Pressure Builds

Not investment advice.

Oil is having an outsized impact on the price of all other assets. Bonds, for instance, are full of oil. Below I show 2-year bond yields (white) in the US versus oil (blue). The recent rise in bond yields is mostly driven by the rise in oil, and similar dynamics are evident in most markets. That’s why the whiff of a possible compromise in Iran matters a great deal.

The market is pricing the war will continue. The clearest evidence for this is the premium at which oil delivered soon (like next month) trades relative to oil delivered next year. Nearby oil is trading at a premium similar to what you saw during the early days of Russia’s attack on Ukraine, as shown below.

Mechanically, to keep prices this high, speculators need buy a lot of oil futures because producers (people who own the oil coming out of the ground) are selling oil to lock in these high prices. So far, these two sides are roughly offsetting. Since the initial lurch higher in prices in March, oil prices have roughly gone sideways. The passage of hundreds of ships through the Strait, increased US production, and the shipment of oil via alternative means (like a pipeline from Saudi Arabia) also help.

No one is privy to what everyone is thinking, so we need to guess. Given the risks, even signing a one-page memorandum will be seen as progress.

Here is how I see the perspectives of the different players:

1. China, the GCC, and the G20 want the Strait to open. China wants its oil, the GCC wants to export, and no G20 leader wants to face voters irate over rising prices. Because China is Iran’s most important client, China’s public affirmation this week of its support for negotiations is important. But it is also nuanced: China also wants to see the US lose.

2. The US is almost desperate. Energy prices are high, inflation is rising, Trump’s popularity is ebbing, and even some MAGA faithful don’t like the war. Gasoline can jump from $5 to $10 a gallon if the Strait does not open soon. Israel has said it doesn’t want to end the war until the current Iranian regime falls, but the US can agree to a deal with Iran even if Israel doesn’t like it.

3. Iran would like to end the war if doing so involves (a) getting paid off in the form of sanctions relief and having assets unfrozen (likely) and (b) being granted some form of control/tribute collection over the Strait, much as Egypt and Turkey retain over their respective straits (less likely). I still don’t understand how the US and Iran come to agreement on Iran’s nukes.

Iran has discovered that even if they don’t have a bomb, controlling the Strait is sort of like having one. It’s possible Iran, knowing Trump’s constraints, digs in and the worst-case scenario unfolds: a spike higher in oil, a violent sell-off in bonds that then crushes the stock market rally. But the odds appear to be shifting away from that maximalist position. Despite Iran launching missiles at the UAE and firing on the US Navy, Brent oil, as I write this, is down on the week. The market is smelling the chance of, if not a resolution, then at least an improvement in oil flows.

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