A Compounding Oil Shock: Part I
Why the Treasury Cannot Short a Physical Shortage
Before February 28, oil backwardation, the premium the market places on a barrel today over a barrel twelve months from now, was roughly $4. By March 9, it had reached $26. The Hormuz Transit Stress Index (HTSI), which tracks daily shipping stress through the Strait, spiked in near-perfect lockstep. The physical world and the financial world were telling the same story, simultaneously.
That chart above is the argument in compressed form. Everything that follows is an attempt to explain what it means: for the structure of the oil price, for the policy instruments being proposed to contain it, and for the central bank that will have to respond when those instruments fall short.
The US Treasury wants to short oil futures. It won’t work.
Reports emerged last week that the US Treasury was considering short positions in near-dated oil futures to dampen energy prices. The Strait of Hormuz is nearly closed. Crude has surged more than 40% in a matter of days. The instinct to act is understandable. The instrument is wrong.
Whether a financial intervention can suppress an oil price spike depends entirely on what is driving it. If the spike is speculative, paper positioning running ahead of physical fundamentals, then selling futures can compress the basis and bring prices down. But if the spike is physical, oil that cannot move because the chokepoint it needs to pass through is closed, then selling futures changes the price on a screen without touching the underlying constraint. The oil stays stranded. In the latter case, the screen catches up to reality, not the other way around.
We are currently in the second situation. Part I works through the structure of the current oil price (the war premium, the inventory scarcity wedge, the shipping cost component) and shows why none of those layers are reachable by a futures operation. Part II turns to the harder problem: if the Treasury intervention cannot work, what should the Federal Reserve do instead, when the same shock is simultaneously pushing inflation up and growth down?
Two consecutive policy questions. The first has a clear answer. The second does not, and that is precisely what makes it worth examining.
Related Post:
A Compounding Oil Shock: Preface
Background
The immediate policy question is no longer just whether oil prices will rise, but whether governments can do anything meaningful to contain them. That shift in framing matters. Once policy enters the picture, markets stop pricing only the physical supply shock itself. They also begin pricing the possibility of intervention, the credibility of that intervention, and the risk that it fails.
Oil is the focal point — the most visible price signal, the one that moves first and most quickly shapes inflation, growth, and policy expectations. But it is also the tip of a much larger disruption. The near-halt of traffic through Hormuz reaches into naphtha, LNG, ammonia, fertilizers, and every industry that depends on intermediate inputs that cannot be rerouted. That distinction matters for what follows: the Treasury proposal targets the tip. The body of the iceberg is somewhere else entirely.
What is the oil price?
Not a single number. A structure.
A useful way to think about the spot price of oil is as the sum of four components:
where MC is the marginal cost of production; τ is the shipping and insurance cost; y(I) is the convenience yield — the premium the market assigns to physical possession of oil when inventories are critically low, and delivery is uncertain; and ρ_geo is the geopolitical risk premium, the market’s forward-looking assessment of the probability and duration of supply disruption.
This decomposition separates different kinds of oil shocks. MC rises when fields shut in or restart lags stretch — it reflects a genuine shift in the short-run supply curve. τ rises when war-risk insurance is withdrawn, and attack probability rises, as it has now that Lloyd’s has voided Gulf coverage. y(I) rises when physical inventories fall below the level needed to guarantee delivery — hoarding, logistics fragmentation, and the breakdown of normal storage and routing all push it higher. ρ_geo rises and falls with the political and military outlook: it was the dominant wedge in the first days of the conflict and has since partially retreated as markets priced in a shorter war.
The distinction matters because different wedges require different policy responses, and a policy instrument that cannot reach the binding wedge will not suppress the price, regardless of its scale.
How spot and futures prices connect: the role of inventories
The convenience yield — the y(I) term — is the most important concept in this analysis.
It is the implicit return to holding physical inventory rather than a paper claim on future delivery. Think of it as the premium refiners and importers are willing to pay for a barrel in their tank today over a contractual promise to receive one later. When physical oil is abundant and logistics are functioning normally, this premium is small. When inventories are tight, routes are disrupted, and supply uncertainty is high, it becomes much larger.
The key relationship is:
As effective inventories fall, the convenience yield rises. And as the convenience yield rises, the spot price rises relative to future delivery.
That matters because it is the channel that normally links the physical market to the futures market through the cost-of-carry condition.
The cost-of-carry condition
For any storable commodity, the spot price and the futures price are linked by:
where F(t,T) is the futures price for delivery at time T, P(t) is the spot price today, r is the financing rate, c is the storage cost, and y is the convenience yield.
Under normal conditions, this relationship keeps spot and futures prices anchored to each other. If futures are priced too high relative to spot plus carrying costs, traders buy physical oil, store it, and sell it forward. If the spot is too high relative to futures, inventory holders sell physical and replace it later via the futures market. Arbitrage enforces the link.
But that arbitrage depends on the convenience yield remaining moderate. When y rises to meet or exceed the net cost of carry (r+c), the market moves into backwardation (i.e. the spot price is above futures prices, usually because current supply is tight and buyers are willing to pay more for oil today than for delivery later), and the normal arbitrage channel breaks down. Buying futures and waiting for delivery no longer substitutes for holding physical oil today, the market is telling you that a barrel now and a barrel in six months are not the same thing. The Brent forward curve is already saying exactly this: the front month is trading at a substantial premium to contracts six and twelve months out, a spread that has widened sharply since the conflict began.
This is where the Treasury proposal enters.
The basis and the intervention logic
The Treasury’s proposed intervention is not a direct attempt to move physical supply. It is an attempt to move the basis.
The basis is the difference between the spot price and the futures price:
Under normal conditions, this spread is negative: future delivery commands a premium over immediate delivery because carrying oil forward costs money — storage, financing, insurance. When the market moves into backwardation, the basis turns positive: immediate physical delivery is more valuable than later delivery, and that premium is the market’s price for certainty of supply now.
The Treasury’s strategy is therefore a basis-compression policy. By selling near-dated futures and leaning against the front of the curve, the aim is to reduce the relative price of near-term delivery, weaken the financial return to hoarding, and induce inventory holders to release physical oil into the market.
The intended transmission chain is:
Treasury sells near-dated futures → front-end futures price falls → basis compresses → storage becomes financially less attractive → inventory holders release physical oil → spot price falls
That is a coherent mechanism — in the right environment. It belongs to a familiar family of financial policy operations: FX intervention, yield-curve control, and any operation that tries to shape real behaviour through asset prices. Each of those works when the binding constraint is financial. Each fails when the binding constraint is physical.
The question is whether the holders of physical oil today are sitting on inventory because the forward curve makes it profitable to do so, or because they have no way to move it.
When the mechanism breaks
For basis compression to reach the physical spot market, three conditions must hold simultaneously — and in the current episode, all three have failed at once.
Condition 1 — Physical inventories must be available and mobile
Someone must hold barrels that they are both willing and able to sell. For the hoarding impulse to reverse, inventory holders must interpret basis compression as a credible signal and respond by releasing oil into the market.
But that is not the current situation. Some inventory exists, but much of it is already committed, physically inaccessible, or stranded at origin nodes that cannot connect to loading terminals because export routes run through the Strait of Hormuz. In practical terms, a significant share of Middle Eastern oil is stuck where it is.
The bottleneck is not abstract. Ships are piling up on both sides of the Strait (in the Gulf of Oman and inside the Arabian Gulf) while Hormuz remains the critical channel in and out. Even if a ceasefire were agreed immediately, clearing the backlog would take weeks. At the same time, Gulf producers are beginning to shut in production because onshore storage is filling up, and exports cannot move. Iraq was the first to announce shutdowns; others may follow. Restarting production after a forced shut-in is not instantaneous. It can take weeks, and in some cases months, to return to full capacity — the same restart dynamic observed in LNG facilities.
In that sense, the crisis does not end when the shooting stops.
Condition 2 — Future delivery must be credible
Selling physical oil today and replacing it later through a futures contract only works if market participants assign a high enough probability to usable delivery at the relevant horizon. The Strait does not need to be open today — but the probability-weighted expectation of it being open by contract expiry must be sufficient to justify releasing a physical barrel now. That expectation is currently badly impaired. With no credible near-term resolution in sight, the market is pricing a meaningful probability of continued disruption across the entire front end of the curve. A futures contract promising delivery in sixty days is of limited use to a refinery that needs physical barrels next week — not because the contract is legally invalid, but because the delivery pipeline behind it is not trusted.
Condition 3 — The convenience yield must remain moderate
The third condition is that the convenience yield must remain low enough for financial incentives to matter at the margin.
At normal inventory levels, it does. Spot and futures stay linked by cost of carry, and holders respond to price signals in predictable ways. But when inventories become critically low, and supply uncertainty becomes extreme, the convenience yield rises sharply — and the physical barrel begins to trade less like a commodity and more like insurance. At that point, no reasonable move in the futures price is sufficient to persuade holders to sell. Worse, aggressive selling of near-dated futures may be read by the market not as a credible policy signal but as a signal of desperation — reinforcing the scarcity premium rather than compressing it.
That is the core limitation of the Treasury’s proposal. It can move futures prices. It cannot create the thing that matters most under these conditions: reliable physical availability. And in trying to manufacture that confidence through a financial instrument, it risks doing the opposite.
What the futures curve is already telling us
The current shape of the oil futures curve is already conveying this message clearly.
Oil is trading in pronounced backwardation, with near-dated contracts priced well above deferred contracts. In a normal, well-supplied market, that would attract arbitrage immediately. Traders would buy physical oil, store it, and sell it forward, narrowing the spread. The fact that the spread remains so wide tells us that this mechanism is not taking place on a meaningful scale. Either the barrels cannot be sourced in the right place, the logistics make the trade uneconomic, or inventory holders will not part with physical oil at any price that would allow the arbitrage to work.
That is the convenience yield mattering. The value of immediate physical availability has risen sharply relative to any financial claim on later delivery. The market has moved beyond the regime where ρ_geo dominates — where geopolitical fear drives prices and expectations-based tools can still matter — into the regime where y(I) has become the binding wedge and financial operations have little reach. The Brent forward curve is already showing this directly: the spread between near-dated and deferred contracts has widened to levels that would, in any normal market, have been closed by arbitrage weeks ago. The fact that it has not been closed is the signal. The physical constraint is binding.
That matters because the Treasury is trying to change behaviour through the basis precisely when the basis is being driven by forces that basis compression cannot reach. The intervention is using a financial price signal to try to override a physical constraint. That is not a question of scale or commitment. No size of futures operation changes the fact that the oil is where it is, the ships are where they are, and the Strait is what it is.
The 2020 analogy, in reverse
The 2020 WTI collapse helps clarify the current episode because it was, in a precise sense, its mirror image.
In April 2020, the oil market ran into a storage constraint. Cushing, Oklahoma — the main delivery hub for WTI — was approaching full capacity. Holders of front-month futures contracts faced a stark choice: take delivery of oil they had nowhere to store, or sell at any price. They sold. The front-month contract briefly went negative. Traders were effectively paying others to take oil away. It was a run out of inventory — a scramble to shed physical exposure because the system had no more room.
The current episode is the opposite. This is not a run out of inventory, but a run into inventory. Market participants who can still access physical barrels are trying to accumulate them, because the expected cost of not having oil over the next few weeks — whether you are a refiner, a utility, or a government buyer — has risen sharply. The convenience yield, y(I), captures exactly this: the insurance value attached to a barrel already in your tank.
Both episodes share the same underlying structure. In each case, physical inventory behaviour becomes disconnected from financial price signals. In 2020, even negative futures prices could not induce anyone to take more oil, because there was nowhere to put it. In the current episode, lower futures prices cannot induce holders to release oil because there is no reliable way to replace what they sell. In both cases, the binding constraint was physical, not financial, and in both cases, the policy instrument that could have helped was the one that addressed the physical constraint directly, not the one that moved the price on a screen.
That is why a futures intervention is the wrong instrument for a hoarding run. The policy operates on the basis, but the hoarding impulse is being driven by something the basis cannot reach: the scarcity value of immediate physical possession. Moving the basis does not create a barrel. It does not open a shipping lane. It does not restore an insurance market. What it can do — in the wrong conditions — is signal that the authorities have mistaken the symptom for the disease.
The failure mode: when intervention becomes dangerous
If the three conditions above do not hold, the intervention does not simply fail. It can fail in a way that makes the price dynamics worse.
The Treasury would be short near-dated futures in a market where the underlying driver (physical scarcity, impaired logistics, a high convenience yield) is still pushing prices upward. If the disruption persists, near-dated contracts do not converge downward as the intervention requires. They rise further, and the official short position accumulates losses.
Once market participants begin to doubt the position can be maintained, the eventual unwind becomes part of the price formation process itself. Traders start anticipating official buy-backs. That expectation attracts speculative longs ahead of the exit, the market front-runs the covering, amplifying the very move the intervention was designed to suppress.
What begins as an attempt to compress prices can end by intensifying them. That is the asymmetry at the heart of the proposal: if conditions cooperate, the upside is limited price relief; if they do not, the intervention itself becomes the next leg higher.
Oil shocks and financial deleveraging
The Treasury proposal addresses the basis. But a physical shock of this scale does not stay in commodity markets. Once oil moves enough, it propagates through financial portfolios in a predictable sequence — and that sequence matters for understanding why the intervention’s failure mode is worse than mere ineffectiveness.
Higher oil prices first act as a tax on global growth expectations. Equity markets reprice downward as analysts cut earnings forecasts for energy-intensive sectors. This is the first-round effect: fundamental repricing, expected and contained.
The second round is less contained. As equities fall and implied volatility rises, margin requirements increase automatically across leveraged portfolios — prime brokerage agreements typically set collateral thresholds as a function of volatility, so a VIX spike triggers simultaneous margin calls across the system. Investors need cash quickly, not because they want to sell but because they have to.
What gets sold is not what investors like least but what they can liquidate fastest. Gold often falls in this phase, even amid rising geopolitical stress, because it is one of the most liquid profitable positions in global portfolios when the margin call arrives. This is not a rejection of gold’s safe-haven role. It is a sign that investors are scrambling for liquidity. By March 8-9, that pattern had appeared: oil pushing sharply higher while gold fell, equity markets outside the oil complex selling off simultaneously — not narrow sector repricing, but portfolio deleveraging spreading across regions and asset classes.
The futures curve matters here in a specific way. Extreme backwardation is first a signal of physical scarcity — the convenience yield on immediate oil has become unusually large. But when backwardation reaches exceptional depth and holds there, it also signals that the market is no longer treating the disruption as a short-lived geopolitical scare. It is beginning to price a shock persistent enough to affect broader financial conditions. The curve does not mechanically cause the financial event. It is the leading indicator of the physical stress within which financial amplification becomes much more likely.
The correct instrument
Once the shock is decomposed properly, the policy problem becomes clearer. There is no single “oil policy.” There is a set of wedges, each with a different binding constraint, and each requiring a different instrument.
That distinction matters because the current shock is not being driven mainly by speculative excess in paper markets. It is being driven by a genuine disruption to physical supply routes. Instruments designed to correct financial mispricing will therefore have limited traction on the underlying problem.
Targeting the shipping wedge (τ): the most direct response
The most direct instruments are those that act on τ, the shipping and transport-cost component of the oil price.
The first is physical deterrence: war-risk guarantees combined with naval escort. The mechanism is straightforward. If policy can raise the cost of interdiction and restore confidence in safe passage, the insurance market reopens, shipping costs fall, and part of the oil price pressure is relieved. The operational environment is more difficult than in earlier episodes, but the policy logic is unchanged: act on the physical bottleneck, not on the derivative built on top of it.
A second lever may not require military action at all. If regulatory capital requirements are amplifying insurers’ withdrawal from the war-risk market, a temporary regulatory adjustment could help reopen coverage more quickly. That would not remove the geopolitical risk itself, but it could reduce the extent to which regulation turns elevated risk into a complete collapse in insurability. If that channel is quantitatively important, the effect on τ could be material.
SPR releases: direct, but bounded
A second physical instrument is a release from the Strategic Petroleum Reserve (SPR). On March 11th, the IEA (International Energy Agency) authorised the largest emergency reserve release in its history — 400 million barrels, more than double the 2022 Ukraine response. Unlike a futures-market intervention, an SPR release adds barrels directly to the physical market, with no reliance on basis compression or inventory behaviour. The effect is more direct. But the market’s reaction was telling: prices dipped briefly, then climbed back. The SPR can ease the immediate scarcity premium. It cannot reopen a shipping lane, restart a shut-in oil field, or replace the naphtha, LNG, and ammonia that strategic reserves were never designed to hold. It is the right instrument in kind. It is insufficient in scope.
Targeting the geopolitical premium (ρ_geo)
A third class of instruments works on ρ_geo, the geopolitical risk premium itself. Credible diplomatic progress, visible de-escalation, or a ceasefire that markets believe will hold can compress this wedge quickly. This is the fastest-moving component of the oil price, and the one most responsive to information. The difficulty, of course, is credibility: markets reprice only when they believe the signal will last.
The futures intervention in context
Set against that menu, the proposed futures intervention targets the basis — the spread between near-dated and deferred contracts — rather than the physical wedges driving the current price. That approach can work in a financially driven spike, when inventories are mobile, future delivery is credible, and the convenience yield remains moderate. It is not the right instrument for a shock defined by physical scarcity and logistical breakdown.
The issue is not that futures intervention is always wrong. It is that it is wrong for this shock.
Bottom Line
The proposed Treasury operation is, at its core, a basis-compression policy — a coherent instrument for a financially driven price spike in a well-supplied market, where inventories are mobile, delivery is credible, and convenience yields remain moderate.
But that is not the shock now confronting the market.
This is a market shaped by physical scarcity, impaired logistics, and a rising insurance value attached to barrels already in hand. The futures curve is in backwardation, not because of speculative excess, but because physical holders will not release oil at any price consistent with normal arbitrage. The three conditions required for basis compression to reach the spot market have all failed at once.
The right instrument is the one that targets the binding wedge directly: the shipping and insurance constraint. That points toward war-risk guarantees, naval escort, credible deterrence, and any regulatory measures that would help reopen the insurance market more quickly. Those tools do not eliminate the geopolitical shock. They act on the part of the price equation that is actually binding.
What comes next: the Fed’s problem
If the disruption is physical, and if intervention in futures markets cannot contain it, the analytical problem shifts to the Fed.
When oil rises through the MC, τ, and y(I) wedges at the same time, each of those forces feeds into consumer prices through the cost-push channel of the Phillips curve. The Fed cannot remove any of them at the source. It cannot reopen the Strait, restore the insurance market, or replenish inventories in the Gulf. What it can do — and what it is entirely responsible for — is prevent the price shock from becoming embedded in long-run inflation expectations.
If it succeeds, the oil shock passes through the price level once and fades. If it fails, the second round becomes the first round of the next shock.
That is the question Part II addresses. A demand shock aligns the Fed’s objectives: slower growth reduces inflation pressure, and the policy response is unambiguous. A supply shock of this kind does the opposite — it raises inflation and weakens growth simultaneously, placing the central bank in a genuine trilemma between anchoring expectations, supporting activity, and containing the financial stress that could migrate through leveraged portfolios. Each objective points in a different direction. The standard playbook was not designed for that configuration, and applying it mechanically risks making at least one of the three problems worse.
[1] The HTSI (Hormuz Transit Stress Index) measures the daily deviation of vessel transit volumes and tonnage through the Strait of Hormuz from their 90-day rolling baseline, standardised to z-scores using IMF PortWatch AIS data. Higher values indicate greater stress relative to recent norms. Author-constructed.
Thanks Gianluca for a lucid breakdown of the oil price and the policy remedies that different components demand. In this case though, I think targeting the shipping wedge will not yield positive supply results without a security guarantee that includes a ceasefire and naval escorts for a time period.
Very informative, thank you! Concerning the the SPR, there is the question about physical constraint of the flow rate (i.e. 2mn bbl a day) - what is your opinion going forward - will the release of the reserves have any mitigatory effects or the brief dip in prices was all there was to it, cheers.