Uncertainty premia in fuel markets decline

The price of crude oil dropped by 13-15% as soon as the ceasefire was announced, and markets started pricing in expectations about the opening of the Strait of Hormuz. But prices have inched upwards again as uncertainty about the durability of the ceasefire has mounted and news of restricted traffic through the strait has been circulated.

For example, Brent crude was selling at USD 98 per barrel when this was written (13:00 hrs. on Thursday), down from nearly USD 110 during the prelude to the ceasefire. Actually, at the peak a few days before then, prices rose above USD 110. Brent crude prices have therefore fallen by 11% since the ceasefire was announced. Petrol, diesel fuel, and jet fuel prices in the European market have more or less followed suit. As of this writing, petrol prices have fallen 8-11%, diesel by 12-15%, and jet fuel by 10% since Tuesday evening. Liquid natural gas (LNG) markets behaved similarly, as the risk of severe disruptions in shipping was all but eliminated from price formation as soon as the ceasefire was announced. Nevertheless, LNG prices have risen again and are now approximately 4-7% lower than during the run-up to the ceasefire.

These responses underscore how finance-driven the relevant energy markets have become. Price formation is determined primarily from estimates of future flows and risks rather than near-term shortages. When the most pessimistic scenario involving a collapse in supplies in the near future is accorded less weight, a large share of the geopolitical risk premium evaporates in just a few days’ time – even though shipping has not yet returned to normal.

Industrial commodities stuck in a supply crisis

At the same time, the price of many industrial inputs and intermediate products has remained high. Here are some examples:

• Urea, an important component in fertiliser production, which is still 50-60% more expensive than before the war broke out.
• Aluminium, as manufacturing in the Persian Gulf has been disrupted, and bringing smelters back online is both costly and time-consuming.
• Sulphur, as a large share of the global supply suffered a shock and the market is showing signs of a shortage.

These markets are alike in several ways: they rely on operational continuity and fairly complex shipping chains, and manufacturers hold only small amounts in inventory at any given time. Even if traffic through the Strait of Hormuz returns to normal in the next few days, it will take several weeks for accumulated inventories or newly produced commodities to reach end users in Asia, Australia-Oceania, or Europe. The bottlenecks that develop in such supply chains during a war do not disappear in one fell swoop because of a single political declaration.

Reboot times vary across commodity categories

The most important explanation for divergent price developments is the varying length of time it takes to restart production and distribution of the commodities in question:

• Oil processing and exportation can recover in a few weeks or, at most, a few months.
• Full-scale LNG flows from the Gulf take longer to normalise but are still relatively flexible.
• Aluminium smelters, fertiliser plants, and related value chains can take months to return to full capacity, however, and in some cases, potential output is lost permanently.

In such instances, industrial commodities continue to be in short supply, even though energy prices fall, at least on paper.

Shipping and insurance still up in the air

Although a ceasefire has been announced, uncertainty about the safety of Persian Gulf shipping remains. Shipping companies and insurance firms are cautious; insurance coverage is costly, and safety is not certain. This has the strongest effect on commodities that must be shipped rapidly and regularly to buyers.

On the whole, the situation can be characterised as a two-speed adjustment:

Rapid adjustment: Financial markets, where oil and gas are repriced more or less immediately, in line with news coverage and expectations.

Gradual adjustment: The real economy, where industrial commodities continue to reflect actual shortages and damaged supply chains.

What does this mean for the inflation outlook in Iceland?

For Iceland, this situation somewhat mitigates near-term inflationary pressures as compared with the pre-ceasefire outlook, but it does not solve the problem. Lower oil prices will probably reduce the probability that petrol prices in Iceland will rise more than they already have. The indirect effects, via imported goods and shipping costs that have yet to pass through to the CPI, take much longer to turn around.

High prices for fertiliser, metals, plastics, and other inputs will continue to increase costs in global value chains. This makes it more likely that cost increases will be passed through to the price level, even if individual items (such as energy prices) recover. Developments like this align well with the scenario sketched out in the Central Bank’s (CBI) recent discussion of its interest rate decision, in which it emphasised that inflation has become more widespread and persistent.

Impact on monetary policy

In the minutes from recent meetings of the CBI’s Monetary Policy Committee (MPC), it is made very clear that the main challenge is to re-anchor inflation expectations at target. Although domestic demand has cooled and there are signs of slower economic activity, the MPC is hesitant to ease the monetary stance too soon.

The bifurcation of the commodity markets supports this position. Lower energy prices cause short-term inflation to ease, all else being equal, but high industrial commodity prices and rising shipping costs exacerbate the risk of second-round effects. In a small open economy like Iceland, where imported inputs weigh heavily, such effects can surface relatively quickly and then become entrenched.

As a result, the CBI will probably view these most recent developments as confirmation that the last mile in the disinflation marathon will be a tough one. Short-term dips in fossil fuel prices do not by themselves justify a departure from the stern message issued by the MPC at the time of the March policy rate hike.

The split in commodity prices following the ceasefire in the Persian Gulf is real, and it is logical from an economic perspective. It should also be borne in mind that it is entirely unknown what will happen after the ceasefire ends, not to mention that there is no guarantee that the ceasefire itself will last two weeks. For Iceland, the divergence in commodity prices somewhat mitigates inflationary pressures, but it is also a source of uncertainty about what happens next. Against a backdrop like this, the CBI is likely to adhere to strict and cautious monetary policy, with continued emphasis on anchoring inflation expectations and ensuring financial stability.