This Is Fine: Paper Markets vs. Physical Reality

I’ve been working (and preparing my portfolio) based on this thesis since the war began. I’m a mental health professional, and two terms began ringing in my head within a few days of the war’s beginning:  ‘Normalcy Bias’ and ‘habituation.’ The meme of the dog in the burning building saying, “This is fine,” followed shortly after. Humans en masse facing seismic events have an ingrained tendency to follow “panic” with mean reversion – an assumption that things will probably be OK because they always have been. By definition, we’re still here – panics in our past were always eventually, ‘OK.’

Full disclosure: I’ve been using Claude to monitor, aggregate, and stress test this thesis since the assault on Iran started. And I’m using it to help edit here – largely to push back on poorly supported claims or grandiosity. I’m doing the writing: AI is great at pushing back and catching poorly sourced claims that exceed the evidence when you tell it to be.

Problems arise – for individual humans and for algorithms trained in 'normal times' – when attempts are made to ‘force’ mean reversion when reality on the ground actually calls for adaptation and dramatic change in behavior. It’s my belief that mean reversion sits at the core of algorithmic trading, not a product of bias or malevolence but a function of the way that modern market economies have evolved. Plenty of crises along the way, but in general the system has adapted and continued to hum along. In "normal" times, mean reversion serves well – algos are able to digest headline data and respond proportionately based on how things moved and settled in response to similar headlines in the past. They aren't prone to swings of emotion and urgency and mean reversion in a fundamentally unchanged system is, more often than not, the best course of action. In "abnormal times," however, algorithms – like many humans – are unequipped to recognize and adapt to systemic changes. This is reflected by wild swings in the market that appear disconnected from reality.

This NY Times article from April 10, The Oil Shock Is Worse Than You Think – The New York Times provided sufficient external, independent validation for me to feel like I may be onto something. Per the industry experts quoted by the Times: The deferred oil futures curve has disconnected from physical supply reality and they don’t know why. Today, April 14, the IEA flagged the same physical/futures disconnect in its latest oil market report: “With oil-importing nations scrambling to source replacement barrels from an increasingly shrinking pool of supply, physical crude oil prices surged to record levels near $150/bbl, far above the prices in futures markets, with the physical-futures disconnect becoming increasingly acute.”

Swings in the market since the conflict began have been transparently driven more by headline sentiment than reality on the ground. This conflict was promised as something that would be finished within a few weeks, and the immediate market impacts on oil and equity prices reflected both the shock of the event and a near-immediate reversion towards the mean. Equities stopped their fall, and the oil futures curve continues to project a return to near-normalcy by the end of the year. Meanwhile, prices on the ground are above what the futures market suggests and companies are not paying for ‘theoretical’ energy – the pinch is already being felt. Fuel protests in Ireland as farmers and truckers see their margins erode. Rationing in Italy and Slovenia – modest measures so far, but still rationing – Australia and New Zealand preparing  emergency plans, African nations warning against hoarding… CLZ26 still sits at $77.

Every major swing is followed by a reversion towards the mean regardless of whether that reversion is actually warranted. The paper markets – equities and oil futures, in this case – simply do not hold or properly weight physical reality. I.e., a headline about damage to Ras Laffan infrastructure or the east-west Saudi pipeline may produce a short-term reaction…but it’s treated with the same weight as a headline where a politician issues a vague threat to escalate. The reversion happens after either drop, but infrastructure damage doesn’t just disappear with the next soundbite. And in-the-weeds structural analyses don’t move the markets as much as the latest Trump threat to exterminate a civilization, so relevant updates about infrastructure get drowned out.

In the real world, potential damage to Iraqi oil wells from prolonged partial or full shutdowns – the effects of which compound over time – don’t get durably priced in. The market still projects a V-Shaped energy recovery – as if production cuts can be reversed by a simple switch flip – when that is improbable at best. And it’s not just oil. Parts of Qatar’s Ras Laffan are offline for the next 3 to 5 years with no way to expedite repairs. Per Qatar Energy in March, it will take a minimum of 3-5 years to repair two destroyed trains representing approximately 17% of Qatar’s total LNG export capacity with repairs constrained by turbine manufacturers with preexisting production backlogs. A gas-to-liquids facility owned by Shell will be offline for at least a year. Force Majeure has already been declared on long-term contracts through 2031 for Belgium, South Korea, Italy, and China. Europe enters its summer refill season with gas storage at 29% – below last year’s 35% and well short of the 80% required by winter – with no Qatari LNG having physically transited the Strait of Hormuz since February 28. And yet natural gas prices dropped 20% on news of the April 8 “ceasefire” with no material improvement to any physical issues.

Oil futures and the broader equity markets have substantially disconnected from physical reality to operate largely in the realm of statistics, hedges, and algorithmically driven “likelihoods.” My prediction is that they are chronically overweighting political and diplomatic noise while underweighting infrastructure damage and current / near-term physical reality. If I'm right, earnings reports and company filings that come trickling in over the next few weeks and months that make mention of "real world" energy prices and declines in consumer spending will be the algos' first taste of the physical realities of this conflict after months of treating it like any other ‘minor’ geopolitical disruption.

The algorithms will respond as if a broad swath of companies – not just one individual sector, but virtually every industry indirectly or directly affected by the Strait of Hormuz and energy price increases – are suddenly facing skyrocketing input costs and slowing growth. And there’s a good chance that the ‘drop’ we might have all predicted if we’d been asked in December, “What does SPY do if Trump attacks Iran at the end of February and the Strait of Hormuz gets forcibly shut for 40 days and counting?” comes hard and fast just a few months later than we expected while compounded by the realities of earnings misses and soft guidance. 

This is not financial advice and I know that timing the market is a fool’s errand. But I would argue that earnings season is where physical reality and the markets – equities and the oil futures curve – begin to collide. I don’t expect it to be pleasant.