Oil industry resilience has been remarkable in the face the biggest energy supply shock of modern history. They have pulled multiple levers in order to cushion the impact of the Iran War. The global market may be months away from breaking point if peace talks fail to produce a breakthrough. Since the onset of the Iran War and the nearly hermetic closing of the 'Strait of Hormuz, the world's largest and most liquid commodities market has been in a state of unprecedented uncertainty. The Strait of Hormuz was previously the conduit of a fifth of all global oil and gas supplies. Few experts predicted that Iran would shut down the Strait before the conflict began on February 28. No one expected the blockade to last for months.

The markets cannot ignore the fact that the transit through Hormuz may remain restricted for several more weeks, as peace efforts are failing and the threat of a renewed military escalation is still high.

The clock is ticking. Oil market has approximately three months left before the tightening of supplies begins to take effect. This will push inventories down to critical levels, which will lead to sharp price increases and, ultimately, demand destruction.

MUDDLING THROUGH So far, the industry's response has been remarkably effective. This crisis was a historic one, with a loss of approximately 13 million barrels of supply per day. Import-dependent countries, especially in Asia, moved swiftly to secure alternate sources of supply. These were mostly the U.S.A. and Latin America. The International Energy Agency (IEA) coordinated the release of 400 million barrels from strategic reserves held by member states. The cost of absorbing this shock is still high. As refiners reduce production, airlines cut schedules, and governments implement measures to save fuel, the demand is already declining. The IEA predicts that global oil demand in the second quarter will?fall by 2.4 millions barrels per daily (bpd), a 2.3% drop from a year ago.

These adjustments were accompanied by an immediate drawdown of inventories, which is the primary shock absorber for the system. U.S. Energy Information Administration data revealed that global crude and fuel inventories?fell by a rate of 5.27 millions bpd during March. This increased to 8.62million bpd during April.

According to the IEA, draws are expected to reach a peak of around 9 million bpd during May, before reducing to 2.7 millions?bpd between September and October. The IEA predicts that inventories will begin to rebuild at this point.

These projections are based on an important assumption: the Strait of Hormuz will reopen by late May, and traffic will resume in June. This timetable looks incredibly optimistic, and suggests that stock draws could be deeper and last longer than official estimates suggest. In fact, independent analyst Paul Horsnell, a veteran, estimates a steeper rate of depletion. He estimates 7.4 million barrels per day in March, 10.8 in April, and 10.2 in May, with 11.2 in June. This would be a loss of 1.2 billion barrels in global inventories.

Horsnell says that at this rate, commercial inventories may fall below the minimum operating level - a threshold below which storage systems cannot function efficiently – as early as August.

SYSTEMIC BREAKDOWN The history suggests that markets seldom reach such extreme limits. Participants tend to adjust quickly and efficiently in order to avoid a systemic breakdown, as the last few months have demonstrated. There are a few important caveats.

One, the timeline of the Strait of Hormuz reopening is highly uncertain. Any partial resumption of flow could reduce pressure on the global supply. Technical constraints on storage systems will not be met everywhere at once. The shortages would likely occur unevenly, sporadically and not in a global crisis.

Prices are a powerful counterbalancing tool. Oil prices are historically negatively correlated to observable inventories, increasing as inventories decrease. A sharper depletion will likely lead to higher prices, which would ultimately reduce consumption and ease some of the pressure. Brent crude global benchmark futures are up about 50% from the beginning of the war to around $110 per barrel. However, given the size of the crisis they have much more room for growth.

China is another important factor. Beijing has the largest oil reserves in the world, estimated to be around 1.2 billion barrels. It could offer additional relief by reducing its stockpiles and reducing imports. The market has some buffers left. They are limited and consumed quickly. The global energy system is increasingly stressed with each 'day' of restricted flows through Hormuz. Despite the fact that it may still be a while before we reach the breaking point, thanks to a combination?of policy choices, price reactions and geopolitical development -- but this is getting closer. If it does ever arrive, the impact will be huge.

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(source: Reuters)