Stocks didn’t stand a chance of gains in yesterday's session which was fraught with negativity from all angles. The latest ISM reading on manufacturing showed a further decline into the contraction zone, led down by weakening employment.
No time to rest on laurels. When Chairman Powell upset the uber-bulls two days ago vowing to cut rates slowly, he could not have known that Iran was going to launch a major missile barrage at Israel yesterday. No, Powell and his merry gaggle of bankers are in no rush for many reasons, chief among them is… er, remains inflation. Yes, it is lower than it was when pundits were using words like Armageddon, but it is still lurking in the shadows. I spent two days writing about how the Longshoreman’s strike could be inflationary. The high-level theory there is a disruption to the supply chain. We all learned just how sensitive the supply chain is when it nearly imploded at the beginning of the pandemic. It was a primary catalyst for inflation.
Moving on, do you remember another catalyst that awakened inflation from its long slumber? Come on, you remember. It was the price of fuel. Going to your local Wawa for fill-up and a giant fountain soda became… unpleasurable as prices spiked. Do you remember what caused the spike, which can be seen so obviously on the following chart of WTA Crude? Now you remember, it was the massing of tanks and military equipment on the border between Russia and Ukraine. Check it out.
That happened, and the actual invasion which took place at the beginning of 2022, set inflation in stone. Now, I want to be clear that inflation was already picking up in 2021, but the invasion and spike in fuel prices really made it clear that inflation was going to stick around for a while. Fuel prices thereafter became a major contributor to the spate of inflation that would last until… earlier this year. Fuel was not the biggest contributor, but it was certainly a factor until alternative supply came online, finally easing prices this past summer.
The initial spike in energy costs in 2021 and 2022 was due to the disruption of supply from Russia. Russia is a large contributor to global oil supply, so sanctions could disrupt supply, and it did. Step back and remember basis supply and demand, when supply declines prices go up. Turning the clock forward, alternative suppliers stepped in, namely the United States which is currently the largest producer of crude, doubling the production of Saudi Arabia. The additional supply along with recently reduced demand has softened energy price.
Just as things appeared to be getting back to normal (whatever normal even is these days), trouble in the Middle East ramped up. Yesterday’s unprecedented missile attack by Iran on Israel took the trouble to a new height causing crude prices to jump by as much as +6.5% with the breaking news before ultimately easing back and logging a +2.4% gain on the day. The reason for the spike was obvious. Iran’s escalation increased the probability of a regional conflict. Iran alone represents roughly 12% of OPEC’s crude production and is currently running at full capacity. With a high certainty that Israel will strike back at Iran, the country’s oil production may be at stake. So, what could be the outcome of a further escalation? Take a look at the following chart which shows OPEC oil production stats.
This cool chart from Bloomberg clearly shows just how much Iran contributes to daily production of OPEC crude (12.6%). If Israel takes Iran’s oil production completely offline with a counterstrike, it could cause a deficit of 3.3 million barrels per day. That could be devastating to global crude supply. For some context, Russia produces nearly 4 times as much, but it still has the potential to cause supply challenges and price increases. What am I saying? That potentiality is already playing out in the futures markets. Take a look at the top right panel of the chart which shows historical daily crude output. You will notice that it has been on the decline. That is because OPEC has been cutting production to stabilize prices in order to combat decreased demand and additional supply from the US. That simply means that there is excess capacity. Just how much excess capacity can be found in the top left panel where you can see that Saudi Arabia has excess capacity of around 3 million barrels per day and UAE has excess capacity of around 1.4 million barrels per day. Those 2 countries alone could make up any deficit caused by an Iranian strike.
So, does this recent bit of news justify a spike in oil prices, and more importantly, will it persist to the point where it can cause a fresh spike in inflation? Well, based on what I just showed you, perhaps… not so much. Remember that Saudi Arabia would be happy to pump oil at full capacity to make up supply outages. It would be a windfall for the country. However, if the conflict erupts beyond Iran and Israel or if it escalates beyond a one for one attack, the whole region’s production could be disrupted in one way or another. That could cause prices to climb and remain elevated. Combine that with the port strike in the US, and I would say that the Fed is probably keeping a hot kettle of coffee on standby, as it measures its next moves… very… very carefully.
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