Why oil prices are about to surge

With mid-term elections looming in November, time is running out for the US president to negotiate a permanent end to hostilities that threaten to plunge the world into a full-blown fuel crisis.

On Wednesday, just hours after reversing course on his 24-hour old threat to charge a 20 per cent fee on cargoes passing through the Strait of Hormuz, Donald Trump thundered about military action before claiming, yet again, that Iran was open to negotiations.

"We received a call just as I was coming here that they want to meet," Trump said in a Fox Business interview.

"They always want to meet.

"They're nasty people, but they want to make a deal."

The ongoing theatre within the White House has helped divert attention from a rapidly escalating energy supply crunch that has yet to show up on oil markets.

While the price of crude has jumped in the past week, as the fragile ceasefire has crumbled, the remarkably restrained price moves have helped create a false sense of security.

At around $US85 a barrel, it is around 30 per cent below the peak in March, after Iran retaliated to Israel's and America's assault by shutting the Strait of Hormuz.

That muted reaction, however, is primarily because energy markets have become hugely distorted.

The trouble right now is not oil. In fact, there's something of a temporary glut with crude.

Instead, alarming shortages of refined products such as petrol, diesel and jet fuel once again are threatening the global economy.

According to MST Financial analyst Saul Kavonic, oil traders may have been lulled by the constant talk of a resolution, but time is running desperately short and the links are beginning to fray.

"Refined fuels are the more broken part of the chain," he says.

When two wars collide

The Ukraine war finally has reached the streets of Moscow, St Petersburg and right across the country to Siberia.

With the world obsessed by events in the Middle East, Ukraine suddenly has struck deep into enemy territory with a surgical precision that has damaged the beating heart of the Russian economy.

Russia's refineries are in flames. Its ports are being thumped.

Estimates range from somewhere between 25 to 45 per cent of Russian refining capacity now being out of action.

Motorists in the capital are queuing for days to refuel, if they can get any at all. Tempers are fraying and violence at the bowser is becoming more common. Crimea has all but run out of petrol, leaving citizens stranded.

A crude oil production powerhouse, Russia is also the world's second biggest diesel exporter.

With so much of its refining capacity in flames, the Kremlin last week banned diesel exports.

In a televised broadcast, Deputy Prime Minister Alexander Novak said, "The current situation at filling stations is causing concern among the public.

"Today, a ban on diesel fuel exports was introduced, and this will make it possible to increase supplies to the domestic market," he said, adding that Russia would start importing fuel in July.

That was just as Ukrainian drones struck Russia's biggest oil refinery thousands of kilometres away in Siberia.

The announcement set off a chain reaction.

Turkey, a major diesel producer and consumer, has also banned diesel exports, while Belarus has begun diverting diesel to Russia as the Kremlin desperately scrambles to secure petrol from India.

Compounding the shortage is China. Back in March, as the Iran conflict moved into full swing, Beijing banned the export of all refined fuel to safeguard its domestic supplies.

That's been partially lifted but only to the extent that refiners must maintain full stockpiles.

Suddenly, China, Russia and the Persian Gulf — three of the world's biggest suppliers of refined fuel — are all off-line.

No shortage of crude — for now

With Russia's refining capacity reduced to levels not seen since 2005, a flotilla of fully laden Russian tankers has found itself all at sea with nowhere to go.

According to Bloomberg reports, around 135 million barrels of oil are stranded at sea, forcing authorities to divert the oil to other markets.

Given Russian oil is under trade sanctions, that's no easy task. Transactions have to be conducted under the radar and at a discount.

During the brief Gulf ceasefire, shipowners scrambled to get tankers out of the Gulf and, while average shipments were lower than normal, upwards of 20 million barrels a day traversed the now blocked Strait of Hormuz.

That provided something of a short-term buffer to oil supplies and, when combined with the Russian surplus, has kept crude oil prices in check.

On top of that, China's decision to conserve its refined fuel resulted in a dramatic drop in crude purchases, as this graph illustrates, which also took the pressure off global prices.

According to Kavonic, China has played a key role in moderating crude oil prices throughout the crisis.

With already large reserves, he explains, China bought up big when the conflict erupted and then sold oil as hostilities went on.

Its purchases are now the smallest in a decade, slicing around 5 million barrels a day from global demand.

Also weighing on crude prices has been the release of strategic reserves, totalling about 3 million barrels a day. But those reserves are now dangerously low.

"We now have a billion barrels less oil and fuel stocks than before the war," Kavonic says.

"We've been living off the oil market credit card and we're close to maxing out the card for refined fuel."

'Diesel, jet fuel and gasoline shortages'

With markets temporarily swimming in excess crude oil, the gap between its price and that of increasingly scarce stocks of refined fuel has again begun to widen.

"There are diesel, jet fuel and gasoline shortages," Kavonic observes.

"The (price) spreads are unusually high."

Prior to the war, the Gulf states were the biggest exporters of diesel and jet fuel. But, while oil can be diverted to the Red Sea via pipelines, there's no such escape for refined product.

Even if the war is brought to a sudden end, The Economist newspaper estimates that at least 1.4 million barrels a day of Gulf refining capacity has been hit, which could take months to repair.

The damage to Russian refining capacity could be even more extensive.

While crude oil prices remain only slightly elevated, Kavonic warns that the current price environment is unsustainable.

"It all comes back to the war," he says.

"The market is still thinking it's not going to get back to the March position. But we have a month, max."

If there is no resolution, Kavonic estimates crude prices will shoot towards $US130 a barrel.

He's not alone.

Earlier this week, Commonwealth Bank commodity analyst Vivek Dhar noted that, while it may take about 10 weeks for the reduced Gulf output to be fully felt, without a reopening of the Strait of Hormuz that could then push prices as high as $US150 a barrel.

Either way, it simply is a question of time. And for Australia, with just two refineries, now may be the time to stock up on crude supplies. Or for the prime minister to do another tour of refining nations to our north.