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Welcome to Dispatch Energy! Israel and Iran agreed to a ceasefire to put a stop to renewed fighting, potentially paving the way for a broader peace deal including the U.S. within “two or three days,” President Donald Trump claimed Tuesday. But hours later—following the Iranian downing of an Apache helicopter over the Strait of Hormuz—Trump reversed course, vowing to “respond” to the attack on U.S. military personnel. The incident marked the latest obstacle in efforts to achieve a deal with the Islamic Republic amid ongoing disruptions to the global oil market.
But would peace mean relief from high energy prices? Probably not to the extent that Americans hope, and either way, there is sure to be a long-term price increase from the war.
Renowned military theorist Carl von Clausewitz has an explanation for what produces peace in the wake of war (provided neither side can achieve absolute military victory):
Since war is not an act of senseless passion but is controlled by its political object, the value of this object must determine the sacrifices to be made for it in magnitude but also duration. Once the expenditure of effort exceeds the value of the political object, the object must be renounced and peace must follow.
For the United States, the political objective now appears to be the elimination of Iran’s nuclear weapons program, and the political cost is the war’s economic toll and the president’s falling popularity. For the Iranian regime, the objective is ensuring its own survival and ability to project power, with the cost being the economic hardship resulting from the U.S. blockade of its ports. For both sides, the Strait of Hormuz has been the strategic centerpiece amid the race to see whose costs become untenable first. Interestingly, recent struggles to reach a durable truce agreement may indicate that neither side has yet reached a point of war exhaustion.
But make no mistake: The genie is out of the bottle, and the fight over the strait will have a lasting impact on energy markets. In last week’s Dispatch Energy, Rory Johnston outlined just how disruptive this war has been (and will continue to be) for oil markets, noting that a repeat closure of the strait is a possibility. That prospect will create a permanent risk premium on energy transiting the strait.
Threatening the waterway has long been speculated as the ace up Iran’s sleeve, but historically Iran has also spent considerable resources bolstering its conventional military capabilities in the hopes of deterring would-be attackers. Now, Iran has learned an important lesson: It could never reasonably fend off a U.S. or Israeli strike, making the strait the only card it has to play against its adversaries (barring its development or acquisition of a nuclear weapon).
If Iran believes it can effectively close and reopen the strait at will, that will become its preferred negotiating tactic. Consequently, there will be both near-term pressure on energy prices from the uncertainty of a peace deal and a long-term premium as the risk of future strait closures gets baked into pricing. Some countries, notably Asian countries that are direct customers of Middle Eastern suppliers utilizing the strait, will face greater scarcity (and thus price increases) than others.
While Trump is clear that a deal is contingent upon the strait’s reopening, ensuring that the strait is free of naval mines is no simple task. We don’t know exactly how many explosives Iran has laid or where, and even if we did know, it is possible that sea currents have caused emplaced naval mines to drift from their initial locations. These mines pose a very real threat to traffic, and insurers know that.
The insurer marketplace Lloyd’s, which facilitates insurance to vessels transiting the Strait of Hormuz, has been forced to raise prices amid the conflict. Insurance has gone from less than 1 percent per hull per transit to as high as 10 percent (i.e., shipping companies would pay as much for insurance as the cost of the entire vessel for just 10 transits). These costs reflect the apparent risks of transiting the strait, and while there may ultimately be some safe routes to resume shipping, the capacity of shipping through those routes may not reach prewar levels.
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On top of all the risk and supply pressures that may keep costs elevated, there is also the phenomenon economists euphemistically call “asymmetric pass-through,” or more colloquially “rockets and feathers”: Prices rocket up but move at the speed of feathers as they fall. This occurs because consumers have already signaled a willingness to purchase at current prices, so for prices to come down, competition is needed. It doesn’t take long for suppliers to bake upstream cost hikes into their prices, but competition-driven price reductions are a more gradual process.
In other words, in the near term, prices might drop somewhat, but they’re unlikely to return to “normal” absent the market entry of alternative suppliers. The United States and other nations may release additional oil from their strategic reserves if they expect these issues to be temporary, though, which could soften prices.
But in the long run, the risks in the strait have moved beyond theory and into reality. Every consumer relying on commodities that transit the waterway now knows that delivery of those goods is contingent upon the whims of a select few powerful individuals who are not exactly known for transparent decision-making. This long-term risk (not to mention Iran’s ambition to institute a toll) will manifest in prices for energy moving through the strait and potentially shift consumption to alternative sources—but that may not be so simple.
About 90 percent of the petroleum products that transit the strait are destined for Asia, with about 37 percent of the total going to China specifically. Despite its efforts to diversify its energy supply, China remains reliant on Middle Eastern oil to fuel its economy. Beijing is trying to buy more oil and gas from Russia and reduce petroleum consumption through electric vehicles, but there’s no getting around the fact that China is Iran’s biggest customer, and almost half of China’s oil imports come from the Middle East.
While some Middle Eastern oil producers are working to bypass the strait by building pipelines, it’s not yet clear whether these efforts could provide sufficient transport capacity to supplant reliance on the strait. One of the biggest new pipeline projects is expected to roughly double its existing capacity of around 1.8 million barrels per day, but even so, around 20 million barrels per day transited the strait before the war. In short, we’re still a long way away from pipelines offering a substitute for the strait.
But here’s the good news: The economy is not a stagnant zero-sum game. High oil prices signal opportunity for market entrants, and because oil is a global market, increased supply in one part of the world can affect prices elsewhere. We are seeing—as expected—the price increase boosting production in the United States. The caveat is that the country’s two biggest suppliers—ExxonMobil and Chevron—have stated that they don’t expect to increase output beyond what had already been planned before the war (yet). Oil extraction and refining is a long-term business, and the war is only one aspect of investment decisions, with looming challenges (like politicized permitting) keeping pressure on investor enthusiasm.
Of course, Washington must exercise restraint in its market interventions if it wants market entry to discipline high prices (a point I’ve made previously). The closure of the strait’s impact on prices means the signals to invest are there, so the question now is whether they are sufficient to overcome the perceived risk. I believe getting the market conditions ripe for new production may play a bigger role in long-term energy prices than a singular focus on reducing risk from transiting the strait, but clearly the incentives aren’t there just yet.
The simple and unsurprising truth is that energy markets have been significantly disrupted by the war, not just because of the continuation of the conflict itself, but because the Strait of Hormuz will now always be a riskier option for energy transit. The solution is generally the same as always: Let the market find ways to alleviate scarcity while our leaders work toward building a durable peace.
More simply, if Washington can bolster domestic oil producers’ confidence and make it easier for them to expand, prices will fall. If Washington adopts policies that create investment risk, prices will remain high.
Policy Watch
- The Department of Energy’s efforts to boost advanced nuclear energy technologies are still moving forward, and last week it selected the California-based nuclear company Oklo for its Surplus Plutonium Utilization program, which will allow participants to use plutonium from old nuclear weapons as fuel. The move signals progress toward the commercialization of newer nuclear reactor designs—in an industry that has historically been plagued by lengthy permitting timelines.
- Pennsylvania recently unveiled new guidelines that data centers must follow to be eligible for tax credits. The requirements focus on environmental protection, community engagement, and labor rules. New Jersey has likewise pursued similar policies. As Axios notes, possible Democratic presidential contenders—Pennsylvania Gov. Josh Shapiro and New Jersey Gov. Mikie Sherrill—seem to be spearheading the initiatives to minimize data center impacts on communities. If and when such policies are implemented, they are likely to significantly affect how quickly data centers are built and where.
- The Trump administration is boosting coal subsidies, unveiling a plan to spend roughly $700 million on coal projects via the Defense Production Act (DPA). The administration argues that these policies will increase energy availability, particularly amid rising electricity demand from data centers. Critics, however, note that the policy amounts to a government handout to the coal industry at taxpayers’ expense. My last edition of Dispatch Energy critiqued presidential administrations’ overreliance on the DPA, noting that improved productivity in targeted industries is likely to entail reduced productivity elsewhere and cause net economic harm.
Innovation Spotlight
- American fusion energy startup Helion Energy raised $465 million in its latest round of fundraising. Fusion energy, which could theoretically provide virtually limitless clean, safe nuclear power, has long been considered a sort of Holy Grail for energy production. However, despite scientific advances in its development, progress toward viable commercial fusion power production has been slow. Helion’s recent fundraising success indicates heightened interest and confidence in fusion’s prospects.
Further Reading
- Perhaps one of the clearest examples of government protectionism is the Jones Act, which requires that goods shipped between two U.S. ports be transported by an American-built, -owned, and -crewed vessel. The law has been a constant target for policy analysts due to the relatively small number of eligible vessels compared to the demand for shipping, with critics alleging that the law has a considerable and difficult-to-measure effect on prices. However, information on just how harmful the Jones Act is to the energy industry became more readily available after the Trump administration waived its requirements in light of recent high energy prices. Writing for the Cato Institute, Colin Grabow dives into the data on energy shipments under the waiver. The temporary lifting of the Jones Act resulted in a considerable increase in intra-U.S. maritime energy trade, he finds, indicating that the Jones Act has probably had a bigger chokehold on the industry than previously realized.