In expectance of volatility

The restrictions imposed on Russian oil could send markets into a turbulent start of the year

09:00 | 6 януари 2023
Photographer: Akos Stiller/Bloomberg
Photographer: Akos Stiller/Bloomberg

By Preslav Raikov

In recent months, a number of geopolitical risks have materialized in the oil markets and put the world economy in anticipation of increased price volatility at the beginning of 2023. The world continues to be in the grip of inflationary processes, and the struggle of central bankers to return the world economy to the state of price stability worries economic processes and post-covid recovery. In 2023, along with the meetings of the Fed and the ECB, the meetings of the oil producers will be equally important for the world economy, due to the fact that they have the potential to dictate the direction of inflationary processes, and accordingly the rise of interest rates and their impact on economic growth.

From being relatively boring and technical, the meetings of the producing countries, and now also of a large part of the oil consumers, will occupy a central place in the investors' calendar in the next year.

At the end of 2022, the EU introduced a partial embargo on Russian oil imported by sea, and the G7 countries agreed to introduce a price ceiling for Russian blends of $60 per barrel. In response, Russia warned that it could seriously tighten the official supply of Russian oil to the countries applying the sanctions and the price cap. Such a move will undoubtedly plunge Europe and the world into another relentless grip of inflation which will prompt central bankers to act even more decisively and plunge economies into an even deeper and longer recession. And although oil quotes have partly reflected such a scenario, the situation of economic war by all means suggests that this move will be realized precisely in the current winter in Europe and potentially send quotes back to $100 per barrel.

We can certainly argue that right now Putin would like nothing more than higher world oil prices, which would lead to another spike in inflation, slow growth and create more political tension everywhere. The Kremlin achieved this result in the natural gas market by reducing exports to Europe and manipulating the market, which led to a spike in prices and strain on European economies for most of 2022.

Oil exports currently provide almost 50% of Russian government revenues, as well as almost all the foreign currency needed to stabilize the ruble, purchase weapons and ammunition from abroad, making it extremely attractive for the conduct of the energy and economic war.

Since the beginning of the conflict in Ukraine, the official data on the export of Russian oil indicates that we have a decrease of almost 1.5 million barrels per day from the country, and taking into account the fact that Russia is also a major exporter of oil and oil products, the quantities that it withdraws from the market , could seriously tighten supply in the coming months. In the medium term, we may find ourselves in a situation of extreme oil shortages, and the world's energy security comes at a price that may prove too high for fragile economies struggling with prolonged and record inflation.

Over the past year, the world has been in a situation of universally tight oil supply, and the strategic reserves of a number of countries, including the United States, have seriously decreased. Investment in new manufacturing has also stagnated dramatically and is insufficient to ensure the energy security of a global economy that still relies heavily on oil to generate value. Over the past year, the G7 countries have resorted to releasing quantities of their strategic oil reserves in an attempt to parry commodity price hikes and satisfy disgruntled consumers. The effect on fuel markets, however, proved extremely short-term, but drastically and almost dangerously reduced the levels of these reserves, setting the stage for potentially high levels of volatility if drastic supply tightening is resorted to in the coming months. Following the U.S. withdrawal, the country's strategic stockpile is at its lowest level since 1984, and the Biden administration plans to release additional quantities.

A wink from OPEC and the USA

Despite the fact that over the past 3 years Russia has extremely successfully participated in the policies of the OPEC + cartel, in the coming months of the current winter in Europe, a sharp change in the course and unilateral violation by Russia of the agreed production quotas is not excluded , in response to the sanctions imposed. The financing of the budget of the Russian Federation is mainly driven by energy raw materials, and the desire for high prices comes for two reasons.

First, it will tighten the inflationary grip on the countries that apply the sanctions and participate in the embargo, since a large part of the inflationary processes in these economies in the past year were driven precisely through the energy channels. Second, higher prices would offset the losses from the imposed sanctions. It's no secret that Russian crude still sells at a huge discount compared to Brent and West Texas, and more and more trade goes through illegal exports and a flotilla of unregistered tankers sailing with their tracking devices turned off and making crude transfers on certain locations to other tankers. The Urals blend discount to BRENT reached almost $35 in the worst months of the war, and now it is likely to deepen even further. Russia needs oil market prices above $90 to make up for its export losses.

A potential move by Russia would limit the amount of oil officially announced for export, with the bulk of volumes being diverted to the illegal channels well known and developed following the conflicts in Iran and Venezuela. The potential for Russia to cut production by 1 to 2 million barrels per day could drive prices back to $100 in the first quarter of 2023. While such a move would be extremely risky for Russia itself, it is entirely possible, given the power that oil markets have and their influence on inflationary processes. Such price volatility would hit hardest the countries of Europe, which would be in a state of increased energy carriers, a severe winter, gas shortages and rising interest rates.

Another indicator of potential price volatility and mid-term tightening of markets also comes from the US. In late November, Washington partially lifted sanctions on crude oil imports from Venezuela for a period of 6 months. It was a clear sign that the Biden administration is preparing a well-planned energy policy to protect the U.S. economy from potential medium-term pressure on oil markets from a potential tightening by Russia. The move is part of a broader energy strategy for the country, which is likely to resume actively exploiting and importing crude oil from Venezuela to ensure fuel price stability without having to re-exploit its shale industry and invest funds in the development of new deposits.

Hinting about the risk of price volatility and potential tightening of supply was also the move of OPEC+ since their meeting in October, when the cartel pulled 2 million barrels a day from the market, and in December reaffirmed its decision. Despite accusations that such a step is in the service of Russia and sends a negative signal to the world economy, Saudi Arabia has not hesitated to cut production and support higher prices. A move that initially did not sit well with the US and was heavily criticized by developed countries.

However, the reality can be quite different. The withdrawal of 2 million per day - mainly from Saudi Arabia - could be a good way to intervene in the future by returning them to the market. In the event that Russia unilaterally withdraws official quantities from the market or begins to more actively replace them with illegal exports, OPEC can intervene by returning quantities back to the markets, parrying sharp price increases.

Prelude to the fight against OPEC+ With the European embargo on oil imports by sea and price caps currently in place, it will be necessary to form a technical group to observe and readjust the price measures against Russian oil, as well as to guide the international community on future actions of oil markets. Most likely, such a technical committee will be formed in the first months of 2023. Along with the meetings of the regular OPEC committees, the international community will have to pay serious attention to this group, which in the future has the potential to implement the policies so desired by the US against the OPEC+ cartel. Washington's desire to crack down on OPEC's cartel practices is about to materialize. Targeted interventions through the strategic oil reserves, proposed price ceilings, and the proposed oil embargo put the US in a position to form an exclusive club of commodity users to dictate its wishes on global price levels.

THE BOTTOM LINE The world is in a situation of tight oil supply everywhere, and the strategic reserves of a number of countries, including the United States, have seriously decreased