The Atom Crash - Trouble in the Strait of Hormuz
Back in January and February of 2020, I would stop by grocery stores every day on my way home from work to see if people had started to panic yet. Things took a bit longer than I had expected to fall apart but of course they did and I find myself in much the same position today where I am stopping by grocery stores and gas stations to see the moment at which people start to realize what's going on. In chatting with gas station attendants, about 1 out of 200 people are filling up extra gas tanks and are actively getting ready. However, unlike 2020, this time I am 100% convinced of what is going to come and I believe it's going to be much worse.
In 2019 at Thanksgiving dinner, my sister-in-law mentioned that a healthy 19-year-old girl had passed away from the flu at her hospital. I had never really heard of a young person dying from the flu and the comment struck me as strange. Then, just a few weeks later, I saw a few twitter posts about a novel respiratory virus in China that was killing young people. At about the same time, my lab received a few unsolicited inquiries about our ability to work with experimental infectious diseases. For whatever reason, I made the connection and started actively tracking the novel coronavirus as it was called at the time and after a couple weeks in December of 2019, I realized that the growth rate was exponential - we were going to have a big problem.
In January of 2020, I started warning family members to stock up on food, durable goods like toilet paper (sorry about that!) and to sell their stocks. I even started putting out a monthly newsletter to a few hundred people that predicted when lockdowns would begin where my estimate was end of Feb 2020. Most people thought I was crazy until everything in the newsletter came to be.
While I predicted the COVID lockdowns and ensuing economic chaos, I did not have much conviction about the financial outcomes because from an economic perspective, COVID was very similar to all prior economic crises. It was similar in that governments had many different levers to pull to change the outcomes. For example, governments could have decided on active immunity where we protected the elderly and made sure all young/healthy people got the virus quickly to avoid mutations. I strongly believed at the time that we would follow the science with an active immunity approach and that no politician would ever support lockdowns which would prolong the disease, increase mutations and lead to decades of economic problems. I also didn’t believe we could convince the public to take a vaccine with no long-term or even mid-term safety testing. Of course though, that is just what we did (#trustthescience).
The point though is just like the financial crisis or even the 1929 depression, policy makers had levers to pull and things could go in many different directions based on which levers were pulled. For example, you could print money, change interest rates and develop all sorts of different types of government programs and policies. However, when we look at what is going on currently with the Iranian war, the economic situation is fundamentally different than most of the crises we have faced before. The Iranians have effectively stopped traffic through the Strait of Hormuz for the last 39 days which constitutes 20% of the world's oil. The best analog we have to this shock is the embargo of the early 1970's which lasted for about 150 days and reduced oil supply by 7% which resulted in a 400% increase in gas prices at the pump in the US. I believe that this shock will be worse than the 1970's shock which caused a decade of stagflation where below I explain why:
Price Inelasticity: "If we have 20% less oil, the price will only go up 20%.....we can live with that."
I have heard this from quite a few people and it represents a lack of understanding of price dynamics where the easy way to explain this is: "would you drive 20% less if gas prices went up 20%?" Of course the answer is no and the better way to think about this is how much would the price need to go up for 20% of the demand to go away (i.e., demand destruction). Perhaps its 80% or in my case, I am not sure there is a price in which I would curtail my driving even a few percent as most of my driving is associated with driving for work. Even if gas prices went to $15 per gallon, I personally wouldn’t change my behavior and for the economy that is a major problem. In economics, this is referred to as inelastic demand where huge increases in cost don’t actually kill demand.
Energy Independence: "The US is energy independent so this doesn’t affect us.”
Even if we ignore the fact that this creates an existential crisis for energy importers (i.e., our allies), this simply isn't true. While the US is a net exporter of petroleum products, the US imports 7M barrels of oil per day and produces 13M barrels of oil per day. Of this, the US exports 9-10M barrels and domestically uses 10-11M barrels per day. The refining capacity within much of the US is designed to work with imported oil (i.e., heavy crude) and thus the US oil market has enormous exposure to worldwide oil prices despite being insulated. This is important because for countries that rely upon oil imports, they will demand oil at any price which will drive worldwide oil prices up which will affect the US. Therefore, the US will perhaps be insulated from fuel shortages, but it will not be insulated from increasing oil prices.
Time Delay
Unlike COVID, the day at which people start to panic in each country is actually pretty easy to predict. Worldwide shipping on water moves at about the speed of a bicycle and the last few ships that passed through the Strait of Hormuz 45 days ago will reach the US in the next few days. For the rest of the world, the ships that passed through the Strait before the war have already all docked and the point of panic is directly dependent on a countries reserves and net importer/net exporter status. For some countries, they are already experiencing panics, shortages and extreme local pricing increases. These panics will spread to the global oil markets over the coming weeks as the crisis intensifies and countries demand oil at any price. For the US, it's unlikely there will be shortages outside of local panic buying as the US only imports 0.5-1M barrels per day from the middle east and the US reserves of 700M barrels can more than make up for this shortfall. However, prices will surge as the US market has enormous international exposure on price.
The Impact of Oil
Prior to the Strait's closure, about 135 ships passed through per day and about 20M barrels worth of oil. At $100 per barrel, that’s only $2B per day which seems like a lot to the individual but in the context of the global economy is quite trivial. However, the thing about oil is that its impact on an economy is non-linear just like the inelastic fuel example used above. If a country loses $20B worth of oil, it could cause a trillion dollars' worth of economic damage because of rising prices and the knock on effects of rising costs.
It's Not Just Oil
One of the most critical aspects of the Strait's closure is that it's not just about oil. The Strait is also a major passageway for helium, liquefied natural gas, aluminum and many other products. This is particularly concerning because without helium we have no semiconductors (i.e., AI chips, computers, electronics), without natural gas we have no fertilizer (i.e., food) and without aluminum we essentially can't make most durable goods (e.g., cars, planes). Just like oil, this will create substantial increases in prices but unlike oil, the US will actually face shortages of various goods where the country is not as well insulated from these effects.
The Strait will open and this will all go back to normal
If we consider that the Strait opens tomorrow 100%, for all countries this still means losing at least 15% of their annual atoms that would pass through the Strait. While for the US this is quite small when looking at oil for example (0.5% per year), for other countries, this is as high as 15% per year and thus will have knock on price effects for years to come based on what has already happened. The reality though is that even if the Strait opened tomorrow, things do not get back to normal immediately and the atom shortage would likely stretch for several more weeks. This is without even considering the long-term damage that has been done throughout the war to critical infrastructure.
The opening of the Strait is much more complicated than this where the game theory is complex and I ask myself several key questions when I think about this:
Even if Iran gets the deal they want (i.e., no sanctions, nuclear weapons proliferation), why would they believe the US to go forward with it given the fact that the US attacked during prior negotiations?
Why would the Iranian's move towards a quick resolution and not just draw out the conflict over months through ceasefires when every day increases their leverage?
The answer to these questions leads me to believe that the Strait will be closed much much longer and there is no quick resolution in sight. What this means is that we are heading towards a time with substantial inflation while growth within companies is zero or negative. From a policy perspective, this situation of stagflation is particularly pernicious as there are no good levers:
Raising rates crushes the economy
Lowering rates accelerate inflation
Printing money causes runaway inflation unlike 2008-2026 where money printing fueled asset bubbles
