when we were talking about the potential for$200 a barrel, it was that third category that I think was largely going to occur, which is advanced economies, wealthy economies were gonna feel debilitating price spikes. It was gonna be basically a tax hike, which is how we typically think about gas price increases for consumers, but that there would need to be demand destruction somewhere and it likely wasn't gonna be advanced countries. It was gonna be in these poor emerging market countries that can't compete for that marginal seaborne barrel.

12:54Did we see a lot of demand destruction from these poorer countries, say the Philippines, Morocco, Zambia? We saw a little bit, and we've seen weakness in demand for a lot of these fuels, which I think makes sense given the high prices, but nowhere near the demand destruction level that you would have required to actually close the gap. Most of what we've seen is a decline in inventories across many areas of the world, and of the demand destruction that people have talked about, a lot of it, you know, numerically ends up in China where we don't have good data. It's kind of what looks like demand.

13:31You know, that diesel question, like diesel looks like demand has fallen in China, but all of the trucks are still driving. So how are they getting the fuel? Okay. So let's bring this up to date. What is going on in the Strait of Hormuz now? How much supply of crude is actually getting through? Yeah, so from the overall Middle East right now, so including the Strait of Hormuz, the Red Sea rerouting, the Gulf of Oman rerouting, kind of everything all together, non-Iranian crude oil supply is back around pre-war levels, which is remarkable. That's, I think, a testament to just how much effort has been put into getting these ships out.

14:14Hormuz itself, relative to that 20 million barrel a day pre-war level, we reached a high watermark in late September of probably near 17 million barrels, which is really, really high. The challenge is that this is a deeply unsustainable and horrifically expensive recovery of these volumes. Right now, it's costing anywhere, you know, ballpark$30 a barrel to get these ships and these barrels out of the Gulf and through Hormuz. Normally, the shipping rate for a barrel between the Gulf and Northeast Asia is like$2 to$3 a barrel. Recently, it's been as high as 30, just on shipping alone, added insurance there and everything else.

14:54These are very, you know, these costs add up extremely quickly. In order to facilitate, in order to basically pay for this extremely high cost, you've seen Gulf exporters heavily discounting their barrels for those willing to come in and risk, you know, life and limb quite literally in order to pick these barrels up. Iraq is a great example. We've seen Iraq recover faster than many of the other countries in the region and kind of bucked initial expectations, largely because they proved the most willing to offer the largest discounts. Okay, so in summary, volumes of crude exports have basically recovered out of the Gulf.

15:34But this is clearly still quite a distressed or distorted market if producers are having to offer these massive discounts to persuade people to come and pick up the oil. tell me what China has been doing in this situation, right? Because obviously they stepped out of the market. They've reduced their buying significantly. That provided this relief to other countries around the world. But more recently, they have been buying some oil again. How are you thinking about that? Yeah, so what we've seen over the past couple of weeks, we've seen China kind of begin to return to the market. Now, we're only very recently starting to see Chinese imports rise.

16:15But we saw this over the past couple of weeks as the number of VLCCs or large tankers that are, you know, indicating China as their destination began to tick higher. China, you know, after drawing down all these inventories is beginning to restock. Now, this, I think, helps explain why prices are still above$100 a barrel for Brent crude, despite this recovery of supply from the Middle East, given that supply has recovered and demand has recovered in tandem. Hmm. Okay. So that's the market for crude, but obviously that is just one piece of the market. And whereas we have seen normalization of volumes coming out of the Strait of Hormuzin crude, we really haven't seen that in refined products.

17:01So now talk to me about what has been happening there. Yeah, I think it's really important for people to remember that while obviously the price of crude oil and the price of refined products like gasoline, diesel, jet fuel, they're obviously connected. They are fundamentally different commodities. The only people that actually consume crude oil are oil refineries. And they're the ones that actually produce all this other stuff. And right now we have a crisis in the available supply of that oil refining capacity. Part of that is because of the loss of refined products from the Middle East. All of that kind of smuggling trade, this dark transit trade that's been facilitating transits through Hormuz.

17:42favors crude, and all those pipelines are crude only, not products. And on top of that, there have been lots of attacks on refineries across the Middle East, early in the war by Iran against the Gulf, and then more recently, the Houthis have been attacking Saudi oil refineries on the West Coast in the Red Sea. On top of that, you have Russia and Ukraine. Upwards of, you know, 50 % of Russia's refining fleet has been taken off at various points this year by this concerted effort by Ukrainian forces. But the combined effect has been a loss of all this refining capacity and this big bottlenecking.

18:15Now, at the end of the day, crude oil doesn't actually destroy demand. Refined product prices do. You and I as consumers, or even businesses, unless you're an oil refinery, consume fuels, not crude oil. Diesel prices are already over$200 a barrel. So you're already trying to get that demand-destructive impulse in the market, even without crude. The way China comes into the story is that basically the only region that has spare refining capacity in this current market is China. And what we've seen in prior episodes, for instance, the winter of 2022, 2023, when we had another diesel crisis and high gas prices in Europe and all this concern, China loosened its export restrictions and allowed a big increase in the export of independent so-called teapot refined products, so diesel, etc.

19:05That, I think, is one of these elements that I'm watching very closely because I think is one of the most available salves for this current very, very tight diesel market that structurally can only be solved by an end to both the Iran war and the Russia-Ukraine war. But in the interim, we're looking for every available barrel that can even kind of plug the gap in the meantime. Okay, Rory, I want to throw to a break now, but when we get back, I want to look to the future and ask you what is going to happen next.

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20:19We are back from the break. So let's look ahead, right? We've got this weird market where volumes are recovering. Prices are still elevated and rising. The refined market is freaking out because we've lost all of this capacity to make refined products. What are the factors making you worried that all this could get much worse? I think the main concern right now is essentially what Trump decides to do coming out of the midterms. There is wide concern that, you know, following that election, and honestly, particularly, if it turns out to go very, very bad for the White House, You know, we could see a kind of an emotional lashing out in the Middle East as a way of kind of something he can actually do.

21:04That I think would make things worse. Right now, the recovered flow of oil from the Middle East does depend on some degree of stability. And I think a return to full-blown warfare would crunch that at a point where we do not have any of the buffers left that we had in March and April that helped float us through to today. But I think more likely than a kind of a full return apocalyptic scenario in the Middle East is either a brokered diplomatic solution or kind of a muddling on for another year of the status quo. And I think it's important to kind of look at both of those scenarios. I think that the brokered piece is the easiest to explain, which is, let's say they agree on something after the midterms and you begin to see some kind of normalization of flows from the Middle East.

21:52Everything starts to return to normal and then we kind of survey the wreckage of the market, what it's left behind. In that scenario, I think that the crude oil market in particular returns to surplus, like we had entering this year, but we likely have a lag on those damaged refineries. So you could see a scenario where crude oil falls back to say$70 or$80 a barrel Brent, but you could still have diesel double the price of crude. And I think even if we return to a surplus, we probably have another year of rebuilding that overhang before prices really begin to pinch. I think that's still, I think, the most likely scenario for where we kind of go from here.

22:30But there's also the scenario where like, let's say nothing changes. We could chalk in next June and it's basically the same. You can see a scenario where this grinds on, prices keep rising, inventories keep falling, shipping rates remain sky high, and we just keep paying more and more at the price of the pump until eventually the global economy begins to kind of grind lower. And this basically manifests as a massive rate hike, increasing costs, contracting margins across the entire global economy until such a point that you do just tip into a recession. And then that helps solve us more from that income-elastic demand destruction side we talked earlier.

23:08So you said earlier that aside from releasing the strategic petroleum reserve, U.S. actions were largely window dressing. Is there anything that the Trump administration could do to cut oil prices, I suppose, short of declaring full peace and let's all hug the Iranians and sing Kumbaya around the campfire? Yeah, I think that's, you know, I think they're likely going to agree and announce yet more releases from the SPR. I think we're still drawing down that final piece of their initial commitment. I think we're probably going to see another one of those releases in the new year. I think, you know, earlier this week, we heard that they were loaning diesel from the Northeast Heating Oil Reserve.

23:52They're going to turn every single knob they can, but these are small things in the scheme of the overall crises. I think some interesting and let's call them unconventional things that we could see happen over the next little while. I mentioned earlier that shipping rates have become a major problem for the industry. Some of the things they could do there, they've already talked about starting to ease sanctions on some of the Russian and even Iranian dark fleet. And just to clarify, that shadow fleet is the fleet of the sanctioned ships that are functioning illegally. Well, I think if you went really unconventional, I think, again, international legality is not always the most top of mind concern, very clearly for this administration.

24:29There's nothing stopping them from just seizing the vessels outright and kind of dumping them back into the system. I think as this crisis continues to grind on and as the fragilities are kind of tested, I think we're going to see more and more of these kind of Hail Mary attempts to kind of say like, how do we possibly fix this? Because right now the market, they'll fix one thing. It's like whack-a-mole. They'll fix one thing and they'll break something else that they fix Tormuz flows and it's strained the shipping market. And then they're trying to fix the shipping market and it's straining refined products or whatever else.

24:59The overall system just doesn't have enough supply underlying it. How should we think about how much of the overall economic shock hasn't hit yet still, right? Are there reasons to think that there's a lot of pain yet to come from price increases that we've already experienced? It's an interesting question. I think one thing we've learned through this is that the global economy, and particularly advanced market economies, are much more resilient to oil shocks today than they were a decade ago, particularly relative to the 1970s. That it's just less important, so there's more capacity to kind of shoulder the burden of those higher prices than what would have used to be the case.

25:39But it's also impossible to avoid the fact that oil markets generally are abnormally patient with this kind of situation. And I think part of that is because in most other periods where you've had big deficits in the market, there was always this feeling that like, oh gosh, we have no idea we're gonna dig ourselves out of this. There's no visibility in the future for where the next surplus is gonna come. What's different about this crisis is that we entered with a structural surplus had history's largest deficit emerge, but the entire market and myself included still assume on the other side of this, we have a big surplus.

26:14So maybe those little inventories are not as worrying today as they would have been, say, in 2022. If that changes, if this becomes a situation where this is now assumed to be the status quo, then you have much higher prices coming down the line because the market's gonna react to that differently. You've already started to see, first in diesel and now in crude, where it looks like the market is beginning to price in a higher for a longer type market. And I think that is something that will begin to drag on the global economy just inevitably over time. Okay, last question, which is how are you seeing permanent effects of this crisis?

26:54Or I guess put another way, you know, how are governments companies investing so that they are less vulnerable to this kind of shock in future? I remember when the shock first started, there was a lot of talk of, oh, don't worry, the green transition will protect us in future. Or, oh, you know, we'll build more infrastructure so that we can bypass the strait or even, you know, storage capacity. What do you think is actually happening, though? I think all of that, right? I think we've seen, for instance, in the Gulf, we've seen all of the Gulf oil exporters really accelerate and launch new plans for new pipelines to get around the Strait of Formos.

27:34Now, it's not going to be as economic as shipping through the Strait, but at this stage, it's an existential requirement for them. So that's definitely going to happen. On the importer countryside, many countries that didn't have strategic petroleum reserves, I think most notably of India here, has absolutely started plans to build them out, sometimes with partnership directly with those Gulf exporters. ADNOC, which is, I think, who's partnering with the Indian government to build out an SPR system. That makes sense for both parties. India gets more secure supply, and the Emiratis get forward-deployed barrels that even if they were blocked off in Hermuz again, they could sell out of those tanks and still kind of keep the flow of funds going.

28:13More broadly, to this energy transition point, initially, in March and April, I thought there could have been a scenario where this was the peak of oil demand. If we did get those$200 crude prices, if we did get this total debilitation of the system, I could have seen that being the moment that everyone raced ahead with every energy transition policy kind of priority they had. I think what's interesting is that our beneficial survival over this period, well beyond my initial expectations, has also reduced that incentive and that mandate to press forward. So I think that I no longer believe that this will be the peak of oil demand.

28:48I think that we will still see the oil demand grow. But you've also started to see that like the days of extraordinarily high price spikes in geopolitical crises that I think we had all become used to in this market may be behind us given China's demonstrated capacity to swing seaborne import demands so dramatically. Rory, thank you so much for joining me. This has been great. Thank you so much for having me.

29:20that is all for this week you have been listening to the economics show with samaya canes if you enjoy the show then i would be eternally grateful if you could rate and review us wherever you listen this episode was produced by katya komkova with original music and sound design from breen turner our executive producer is manuela saragossa i'm samaya canes thanks for listening

30:13We'll see you next time. win, lenders win, and so do Linda's. When you build credit scores the right way, everybody wins. Get started at VantageScore.com. The new episode of the Next 5 podcast is all about sovereignty, data, and control. Charlie Giancarlo at Everpure joins me. You always get a very embarrassed response if you ask them if they know where all their data is. As does Professor Sana Karagani. There isn't any modern AI system that's entirely sovereign. and Claire Schramm-Fergus at Lloyds Banking Group. We really need to design for safety rather than bolting it on at the end. Listen to The Next Five wherever you get your podcasts.

30:51Enjoy.