By Myra P. Saefong

Maritime transit through the Strait of Hormuz has improved since the start of the Iran war - but it's still far from normal

A faster-than-expected reopening of the Strait of Hormuz has been part of the reason for oil's roughly 10% price decline since mid-June.

Oil prices have finally fallen back to pre-Iran war levels - but the crude market is far from seeing a normalization of shipping, oil supplies and demand that such a big retreat implies.

A faster-than-expected reopening of the Strait of Hormuz has been part of the reason for oil's roughly 10% price decline since mid-June, when the U.S. and Iran announced plans to extend their cease-fire by 60 days and to reopen the waterway.

As the military escalation faded in the wake of the agreement, traders rapidly removed the geopolitical risk premium in oil prices, said Salih Yilmaz, senior industry analyst at Bloomberg Intelligence. That premium had lifted global prices as high as $126.41 on April 30, a roughly four-year peak, according to Dow Jones Market Data.

The oil market also became more comfortable with the "adjustment mechanisms," Yilmaz told MarketWatch by email. In other words, the market found ways to deal with shipping disruptions in the strait during the war. That included tapping spare production capacity from the major oil producers known as OPEC+, as wella s global emergency reserves. Regional infrastructure also has come into play, including pipelines to bypass halts in maritime shipping.

But shipping of oil and other goods is far from what was considered normal before the war began. About 37 oil tankers traveled through the Strait of Hormuz on July 1, more than the 10 tankers seen daily in recent months prior to the latest cease-fire agreement, according to data from analysts at Kpler. But before the war began on Feb. 28, more than 100 vessels in total per day typically traveled through the waterway, with most of those being tankers, the Kpler analysts noted.

'The return to prewar prices reflects a much lower probability of a severe supply shock, but it does not mean the market has returned to normal.'Salih Yilmaz, Bloomberg Intelligence

"The return to prewar prices reflects a much lower probability of a severe supply shock, but it does not mean the market has returned to normal," said Yilmaz. Shipping patterns remain disrupted, insurance costs are still elevated and transit through the strait has not fully normalized.

While the market has priced out more extreme risks, it could be "underestimating the persistence of lower-level geopolitical risks that could keep a modest premium in crude prices," he added.

In Thursday dealings, September Brent crude (BRNU26) (BRN00) traded at $70.83 a barrel, down 1% for the session. It lost 38% in the second quarter to mark its biggest quarterly drop since the first quarter of 2020. August West Texas Intermediate crude (CLQ26) (CL.1) (CL00), the U.S. benchmark, was down 1.3% at $67.69 a barrel, after losing about 31% in the three months ended June 30.

The speed of the decline in oil prices has been "remarkable but not entirely surprising" since, historically, the market tends to remove geopolitical risk premiums much faster than they build them, said Yilmaz.

"Many of the conditions that allowed the market to absorb the initial shock remain temporary or incomplete, leaving prices vulnerable if tensions persist or shipping conditions deteriorate again," he said.

China's part

Another key factor that helped the market deal with the supply shock was a "collapse in Chinese oil demand and imports," said strategists at J.P. Morgan, led by Natasha Kaneva, in a Thursday note.

In the wake of the Iran conflict, the world lost roughly 11.7 million barrels per day of crude-oil supply, they noted - with about 4.3 million barrels per day of that loss offset by inventory releases, and another 5.3 million barrels per day absorbed through demand loss.

China's crude imports are signficantly below the levels seen before the Iran war.

China's decline in demand and imports accounted for nearly one-third of those offsets, and they're still running about 4 million barrels per day lower than they were before the war, the J.P. Morgan analysts said.

China has "quietly" retrenched enough demand to subsidize continued oil consumption in countries like Japan and Australia, and combined with some nations releasing oil in storage, refiners across Asia and Europe had enough supply to secure cargoes for July and August, the analysts said.

That means the barrels of oil increasingly exiting the Strait of Hormuz have nowhere to go except China - yet China is not buying, the J.P. Morgan analysts said.

The market is "facing the risk of a temporary glut as trapped oil finally re-enters a system that has already spent months learning how to function without it," they noted.

What now?

Looking ahead, what happens next will depend on the supply-and-demand balance, said David Aspell, chief investment officer, global macro, and managing partner at Mount Lucas Management.

It's unclear how countries will approach rebuilding their strategic petroleum reserves, and whether industrial demand picks up as producing countries potentially increase supplies, he said.

Generally, after events like this, some amount of demand destruction remains in place for a period. Potentially, some of the risk premium in oil will be reduced if reliance on the Strait of Hormuz eases over the next few years and "workarounds," such pipelines bypassing the strait, make the system a bit more robust, according to Aspell.

For now, Yilmaz of Bloomberg Intelligence said oil prices are more likely to remain "relatively well supported," rather than fall substantially from current levels.

To sustain current prices, Yilmaz said the cease-fire needs to hold, negotiations need to continue and commercial shipping through the Gulf needs to keep normalizing without any renewed attacks or disruptions.

However, as long as Gulf shipping, regional exports and broader geopolitical tensions remain below full normalization, "some residual risk premium" in oil prices is likely to persist even if volatility continues to decline, he added.

-Myra P. Saefong

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