We first wrote that the closure of the strait was a problem of ‘time’ back in March. This supposed “ceasefire” changes nothing.
( Full Disclosure, at the moment, we run a portfolio with many long and short positions. At the time of this writing, our Equity Fixed Income Hybrid Core holds 17 risk assets, with a hedge wherein those risk assets delta’s are beta-weighted to the SPY, and holds a 0.50 hedge to those assets. Our Long-Short Valuation Book, is net short the indices. And our Short Term Trading Account, has deltas that are long the 10 year (hedged), short the S&P, long 5 year instruments, and short instruments with 30 year exposure. )
I like engaging in counter-factuals. Counter-factuals are “what if” scenarios that explore alternative possibilities of ‘what is’ actually true, or has occurred. These mental simulations … often framed as “if only’s” or “what if’s” … allow us to explore “the roads not taken,” and therefore evaluate causality, and frame even present realities in a more concrete manner.
So let’s engage in such a ‘counter-factual. Let’s start with a simple premise.
Let’s assume the Strait of Hormuz is open today. It’s not. But let’s suppose it is. Fully open. No risk, no delays, no insurance complications, no hesitation from shipowners. Just normal flow of traffic through the Strait of Hormuz … as if nothing had happened.
Even in that world … with that very, very hypothetical premise? As we have mentioned in this article here at this link on March 19th … it’s already too late. It’s too late … and it is on top of a massive amount of damage has been done.
Because the system we are dealing with is not an instantaneous system. It is ‘path dependent’ system. And most importantly, it is time dependent. And we’re going to stress once again … time … is the problem.
Roughly 20 million barrels per day move through that corridor under normal conditions. That is not a number you simply “replace” because a ceasefire headline crosses. That flow was disrupted. That 20 million barrels, takes time to traverse it’s path to the energy markets, and then to be refined and consumed by the final end consumer. And once disrupted, the clock starts. Tankers that did not move are still not where they need to be. Cargoes that did not load are still not in transit. Deliveries that were supposed to arrive simply do not exist in the system.
So if we engage in our ‘counter-factual’ that the Strait of Hormuz is open this very second … even if everything normalized this very second, you are still dealing with a supply chain that has already been emptied, and we are facing a massive impact in terms of restoring that supply chain. This will take months to even begin to repair.
If the Strait of Hormuz were open today.
Which it is not.
Think through the mechanics. A barrel that needs to reach Asia does not step onto the transporter pad on the U.S.S. Enterprise to be teleported to it’s destination.
It loads, it sails, it queues, it unloads, it gets refined, and then it moves through product channels. That is a 30 to 45 day process under ideal conditions. Possibly even 60 to 90 days. But … we’re engaging in counter-factuals. So we will use the best case scenario, and think of ideal conditions. So imagine that 30 to 45 days window with no ships are sailing. And while that is happening, inventories are being drawn down.
The floating storage that once acted as a buffer is gone. Strategic inventories built for this purpose have been tapped and balances are fragmented.
This is where most people make the error. They look at marginal improvement in news headlines and assume resolution, and then base a risk decision, from that. A few ships get through, a headline crosses, a ceasefire is announced … and the conclusion is drawn that the problem is over.
No. It’s not.
And that if it was if the strait is open today.
Which it is not.
The problem is cumulative.
If you remove supply from a system for a period of time, you do not just replace that supply by restarting the flow. You must replace what was lost. That requires sustained surplus over time, not a short burst of normalization.
If the Strait of Hormuz were open today.
Not let’s return to reality for a moment, and push our counter-factual aside. In reality, there was a two week ceasefire announced. In normal conditions, roughly 135 ships cross that corridor daily. Recently? It was three. At that rate, clearing roughly 800 vessels currently backed up takes 267 days. The ceasefire is for two weeks. The math does not reconcile. And that assumes everything works perfectly starting today … which it does not.
And that ceasefire was announced almost 3 days ago. We have 11 days left. If you are an insurer of these vessels, do you want them going into the Strait of Hormuz?
And there is the human element to consider. Behavior does not normalize overnight. Participants do not suddenly act as if nothing happened. Risk remains embedded in the system.
Which brings us back to the core point.
As we said back in March? This … it is … “Actually, not what’s taking place today … but what’s already taken place …”
What has already taken place is a break in the chain. And once that chain is broken, time compounds the problem. Inventories draw down, supply chains stretch, prices adjust, and behavior changes. You are no longer solving for equilibrium at time ‘T’. You are solving for equilibrium at ‘T’ plus the time required to rebuild what was lost.
And that is where we feel the market is making a critical error right now. It is pricing the headline, but is not pricing the mechanics.
Which is why you are seeing rallies in risk assets on the back of “peace” headlines. Hope. Relief. What we would simply call complacency. I refer to it as ‘hopium’.
And this speaks to a larger issue of the behavior of market participants in the last 6 years. It is a discretionary, qualitative judgement? But we see an incredible amount of market complacency in recent years. And it goes by several names. The “Fed Put”. Fiscal stimulus. “There will always be a fix …” Now it has a new label. TACO. These are all basically flavors of the same underlying belief … with different wrapper. That things ‘will just work out’. All of this is the epitome and definition of Normalcy Bias.
But markets are not narratives. They are systems. And systems break when the underlying mechanics fail.
So no, we are not buyers of this rally. Now … to be sure … due to the aforementioned complacency, as more headlines hit and more discussions take place, you will get more upside bursts driven by positioning and short covering. When it comes to discussions around 2008, few people talk about the rally in 2008. Due to the cognitive bias of availability heuristic, most people simply focus on the stupendous crash of 2008 in financial markets. But in truth … the S&P 500 rallied from March of 2008 to May of 2008.
So might the market rally? Sure. It rallied for ~ 60 days back in 2008. Nearly two whole months.
That is fine. But none of that changes the underlying condition.
The damage has already been done. And more importantly … it is still being done.
Because despite the ‘ceasefire’ … and despite headlines?
The Strait of Hormuz is not open. The system is not functioning in the way it once did. Those sea-lanes are empty. And the clock is still running. Which means that not only does the problem remain … but it grows larger. And larger.
And larger.
And that is all before we talk about the damage to energy infrastructure through missile attacks. So we come back to the same conclusion. This problem is not about what’s taking place today … but what has already taken place.
Until next time, stay safe and trade well.
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