Nearly six weeks into the Ukraine crisis, oil prices have remained at near-decade highs. Now, with the prospect of additional sanctioning of Russian oil and gas production, an already-uncertain forecast for oil markets has only grown more complicated.
The crisis in Ukraine is the latest development in a two-year period of demand and supply-side shocks throughout the oil market. The Covid-19 pandemic and the corresponding price collapse in April 2020 forced companies producing hydrocarbons in the US from shale rock sources to be more disciplined with their capital, exacerbating long-term underinvestment in oil and gas production.
Add to that the beguiling effects of Covid-19 on recovering oil demand – exemplified by yet another possible demand disruption from renewed lockdowns in China – and oil market fundamentals have been, at best, a moving target, if not entirely uncertain.
The war in Ukraine further complicated that picture. An embargo of Russian oil by the US and the UK in response to Russia’s actions has had a limited impact on the market, given the relatively small role either country plays in Russia’s oil exports. However, unprecedented banking sanctions by both the US and EU have introduced enough uncertainty for prospective purchasers of Russian oil to “self-sanction” their trade with Russia.
Some of these barrels are already beginning to end up in China and India, and will likely continue to do so. But the total Russian production without a destination is still uncertain, with estimates ranging from 1 to 3 million barrels per day stranded. Now, with calls for sanctions against Russia’s energy industry growing in fervour, the possibility of a broader embargo, tariffs or curtailments as a result of direct sanctions against Russian state-owned companies has further clouded the future of Russian barrels on the open market.
Managing the growing risks in a tight market of supply disruptions on energy prices, inflation and economic growth has preoccupied policymakers and industry leaders. But there are few useful tools on the table.
In line with historical commitments to not weigh into geopolitics, Opec+, a grouping that includes the Organisation for Petroleum Exporting Countries and other major oil-producing nations, has largely stuck to stabilising the market’s demand-side gyrations from Covid-19 over the past two years through steady re-introductions of oil supplies as demand recovers. In order to maintain group cohesion, and despite appeals from the US, some individual members of the group have been largely unwilling to dip into their spare capacity.
US shale production, meanwhile, will take time to add barrels back to the market following significant production declines as a result of Covid-19. Despite steadily rising oil prices over the past nine months, pressure from investors for fiscal discipline with an eye to shareholder returns limited capital allocations necessary to quickly ramp up production. Now, even with prices surging well beyond break-even prices for most fields, constraints on available labour, drilling equipment and fracking sand supplies will take time to build back into the sector.
President Joe Biden’s administration has made unprecedented releases from the US Strategic Petroleum Reserve to alleviate high energy prices. But the efficacy of even regular releases is likely to be limited, if not harmful over the medium term. Any optimism that Iranian barrels might come back onto the market through successful negotiations for a new nuclear deal with Tehran has quickly faded.
Such challenges will hang over the oil market for some time, and there is unlikely to be any price relief in the short term. With few sources of new supply, it is possible that broad sanctioning of Russian oil quickly sends prices over their previous crisis highs to above $150 for a prolonged period. At the same time, with inflation also increasing prices for electric vehicles, and consumers desperate to travel as pandemic lockdowns ease in the West, it is also uncertain whether high energy prices will drive the type demand destruction one would expect in similar oil price environments absent an economic recession. And yet, such a recession appears to be an increasingly real possibility. This week, Deutsche Bank predicted that the US could face a recession late next year.
Eventual production from the US, as shale producers slowly respond to a favourable price environment, will alleviate some supply-side tightness over the next 12 to 18 months. However, the medium-term picture will be characterised by the next phase of the crisis in Ukraine, and whether – and how – possible sanctions against Russian oil production unfold. The scale of such a programme would affect how much Russian oil will be available on the market. And the effect will be further complicated by the possible incentives to purchase Russian barrels at an artificial discount or on the black market, should those barrels not be replaced and high prices persist. Even so, further removal of Russian oil production from the open market could presage a prolonged and severe supply-side crisis on the horizon.
Over the long term, a key question will be under what circumstances Russian barrels return to the oil market in a presumed resolution to the war in Ukraine. Even under sanctions, Russia is not likely to completely end production; halting operations at any oil well risks damaging it permanently. This means a significant amount of oil might remain in storage and suddenly come to the market should sanctions immediately lift once the war concludes.
Alternatively, given consistent demand for heavier Russian crudes, Moscow might find ample opportunities to circumvent sanctions, possibly resulting in a longer-term shift in Russian oil flows from the West to the East where they are more willingly – or easily – purchased outside the reach of western sanctions. Here, continued imports of Russian crude by China and India will be a trend to watch as they balance the advantages of discounted Russian oil shipments with existing import partnerships with Middle East producers, and the risks of exposure to possible secondary sanctions.
Yet perhaps more crucially, it’s unclear how oil and gas companies’ “self-sanctioning” of Russia’s energy industry will unwind, with many of those companies offering significant technical expertise to Russia’s ageing and hard-to-develop oil resources.
Market conditions will continue to be shaped by a backdrop of structural supply uncertainty that emerged long before Russia’s invasion. Though western policymakers have sought to quickly bring more hydrocarbon supplies to market as a solution to the current crisis, it is unclear whether over the long term this will be outweighed by commitments to transition from fossil fuels in the name of both diversification and climate action, and whether policy and financial support for additional hydrocarbon production will wane as a result.
With that transition very much still a work in progress, the long-term picture for oil markets will likely continue to be tight supplies highly exposed to geopolitical disruptions, such as what we are seeing in Ukraine today.