Thanks to the war in the Ukraine and corresponding sanctions, crude oil markets have been roiled worldwide as traders in various parts of the world grapple with sharply higher crude oil prices. The trickle down has hit just about all phases of oil production to the retail level. The mayhem has reached the natural gas market, as Russia is the world’s number one exporter of natural gas. Most fortunately in that respect, winter is winding down in the Northern Hemisphere, buying some time for the gas markets to regroup. But what lays ahead for crude oil, now that the pandemic is on the wane and more people are driving back to the office to work?
Depth of the shock: Statistically, the depth of the shock to worldwide oil markets was more powerful than has been seen since 1956. A relatively short period of settling down has taken place as traders come to grips with the new normal. But the longer the war persists, the longer the sanctions will stay in place, and the longer the buying public will have to cope with dramatically higher prices. Impacting the shock wave was the prior state of the crude industry itself—still in the process of ramping back up from the shutdown caused by the pandemic. The process of bringing oil out of the ground, to the refinery for product creation, and to the retail user involves many stops in what’s known as the midstream. This includes, but is not limited to, pipelines, storage facilities, water removal facilities, refineries, ocean transport, and then after refining, storage and delivery to retail outlets. Some of the usual midstream processors have not yet fully ramped up creating more supply bottlenecks.
Diminished Supply: Although crude oil is still being shipped out of Russian ports, most of what’s moving was already transacted before the war began and sanctions were applied. Fresher supplies of Urals crude are not trading, in spite of discounts of 25% or more. As the sanctions reach to the far corners of the world, many processors, traders, and distributors are reluctant to get tied up with shipments of Russian crude as their customers are disappearing. Financing these shipments (also sanctioned) has impeded the flow as these same processors, traders, and distributors dealing in Russian crude are becoming more and more shut out from international banking that’s required to complete oil shipment transactions. In the past, many large, multinational banks have been forced to pay massive fines for violating sanctions on countries such as Iran, and are reluctant to get involved again. Owing to insurance issues, ships from foreign countries are staying out of the Black Sea, where much of the Urals crude is shipped. Russian producers will be forced to stop pumping and shut down as their storage facilities fill up.
Picking up the supply slack: In theory, China could buy more Russian crude, taking part of their supply needs away from other markets. However, shipping from Russian to China would take as much as nine times longer than shipping to Europe where most of Russian crude had been exported. Pipelines to Asia and other worthwhile alternatives could take years to bring up to speed. OPEC could be counted on to ramp up production to a certain level, but many OPEC members have not needed for numerous years to drill for new wells and build the infrastructure necessary for midstream processing. This would add to the lengthy timetable required to get new supplies of crude to markets formerly served by Russia.
American suppliers have agreed to ramp up an extra million barrels per day, along with releasing some of the strategic petroleum reserve. But the shale wells in America shut down from the pandemic could require up to a year to open back up and ramp up to delivery. A new nuclear treaty with Iran would lift sanctions on that country and should add still more to the supply, but the treaty is not yet complete. All these things will help worldwide markets to a certain degree, but will not very soon replace Russian exports that ranged from seven to eight million barrels per day before the sanctions set in.
Other issues: Russian crude contains a relatively high sulfur content, and must go through a modified refinery process that is geared to handle the extra sulfur. Those countries that have been regular customers of Russian crude will need to retrofit their processing facilities to refine crude from other sources.
Conclusions: It would appear that under any and all circumstances a substantial portion of Russian crude will be exiting the worldwide marketplace. Efforts to replace the supply will help, but fall short by as much as half or more. The impact will be felt not only at the retail level, but throughout many major economies. It has been forecasted that if crude should reach $200 a barrel, demand destruction could take place, as voluntary to mandatory cuts in usage would be required. Even the lifting of the sanctions themselves might not bring immediate relief, as Russian producers are considered in the industry to be risky trading partners and could remain marginalized after sanctioning ends. All this adds up to a steady stream of higher prices for petroleum products throughout the system.
Sources: Barrelled over, The Economist, March 12, 2022.