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Edward Bell - Senior Director, Market Economics
Published Date: 04 March 2022
Oil prices will be enormously volatile in the near term as the impact of Russia’s invasion of Ukraine embeds into markets. Sanctions from the US, EU, UK and others have so far carved out Russian exports of oil and natural gas, but traders and financial institutions are choosing to ‘self-sanction’ and are limiting trades to avoid falling foul of sanctions, whether already in place or anticipated. That has helped to push oil prices up well above USD 110/b with Brent this week coming close to USD 120/b for the first time since 2012.
Source: Bloomberg, Emirates NBD Research.
In this context of ‘self-sanctioning,’ OPEC+ chose not to increase output at a faster pace as headline market balances in the oil market are arguably unchanged. Russian crude is technically still available for purchase, indeed at a steep discount. However, in practice the market is avoiding Russian barrels and with limited offset capacity, the oil market is tightening considerably. The front-month time spread for Brent futures had moved up to over USD 5/b on March 3rd, its widest level at any time in data stretching back to 1990, as markets chase down any spare barrel.
Source: Bloomberg, Emirates NBD Research
Russian supply increase needs to be written off markets if no one is buying it
Russia’s supply increase as part of the OPEC+ agreement was meant to account for more than 15% of the total increase from the producers’ alliance this year. With the war in Eastern Europe and sanctions response showing no sign of imminent de-escalation, any increase in Russian supply needs to be discounted given the scarcity of buyers. Stripping out an increase in Russian supply has a negative impact on headline market balances, extending the balanced conditions into Q2 instead of our pre-existing assumption of a surplus developing.
If there is further escalation in the conflict and buyers of Russian crude completely shun offers, or sanctions directly target oil exports, then there is scope for Russian output levels to fall substantially as buyers disappear and domestic storage facilities reach capacity. Assuming that 4.5m b/d of Russian production are removed from the market, roughly in line with total Russian crude exports in 2021, markets would need to adjust quickly to compensate. Within the rest of OPEC+ there is roughly 6.2m b/d of spare capacity but how it is broken down imposes important caveats. That total number includes more than 1m b/d of Iranian capacity, which is still under sanctions as a JCPOA revival remains so far out of reach. Additionally, nearly another 300k b/d comes from Venezuela and Libya, neither of which has been a stable supplier to markets in the last several years.
Source: IEA, Emirates NBD Research. Note: spare capacity represents level that can be sustained for a prolonged period per IEA estimates.
No certainty rest of OPEC+ will step up
In reality, the response to any full exclusion of Russian exports from international markets would fall on the core OPEC members which have so far been hesitant to increase production to dampen down oil prices. A legal restriction on Russian exports would probably constitute a “change in fundamentals” according to OPEC and thus necessitate a reaction in the form of higher output. Producing at full capacity would mean an additional 4.3m b/d of production, almost negating the assumed drop in Russian production but there is no certainty that OPEC would choose to increase output to maximum capacity.
Supply reaction from non-OPEC+ producers will be positive to the price gains and potential shortfall of Russian crude but will take time to come onto markets. US oil production has actually fallen since the start of the year though it is still projected to increase considerably by the end of 2022: the EIA is forecasting output of 12.4m b/d by December 2022, around 800k b/d higher than current levels.
Assuming non-Russian OPEC+ supply increases by around half its spare capacity and output increase from the US, Canada, Brazil and others, oil market balances would move into a deficit on average of around 2m b/d for Q2-Q4 this year if Russia’s production drops in line with our assumptions, though that also assumes no change in the status of Iran’s oil. While that deficit may not actually show up in headline data, as Russia may choose instead to keep producing oil, the market will need to price the shortfall in anyway as trading in Russian exports becomes difficult.
Source: IEA, Emirates NBD Research
Geopolitical premium to become more entrenched
Oil markets will need to price in geopolitical risk in a more meaningful way going forward. Since the advent of shale technology, oil markets have been able to quickly discount short sharp shocks to supply. The attacks on Aramco facilities in September 2019 are a case in point: Brent futures shot up almost 15% in response to the attacks to end the month just 0.6% higher m/m as prices quickly settled. A prolonged absence of Russia as a major exporter to international markets is at another scale of geopolitical risk, not least in fear that the conflict could spread to involve direct NATO engagement at some point.
Accounting for geopolitical risk in oil markets is guesswork at best. A risk premium always exists in oil prices but expands and contracts based on the geopolitical context at the time. Currently it is obviously quite high even as oil markets look balanced rather than actually being in a deficit. But assumptions that geopolitical crises can be contained or that more oil can always be found need to be revised considerably if not rejected entirely. That sets the trajectory for oil prices in the medium term at a much higher pitch than we had built into baseline assumptions.
What does that mean for our own oil price assumptions for this year? Certainly they will need to move higher. We had already last month revised up our projections for oil prices this year to an average of around USD 80/b in the Brent market, but a prolonged conflict or rejection of Russian crude will mean prices can sustain at USD 100/b and above. As the situation around sanctions evolves, we will adjust our price assumptions accordingly.
Demand will respond too, but negatively
Just as supply will react to high prices so too will demand. Repeated requests from importing nations for OPEC+ to increase output at a faster pace have largely been ignored and Fatih Birol, head of the IEA, said the reluctance to increase production was “disappointing.” While some major importers like the US have a domestic energy industry to fall back on and support—offering up new leases for drilling activity for instance—most do not and thus the demand reaction will be negative to allow for a new equilibrium price. Markets are growing more concerned over the threat of stagflation, high prices and slow growth, and energy rationing could become an eventuality in that context.
Alternative technologies should allow some energy breathing space albeit not imminently. High oil and natural gas prices will serve to further the necessity of the energy transition—if all energy prices are high why not use the ones that will have less of a damaging climate impact. Cheap energy prices encourage their unproductive use, making climate challenges all the more difficult to surmount. Higher long-term costs as a result of the conflict could help—we stress the ‘could’—the development of energy industries in importing nations using renewables as a source that are less likely to be affected by geopolitical uncertainty.
Nuclear power may also receive a revitalization as a result of the conflict. Germany largely rejected nuclear power in its energy mix in the wake of the 2011 Fukushima accident. While a political popular decision at the time, it had the effect of increasing Germany’s reliance (or now apparent vulnerability) to flows of natural gas from Russia.
Source: Eurostat, BP Statistical Review of World Energy 2021, Emirates NBD Research
Russia’s war on Ukraine has only lasted for one week at this point. But the impact it will have on security of supply in energy markets will be long felt. Prices will need to establish new, higher equilibrium levels to allow balances to clear. Higher energy prices will benefit—at headline level—some resource-rich economies, including those of the GCC. But net-net, higher energy costs are a negative for the global economy.
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