$200 Oil by June?—The Biggest Oil Shock in History with Rory Johnston

The current high valuation of equity markets is largely attributed to optimism surrounding AI penetration, a stark contrast to the unprecedented energy shock the world is experiencing. Rory Johnston, an independent oil analyst, joins Bankless to discuss the intricacies of the oil market, its current state, and its future implications. **Oil Market Fundamentals: A Crash Course** A "barrel of oil" is the standard unit of measurement, equivalent to 42 fluid gallons, a legacy from historical transportation methods. Today, it's purely a unit of account. The global oil market operates as a continuous flow system; it's not designed to be easily shut down without significant complications. Currently, the world consumes and produces approximately 100 million barrels of oil daily, a critical energy source powering transportation (over 50%), asphalt, petrochemicals, and plastics. Oil is transported primarily via tankers, making the shipping industry central to its market. While pipelines are used domestically, especially in Canada, most global oil exports reach "tidewater" (the open ocean) for international transit. Tanker transport, under normal conditions, is cost-effective, integrating oil into the global market once it reaches the sea. Oil is not entirely fungible. Different grades exist, primarily differing in density and sulfur content. West Texas Intermediate (WTI) and Brent crude are benchmark grades, typically light and sweet (low sulfur). Canadian Western Select, however, is heavy and sour. Sulfur content is undesirable as it's an environmental pollutant and requires costly extraction during refining. Heavier, sour crudes are thus generally discounted. Refining separates crude oil into various fractions like asphalt, fuel oil, diesel, jet fuel, gasoline, and lighter gases, with heavier crudes requiring more intensive refining for lighter, more valuable products. **Oil's Evolving Importance** While the energy intensity of economies has decreased over the past 50 years, meaning each barrel of oil supports more economic activity today, oil's relative importance within the broader energy mix has diminished. This is due to the diversification into natural gas, nuclear, coal, and renewables, especially for electricity generation. Oil's role has become more specialized, primarily in transportation, where electrification is the main substitute. The concept of "peak oil" has shifted from peak supply to peak demand. Historically, concerns centered on running out of oil. Now, the focus is on the point at which global demand for oil begins to decline, driven by better substitutes and the energy transition. The shale revolution in the United States, utilizing horizontal drilling and hydraulic fracturing, significantly boosted global supply, altering the peak oil narrative. This technological ingenuity contrasts with the declining geology of conventional oil fields. **Spare Capacity and Inventories** Spare capacity refers to the ability to increase oil production within a short timeframe (e.g., 30 days and maintain for 90 days) without significant investment. Countries like Saudi Arabia, through state-owned Saudi Aramco, can strategically manage spare capacity as both an economic and geopolitical tool. OPEC, the Organization of Petroleum Exporting Countries, plays a role in managing supply through policy decisions. Inventories act as a buffer system. "Stocks" include oil in transit (tankers, pipelines), strategic reserves (like the SPR), and commercial inventories. OECD commercial inventories, typically 2.5 to 3 billion barrels, are the most closely watched and inversely correlated with oil prices. A significant drawdown of these commercial stocks, as seen in the Hormuz crisis, is highly bullish for prices. **The Role of Oil Futures** Oil futures contracts are crucial for pricing and hedging. The futures curve, depicting prices for delivery at different points in time, offers insights into market tightness. Backwardation (near-term contracts priced higher than later ones) signals a tight market, incentivizing inventory drawdowns. Contango (near-term contracts priced lower) indicates an oversupplied market, encouraging storage. The current market is in backwardation, reflecting a significant supply shock. Dated Brent, a physical benchmark, has seen record highs, indicating extreme tightness in the physical market, far exceeding futures prices. **The Hormuz Crisis: Impact and Implications** The closure of the Strait of Hormuz, a critical chokepoint for approximately 20% of global oil supply (around 20 million barrels per day), has led to a substantial supply deficit. Despite some rerouting via pipelines like Saudi Arabia's East-West pipeline and UAE exports, an estimated 13 million barrels per day have been shut in from the Middle East. This forced shut-in is due to full domestic storage capacity, with wells having to be closed, potentially permanently damaging some facilities if prolonged. The guaranteed loss of oil supply from this crisis is estimated to be around a billion barrels, significantly impacting global commercial inventories. The market's response, or lack thereof, has been a subject of debate, with some analysts suggesting it's underpricing the disruption. Factors influencing this include the hope for a diplomatic resolution ("taco" factor), verbal interventions by political leaders, and the market's tendency to react to realized inventory drawdowns rather than anticipate them. The crisis highlights the regressive nature of oil price shocks, disproportionately affecting poorer nations. While North America, particularly the U.S., is relatively insulated due to domestic production and pipeline infrastructure, consumers will still face higher prices. China, despite being a major importer, possesses significant strategic reserves, offering some buffer. Major U.S. allies in Asia, like Japan and Korea, are more vulnerable. The potential for permanent damage to Iranian oil facilities if storage capacity is exhausted is a concern, though the extent of permanent damage from shut-ins is debated. The ongoing crisis is seen as a strategic win for Iran, allowing them to exert pressure without suffering further direct damage, particularly following a ceasefire. **Future Outlook** The Hormuz crisis is expected to accelerate the energy transition. The reminder of dependence on Middle Eastern oil and the associated price volatility will likely strengthen the case for reducing oil consumption, particularly in Asia. While the near-term impact might be bullish for oil prices, the long-term consequence is likely negative for oil's dominance. Natural gas is expected to remain a significant commodity, and the rise of electric vehicle technology presents a viable substitute for oil in transportation. The future of oil's importance hinges on the pace of this transition and the development of alternative energy sources.