MARKETS:
Gulf War 3’s Flurry and Fallout
Commodity price responses to major geopolitical events tend to follow a flurry-then-fallout pattern. Initially, a flurry generates extreme price volatility. Then, once the event is better understood and a likely path emerges, prices gravitate to levels consistent with the fallout. Until then, as we are experiencing now, deep uncertainty prevails.
MARKETS: Gulf War 3’s Flurry and Fallout
Gulf War 3 (GW3) has caused hefty rises in some commodity prices. The war has mostly halted ship traffic through the Strait of Hormuz (SoH), causing oil prices to rise by about 50$, and then shed some of that gain. Grain and oilseed prices traded a similar, but smaller amplitude, pattern. Interruptions to fertiliser supply from the region are a major issue for crops. Commodity price responses to major geopolitical events tend to follow a flurry-then-fallout pattern. Initially, a flurry generates extreme price volatility. Then, once the event is better understood and a likely path emerges, prices gravitate to levels consistent with the fallout. Until then, as we are experiencing now, deep uncertainty prevails.
The Flurry
The flurry is commodity markets’ reaction to a sudden supply interruption. The market needs to rearrange the available supply. This rearrangement usually has a severe price impact because the imperative is to deliver. The cost/price becomes a minor consideration. Producers and merchants can declare force majeure, but only in limited circumstances. Moreover, too easily declaring so damages the reputations of suppliers and merchants. Deliveries now will often be loss-making. But that loss is traded off against maintaining, or possibly enhancing, their reputation to secure a much larger volume of later sales.
The price spikes seen so far are characteristic of these flurries. The flurry also tends to spread very quickly across similar commodities and their downstream products. Merchant’s imperative in these crucible moments is not far from ‘just buy anything’. And there is good tactical logic to that approach because price correlations shift, categorically, to all but 1 during flurries. The willingness to pay those high prices is a triaging process for getting available supply to those with the greatest need. The triaging consumes any ‘slack’ in the supply chain, making it über JIT. In a grim irony, on about the 250th anniversary of “The Wealth of Nations”, we are living through a vivid example of The Invisible Hand in action.
Prompt & Deferred
Importantly, the flurry is about spot or near-spot (prompt) supply. Therefore, the flurry primarily plays out in prompt prices. However, commodity markets not only trade prompt supply – they also trade deferred supply. Prompt and deferred prices are rarely the same, but the gap between them can vary substantially. GW3 has caused an unusually large gap between prompt and deferred oil prices. That gap is because prompt prices have increased roughly twice as much as deferred prices. The stress is in the prompt markets. That price difference is meaningful. Prompt prices are perhaps already in oil shock territory, but deferred prices are not.
The crude oil futures curve is, for now, perhaps the best visible proxy for the war’s impact. Particularly, while transiting the SoH is risky. That prompt-deferred gap is likely (qualitatively) similar across energy and energy-product (EEP) prices, fertiliser included. The “for now” is important because events can drive greater divergence between different EEP prices.
The Fallout
Beyond the immediate flurry is the sustained fallout. Deferred prices are an important indicator of GW3’s fallout.
Deferred oil prices are higher because of GW3. Most of the rise was likely due to different players buying back some form of short position. Certainly, the fallout might cause deferred prices to match prompt prices. However, there is no certainty that will be the outcome. Smaller rises are not necessarily a sign that markets expect supply disruptions to be largely resolved. Instead, it is more likely a sign that markets are uncertain about the fallout. Consequently, few are developing strong convictions and setting positions. The uncertainty is reflected in implied volatility. Crude oil’s deferred price volatility, in normal circumstances, is 20-25%. Last Friday, it closed around 45%, indicating a higher chance of a much wider price range
Markets lack of conviction is understandable. Predicting the persistent EEP implications is unusually difficult. GW3 is obviously not the usual issues that drive these markets. Markets understand what EEPs come from where, and where and when the EEPs need to go. In normal circumstances, markets presume that production and distribution will run more or less smoothly. GW3 means that the analytical starting point is no longer valid. A solid presumption becomes a volatile perception. A single premise becomes an overwhelming menu of possibilities, generated by:
- the war’s political and military actions and reactions,
- the Iranian regime’s weakening grip on Iran,
- big problems prompting big policy responses,
- commodity supply chains always amazing flexibility, and
- the speed of evolution.
Consequently, the fallout has a very wide range of outcomes. And, because the initial context can change so quickly, any extrapolation can quickly become redundant. That setup reduces market confidence to predict. During events like GW3, humility is your friend. Admission that we just don’t know what path events will take is a powerful liberation. Being freed from a particular view allows a flexible response as the fallout evolves.
Consequently, the fallout has a very wide range of outcomes. And, because the initial context can change so quickly, any extrapolation can quickly become redundant. That setup reduces market confidence to predict. During events like GW3, humility is your friend. Admission that we just don’t know what path events will take is a powerful liberation. Being freed from a particular view allows a flexible response as the fallout evolves.
An important feature of crop commodities is their seasonality. Crops are more periodic (seasonal) than continuous, and so too is their input use. The fertiliser thus needs to be available by certain dates, so it is less continuous than energy. That characteristic is both a strength and a weakness, depending on the timing of supply interruptions. The seasonality does afford supply chains somewhat greater flexibility to work around problems. The timing now is on the cusp of northern summer and southern winter crop planting. Also, northern winter crops are emerging from dormancy. Growers will apply fertiliser to crops soon. How much of the fertiliser is already available to growers is unclear.
Fertiliser is the main issue for crops. Fuel and chemicals can also have an impact. Clearly, any sustained, material interruption to fertiliser supply would reduce crop production. And GW3 is material, given that 20-30% of supply, as either fertiliser or feedstock, travels through the SoH. Knowing the interruption is material is a long way from estimating the crop impact with any precision. Also, any estimate is subject to the same 5 uncertainties that can radically alter any forecast’s starting point.
GW3 still has plenty of twists and turns to come. Stay agile.
