Strait jacket

Published at 09:46 3 Jul 2019 by . Last edited 11:18 22 Aug 2019.

The 13 June tanker attacks in the Strait of Hormuz and the subsequent escalation of tensions between the US and Iran represent a risk for Middle East LPG and naphtha exports. Light ends fundamentals are otherwise bearish, but with over 1 mb/d of LPG and nearly 0.8 mb/d of naphtha moving through these waters, the market cannot afford to ignore the possibility that a further escalation in tensions could send prices spiralling higher. The question is: should armed conflict break out in the Strait, what level of Middle East supply disruption needs to occur to invert current global market length into a deficit meaningful enough to support or even enhance the war premium?

A total shutdown of flows through the Strait is unlikely. Notwithstanding our view that both the US and Iran are wary of a direct conflict, even during the previous ‘tanker war’ of the late 1980s, military convoys were able to ensure the safety of outbound cargoes from the Gulf. Still, delays and constraints would occur. We posit that the market could only cope with a 40-45% drop in LPG and naphtha volumes through the Strait, after taking into account non-Middle East supply sources and upcoming increases in export capacity and production that could ostensibly fill the shortfall. The situation might be worse for naphtha, as Middle Eastern naphtha and condensate exports have already been reduced much more than LPG shipments because of the OPEC+ production cuts—now extended through Q1 20—and Iranian sanctions, so a loss of another 0.3 mb/d would be more challenging to bear. Indeed, the 13 June attack had the immediate effect of jolting the naphtha market, which had slumped amid fears of oversupply, back into backwardation. The Asian naphtha physical crack, which had turned negative for the first time in a decade in the week preceding the tanker incident, returned to positive territory in the immediate aftermath. All ships transiting the Strait now face significantly higher war premiums for insurance cover, meaning outbound Middle East Gulf freight rates and Asian delivered prices have jumped as a result.

While the non-renewal of Iranian sanctions waivers set the stage for naphtha tightness in Asia, Japan and South Korea look the most vulnerable to any further squeeze, as the Middle East is a traditional baseline supplier. Meanwhile, the tightening of the Asian LPG market is likely to have a greater impact on India and China, which received 94% and 80% of their respective H1 19 LPG imports from the Middle East. While South Korea and Japan have been lifting other grades of naphtha from Australia and the US, India and China have adopted a wait-and-see approach with respect to alternative LPG supplies for now.

However, we cannot overlook the bearish global demand picture, particularly as the market is contemplating geopolitical risks rather than actual disruptions to supply for now. We continue to be concerned with the disappointing state of global petrochemical margins, which were first laid low by oversupply all along the value chain but are now increasingly menaced by waning consumer sentiment. In their ongoing tariff war, the US and China have kicked the proverbial can down the road. Without a true deal, consumer sentiment cannot fully recover. This primes Q4 19 for a clash of supply and demand, especially since we expect naphtha supplies to rise ahead of IMO 2020. So, while there could well be some near-term upside for LPG and naphtha prices, we expect this to be swatted down in the longer term by languishing demand.

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