The Taiwan Banker

At the beginning of his second term, before the markets had created the term TACO (“Trump always chickens out”), US President Donald Trump had an ambition to settle the Ukraine war in “one day.” TACO was used to describe the trade war, a situation which he had manufactured himself, with a coherent status quo to which he could retreat. Ukraine, on the other hand, was not a situation he had created in the first place, and could not withdraw from, despite his willingness to stomach a collapse in Ukraine’s bargaining position. When these negotiations were recently revived, two years later, the US and Russia still found their positions to be equally incompatible. Petroleum markets have long gotten used to the rhythm of on-again off-again Middle Eastern tensions. While geopolitics was always a known risk factor, the default assumption was that maritime chokepoints like the Strait of Hormuz would remain open. Transit through the adjacent Bab-el-Mandeb strait never fully recovered from 2023 attacks by Houthi rebels in Yemen, but maritime traffic rerouted around Africa, which affected shipping costs but not availability. Now, the Strait is closed by default, absent temporary military escorts or ceasefires. The best hope for an alternative outcome was probably the June MOU, whose collapse illustrated just how far apart the Iranian and US positions remain. Trump’s original decision to strike Iran was based on limited aims, and a presumption that any subsequent results would ultimately be inconsequential for the security of the US – whether adverse, or even beneficial. Because that misunderstanding no longer prevailed at the time the MOU was signed, however, its later collapse was arguably the most pivotal moment of the war so far. The fundamental difficulty in this bargaining process is that the discount rate has approached infinity: in Iran’s eyes, nothing exists unless it exists today. In the words of Majid Shakeri, an Iranian foreign policy advisor, posting on X (formerly Twitter), “There is no temporary solution for the Strait of Hormuz. Every temporary solution will become permanent.” The MOU is of course not the first such agreement to collapse. The Joint Comprehensive Plan of Action (JCPOA), signed during the term of former US President Barack Obama, previously kept relations on a stable footing. While Iran now views control over the Strait as paramount, its second priority is cash in hand, as originally promised under the MOU, such as through the release of previously frozen assets. Such funds neutralize the economic warfare the US has attempted against Iran, such as through its counter-blockade. Against this background, one aspect of US foreign policy toward Iran which is more stable is its sanctions regime, which is partially authorized by Congress, and would require legislation to remove. Iran might conceivably accept eliminating the entire legal basis of sanctions (as opposed to waiving them on an ad hoc basis) as a third-best option, but such a move would visibly impair the credibility the US gains as the reserve currency issuer. For close to 50 years, Iran has played a special role on the sidelines of the Bretton Woods II international monetary system. One interpretation of the ‘petrodollar’ arrangement is that Arab oil exporters invested their profits in the US, in exchange for the US providing regional security and protecting shipping routes. Later, as the utility of monetary dominance for sanctions became better understood, Iran also played a critical role in shaping the exercise of US hegemony. In 2012, the US persuaded the EU to align with its sanctions on Iran, exerting indirect control via SWIFT, despite the incorporation of the latter in Belgium. For either the US or the EU to reverse these sanctions now under duress would constitute at least a deeply symbolic step toward a more geopolitically independent Europe. These structural factors jointly make sustainable de-escalation unlikely. Professor of political science Robert Pape at the University of Chicago has advanced an escalation ladder thesis, which will gradually bring both sides closer to a hot war. Examining the rhetoric of Iran’s new Supreme Leader Mojtaba Khamenei, one intermediate step he predicted was attacks on US soil, a prediction which may have recently materialized in the form of cyberattacks initially attributed to Iran. With these trends in mind, why have global crude prices defied early fears? The release of petroleum stockpiles, coordinated across member economies of the International Energy Agency (IEA), clearly played a major part. “Part of the reason…the very worst predictions never came to fruition is because Scott Bessent and Chris Wright did an amazing job absorbing as much of that shock as possible,” said US Vice President Vance in an interview with New York Times columnist Russ Douthat. These references to the Treasury Secretary and Energy Secretary, respectively, suggest that the administration would like to take credit for market stabilization via physical collateral. The reserves are designed to smooth over temporary disruptions, however, rather than to replace lost supply indefinitely. When new production is not expected to resume, it is most prudent to allow prices to adjust, and ration reserves over the lengthy period it takes to bring new production online. Mixing up the two scenarios is akin to leveraging a bad bet. There are also more specific ways in which the reserve release resembles financial leverage. The US Department of Energy has utilized Strategic Petroleum Reserve exchange agreements to distribute its holdings, in which recipients are expected to return the borrowed oil at some point in the future, with interest charged in actual barrels. This arrangement preserves the government’s financial position, but ultimately further drives future market demand. Other countries are likely to also increase their reserves going forward, providing a sustained source of demand. Another important reason for the limited rise in crude prices, meanwhile, has been China’s sudden cuts in imports. Its motivation remains mysterious, but there are not many other places to attribute the shortfall except for its own separate drawdown in reserves. China lacks the data transparency of IAE members. It is important to distinguish between different prices within the petroleum market, however. Crude oil has long been the benchmark, because the rest of the supply chain would generally follow it. That correlation has recently weakened, with crack spreads (i.e. refinery margins) exploding even in the absence of price movement for crude. Thus, these reserve releases have often subsidized refiners rather than end consumers. The crude releases may be helping cover up a larger downstream crisis, which is broader than just Iran. Global refining capacity had already been declining before the war, but refineries have turned out to be a vulnerable military target for Iran, as well as Ukraine. Strikes by the latter recently turned Russia from an exporter to an importer of certain refined products. Refining all over the world is running near maximum capacity, except for China. Supposing at some point it were to resume importing crude and exporting refined products, on the other hand, it would simultaneously relieve one market and tighten the other. Thus, the true situation is closer to a pair of rolling crises than just the one. The overall direction of the market notwithstanding, however, the more important political question is when pain might start to be felt. The US midterm congressional elections take place in November, and Professor Pape anticipates the potential for further escalation before then. For markets, a key variable to watch is destruction of crude processing or refining facilities, which has longer-term implications for supply recovery, beyond just transit counts. A further point is broader potential spillover out of commodity markets. In the classic transmission story from an oil crisis to a recession, durable investment items, like cars, often required oil to operate. Today, the economy is much less dependent on oil, which has undoubtedly helped in the present crisis. At the same time, however, the exceptionally high debt level of the US increases the importance of interest rate decisions. This is the most significant way in which the US has made a leveraged bet on the end of the Iran war. In early August, long-dated bond markets rebelled against the decision by the Fed to hold rates steady. While treated by the media as a question of central bank independence, that episode was equally a reflection of strategic failure on a geopolitical level.