Inflation – Why the Iran War Will Impact CPI (a follow up)

First, my claim:

Due to a mix of factors impacting both the supply and demand for petroleum products, along with other factors, we will see a sustained increase in prices for these commodities that will ripple through the rest of the supply chain impacting overall inflation levels.

Yesterday I made a post detailing why I think the war in Iran will have far reaching consequences throughout the economy. The core of my claim is that inflation caused by the Iran war will be the first domino that will impact a series of factors throughout the economy. A few of you questioned whether or not the Iran war would cause pervasive inflation. I wanted to make a follow up to explain why it will.

Supply

There are reports that as much as 40% of the oil infrastructure Im the gulf has been damaged during this conflict. “Damage” is a broad term, and Im sure some of it is quickly reparable, but if even 1/4 of that damage is serious we’re talking about 2m bbd being taken off the market. This doesn’t take into account the unknown levels of damage that can occur when these oil fields are restarted. Turning off an oil field is a complicated process and even when it’s done correctly there is a risk of damaging the field. That would only compound the issues with supply.

The real problem with supply is with LNG. After the Russian invasion of Ukraine, the world’s LNG facilities have been running close to capacity. There is not a material amount of slack in the system to make up for the damaged LNG facilities in the gulf. In addition to this war, Australia has been hit with Cyclones taking out some of its LNG facilities, only compounding the issue.

We will fix this infrastructure eventually, but every day spent doing so is millions of barrels of oil and tens of thousands of tons of natural gas that will never make it to market. Current estimates are that Qatar alone has lost almost 13m tons of annual LNG capacity and will be offline for the next three years.

Demand

In addition to a constriction of supply, we will see an increase in demand at the same time. Countries in Asia are dependent on petroleum coming out of the gulf. Currently, they are using their reserve fuels while they wait out this conflict. When the strait reopens, they will need to replace those reserves, so not only will they be buying their normal amount to operate their economies, but they will increase their buying to rebuild their reserves.

Not only will they want to get their reserves back to pre conflict levels, but I think it’s reasonable to assume they will want higher levels of reserves. Right now, the Thai government has stopped using its elevators and has told people to take the stairs to save oil. The Philippines has cut down to a 4 day work week to lower gas spent commuting. Australia reportedly has less than 2 months of gasoline supply left. After experiencing shortages like this, these countries will want to fill up their reserves to higher levels than before the conflict to feel secure that they could weather another closure of the strait.

That’s a double whammy of whipsaw style inflation. Just these factors alone mean that elevated petroleum prices will maintain for months while the industry rebalances. For LNG, that timeline may be closer to years.

What about 2022?

When Russia invaded Ukraine in 2022 gas hit $4 a gallon. Why is this time different?

First, that did create a problem for CPI inflation that we are still dealing with now. Even though the US was able to step in and fill Europes need for oil and natural gas, we still got years of elevated inflation.

Second, going into 2022 inflation was below expectation. The US had low levels of inflation going all the way back to 2008. We went from low inflation to high inflation. This time we are starting off with inflation that’s already above the Fed’s target, and that’s at sub $70 oil.

Additionally, the US had the capacity to step in and fill the gap in the market created by the Ukraine conflict. That’s not the case this time. When the Ukraine war started, that was the only hit to the petroleum market. That war is still going on, and the Iran war is additive.

Other factors

In addition to the supply and demand dynamics in petroleum, there is also a spike in shipping costs. The cost to charter an oil tanker has gone up by a factor of 10. Ditto with war insurance. On top of that, there are merchant mariners that have been stuck in the gulf for a month now. You’ll probably have to pay them more than usual to go back there. This means that in addition to the increase in the price of oil and LNG, countries will also be paying close to 10x more to get this products delivered to them.

Another factor to keep in mind is that the conflict is still happening. The US has not yet opened the strait and there’s some possibility it takes them much longer to do so. Every day the strait remains closed these problems just compound. More infrastructure is damaged, more reserves get used up, and countries become more convinced they need even higher levels of reserves. Every report of mines in the strait or shipping vessels attacked just makes it more and more expensive to operate a ship.

At this point higher levels of CPI inflation are already locked in for late 2026 and 2027. Even if the strait opens today, we still have the supply and demand dynamics I outlined above. Also, the strait is not open today. The US is sending in more troops and considering a ground operation to seize the enriched uranium held by the IRGC. To me that does not suggest that the strait will be open this week (although anything is possible).

Last post I included a list of sources, but I don’t think anyone read them. This time Im going to leave them off, but if you want to see where I’m getting the info, I can repost with a list of links.