A Recessionary Bear Ahead?

In the wake of Gulf War III, the odds of a U.S. recession in 2026 have spiked in the betting markets. Even though the implied recession probability has retreated, they are nevertheless elevated.
 

 

Economic recessions are bull market killers. What are the chances of an oil shock-induced recession? Here are the bull and bear cases.
 

 

A COVID-Style Crash?
The bear case is easy to make. Just take a look at the blockade at the Strait of Hormuz. A Bloomberg podcast with Rory Johnston outlines the risks.

For some context, the blockade of the Strait of Hormuz (SoH) is an unprecedented event. The SoH accounts for about 20% of global energy production, or 20 million of barrels per day. To put that 20% figure into perspective, Johnston pointed out that the degree of demand destruction during the peak of the COVID Crash in March and April 2020 accounted for 20% of global energy demand.

In other words, if the SoH were to remain closed for a prolonged period, the global economy would have to experience a price-induced demand destruction roughly equivalent to the effects seen at the height of the COVID Crash. Under those circumstances, Johnston postulated that it would be very easy for oil prices to reach $200. That’s the apocalyptic scenario.

A SoH blockade also exposes the supply chain bottlenecks concentrated in that narrow passage of water. It’s not just oil, but LNG, urea, which is a key input to fertilizer production, sulfur, which is used for copper smelting, and so on. Such an event is reminiscent of the COVID-era supply chain bottlenecks that drove up prices and sent shockwaves around the world.

The accompanying chart shows the days of inventory available to different countries and regions under a full SoH blockade and no use of strategic reserve for different energy products. The main exposure is Asia, followed by Europe. The U.S. is a net energy exporter and it’s therefore insulated from the physical effects, but not financial effects of energy supply shocks. Not shown in the chart are the substantial petroleum reserves accumulated by Japan, and China.
 

 

Bloomberg Economics modeled the oil price depending on the length of the Strait closure. The longer the flow is interrupted, the higher the floor is in future months. A three-month closure would see Brent reach $164.
 

 

Even though the U.S. is largely insulated from the physical effects of an oil shock, New Deal democrat argues that “$4/gallon gas could take the economy from a nearly complete stall into outright recession”. The accompanying graph of gasoline prices is normalized for average hourly earnings, with $4 gasoline represented as the zero line. Viewed in that context, $4 gasoline prices wouldn’t represent a significant headwind to household expenses. But he argued that higher gas prices combined with a fragile employment market might tip the economy into recession.
 

 

The Street is turning nervous. MarketWatch reported that Goldman Sachs downgraded the forecast for economic growth, citing higher oil prices. Torsten Slok quantified the effects of $100 oil. He projects an increase of 0.1% to core inflation, 0.1% increase in unemployment and -0.1% decline in GDP growth, which is roughly in line with Goldman’s estimates.
 

 

 

Supply Buffers and Mitigation Steps
To be sure, there are ways of alleviating some of the supply shortages to buy some time.

The most immediate source of oil is floating barrels of Iranian and Russian crude that act as an initial buffer. This functions as a shadow SPR that can’t be refilled. Estimates vary, but they are around 70 million barrels, which amounts to 2.5 days of SoH daily flows. They’re useful, but not a game changer.
 

There’s also Iranian crude that flows through the SoH, which functions as a filter, and not an absolute blockade. The WSJ reported that “over the past six days, tankers have loaded a daily average of 2.1 million barrels of Iranian oil, higher than the 2 million barrels a day Iran exported in February, according to Kpler.”

Saudi Arabia has an east-west pipeline that bypasses the Strait. The WSJ reported that the pipeline carried 2.8 million barrels per day before the crisis. Aramco has promised to ramp up throughput to the stated capacity of 7 million barrels in the near future, but the loading capacity at the Red Sea port is reportedly 3 to 5 million barrels.

Finally, the IEA announced a release of 400 million barrel release of strategic reserves from different member states. The headline number of 400 isn’t what matters, it’s the daily rate of flow that matters. Japan announced that it will release 80 million barrels from its reserves. The U.S. announced that it will release 172 million barrels over 140 days, or about 1.4 million barrels per day. All of these measures are useful and they buy time. But they are not the solution to the 20 million per day shortfall through the SoH.

Let’s do some back-of-the-envelope math. The shortfall from a complete blockade is about 20 million barrels. The additional flow from the port constrained Saudi pipeline is no more than 2.2 million, Iranian sales about 2 million. Sustainable continuing flows amount for 21% of the shortfall, which is useful but not a full solution. The rest has to be made up from release of strategic reserves, which is finite.The Economist reports that IEA combined reserves amount to 1.2 billion barrels, but not all are available for use. As an example, “America’s must keep a minimum 150–160M barrels —35–40% of today’s levels — to preserve the stability of the geological caverns that serve as depots”. Reserve drawdowns have limited capacity: “Were all IEA countries to liquidate their strategic stocks at their maximum achievable rate, they could add at most 3 million barrels per day to global supply, calculates Martijn Rats of Morgan Stanley”.
 

 

During past oil shocks, OPEC members have ramped production to meet supply shortfalls. This time, the supply capacity is trapped behind the Strait. The only source of ready supply is Russian crude, whose purchase comes at a geopolitical cost.
 

 

A Narrow Path to Peace
In the face of rising oil prices, which has pushed U.S. average retail gasoline above the politically sensitive $3.50/gallon level, it’s not a surprise that President Trump is trying very hard to open the Strait.
After the initial U.S. military success in Venezuela, President Trump may have thought that he could apply the same template to Iran. But Iran isn’t Venezuela, and he may have overplayed his hand. By surviving the initial onslaught and the decapitation of the Iranian leadership, the Iranian regime appears to have gained the upper hand in the conflict by demonstrating supply chain dominance in key commodities and ominously emerging as a belligerent regional hegemon to the detriment of Gulf states.

It’s TACO (Trump Always Chickens Out) time, but with a key difference, which I will explain. From the American perspective, the combination of rising equity and bond volatility, rising bond yields, weak equity markets and an approaching November mid-term election, Trump is under pressure to reverse course. It’s not a surprise that President Trump is trying very hard to open the Strait.
 

 

Moreover, average U.S. gasoline prices are already over the politically sensitive level of $3.50/gallon. That’s before refineries switch over from the winter blend to the more expensive summer blend, which will add another 10–15¢ per gallon.
 

 

U.S. foreign policy is stuck between two unpalatable choices: Commit ground troops and force a full regime change. But the U.S. doesn’t have sufficient military ground forces to control Iran, a country the size and population of Turkey. Choosing such a course of action means a multi-year commitment to install a friendly government and to provide sufficient security in case the government teeters. Think of it as a Vietnam-style commitment of troops, whose ranks will need to be filled with a draft.

The other best-case option is a Korea-style frozen conflict. The U.S. commits to stationing troops in the region to contain a belligerent Iranian regime from bullying her neighbours. Iran will become a regional hegemon that threatens the energy, financial and infrastructure of Gulf states for the foreseeable future.
It is against this backdrop that President Trump seems to be looking for an off-ramp. The latest objectives of the campaign, according to Secretary of State Marco Rubio: “It is to destroy the ability of this regime to launch missiles, both by destroying their missiles and their launchers; destroy the factories that make these missiles; and destroy their navy.” General Dan Caine, Chairman of the Joint Chiefs of Staff, gave the same message to the press in a briefing.

What’s missing from that list are past demands for unconditional surrender, regime change and there is no mention of ending Iran’s uranium enrichment program. This is a signal that the U.S. is trying to open the door to a truce that can open the Strait of Hormuz.

Trump’s recent statements include the war will end “soon” because there is “practically nothing left to target”. When informed that Iran was laying mines in the Strait, he threatened to escalate attacks, but later backtracked and said he didn’t believe Iran was laying mines in the Strait of Hormuz.

Iran’s public posture has been highly assertive, but a little publicized development is a sign of the regime’s weakness that opens the door to an agreement. The Iranian regime initially said they would not allow “one liter of oil” to be shipped from the Middle East if U.S. and Israeli attacks continue. This opened the door to a truce or ceasefire if the attacks were to cease. It added an additional demand that any ceasefire needs assurances that the U.S., Israel and other regional states wouldn’t attack Iran in the future.

The two positions represent a start for negotiations, and there are various countries that have tried to act as mediators, one less-known development may have an earth shattering impact on the regime’s stability. The Jerusalem Post reported that Iran’s Bank Sepah data centre in Tehran was bombed and the bank had been the target of cyberattacks. The article went on to explain that “Bank Sepah is a state-run institution, largely responsible for paying the salaries of Iran’s military and the Islamic Revolutionary Guard Corps”.

During the 1980 Iranian Revolution, the Shah’s regime collapse was triggered when it lacked the resources to pay its troops and security forces. Bank Sepah pays the salary of low and mid-level Iranian military, militia and Revolutionary Guards. Unpaid or underpaid security forces become unreliable. There are unconfirmed reports of dissension between the Iranian Army and IRGC units about the uneven casualty rate. Attacks have mainly targeted IRGC and Quds Force units and the regular army has largely be insulated from attacks. Disproportionate losses among underpaid IRGC members, who are the backbone of the regime’s internal security apparatus, is a source of vulnerability for the regime and could pressure it to make a deal.
 

 

Nearing a Pivot
Putting it all together, the headlines look dire for investors. The global economy is staring into an abyss of a COVID-style adjustment. But I believe sufficient pressure is building on both sides to negotiate a settlement.

Tactically, sentiment and some technical conditions are becoming oversold. MarketWatch reported that Charlie McElligott at Nomura highlighted panic conditions among option traders: “Equities Options Skew (ESP MegaCap Tech / Mag7+) remains insanely tilted towards Downside and OTM ‘Crash’ Left-Tail Hedges, while ‘Nobody owns the Right-Tail’”. In plain English, the crowd is stampeding for put option protection and no one is interested in call option upside.
 

 

Similarly, the Zweig Breadth Thrust Indicator and the NYSE McClellan Oscillator (NYMO) have reached oversold levels comparable to the “Liberation Day” panic bottom, despite exhibiting only a minor drawdown in the S&P 500.
 

 

It’s time to buy the panic.