The Oil Market After The War

Naturally, the war in Ukraine and its impact on Russian oil flows is the dominant factor in today’s oil market, but few wars last forever. It is possible that Putin will declare victory and leave in the near future, but equally possible that the conflict will revert to pre-invasion status, that is, continuing but low-level fighting in eastern Ukraine. Aside from these unknowns (or at least, known only to Putin), there are a number of salient facts that need to be considered but are often overlooked.

The most important thing, and a lesson that never seems to penetrate the public mind: wars and crises tend to be transient and temporary, and many — if not most — factors will soon revert to pre-crisis behavior.

First, sanctions will ease: Russian oil and gas have not been put under sanctions by any major consuming nations; the biggest impact has come from companies that have voluntarily ceased purchases primarily of oil. This could change, with some forecasts seeing a loss to the market of 3 million b/d of Russia’s roughly 11 million b/d of total production. Some combination of lower violence and/or crisis fatigue will certainly result in a quiet resumption of purchases, which will lessen pressure on the market and reduce prices, whether through lowering the security premium or erasing the demand for prompt barrels. (This means a decline in backwardation as well, already partly accomplished.)

Second: supply chains will eventually rebalance. Higher gas exports to Europe from Russia are likely and will reduce the incredibly elevated prices there, as well as elsewhere. LNG cargoes will resume going from the U.S. to Asia and in all probability, by next winter natural gas prices globally will be below pre-crisis levels. (The U.S. market is a special case, to be discussed in more detail in a later post.) Some European customers will seek long-term contracts for U.S. gas, especially with cost-plus contracts to avoid another price spike.

Next big issue is oil on the water. A lot of Russian oil has been diverted from Europe to Asia, which means that there are an additional tens of millions of barrels in tankers underway, compared to pre-crisis levels. (Semi-educated guess: 25-50 million.) Storage tanks in Russia are reported brimming, and that could add another 10-20 million barrels to the market, again fairly quickly. (Less than semi-educated guess.)

In theory, these volumes would raise on-land inventories fairly quickly, and could mean a sharp bump down in backwardation—potentially to contango. However, given that OECD inventories, which are about half the global total, are down by 300 million barrels compared to the five-year average, this will not rebalance the market. Prices are likely to remain above $80 until inventories grow much more.

Third: politically strategic petroleum releases would probably end, but are not guaranteed to do so. Countries like the U.S., Japan and others are concerned about high inflation and would not want to cease releases if it would mean less downward pressure on oil prices. November elections looming in the U.S. will certainly be a factor in any decision. Uncertainty remains, however, about when countries resume filling their strategic reserves which could either support or push up prices. Biden’s move to empty the U.S. S.P.R. by 180 million barrels this year just means that much more oil will be demanded in the future to fill it back up. Historically, many governments have bought oil for their strategic reserves when prices were most elevated and that could prove true again.

Fourth: Americans love to burn petroleum on the highways. There will be a pullback in several areas once it becomes clear that oil and gas prices are not going to remain elevated. In particular, recall that back in 2008, when the price of oil hit $145, there were numerous voices insisting that this represented a sea-change for demand. At the time many believed American gasoline demand had peaked, while environmentalists castigated automobile manufacturers for being too stupid to realize that motorists wanted smaller, more efficient cars. That proved woefully incorrect (unless you are a pickup/SUV manufacturer, then it proved wonderfully incorrect). Sure, sales of electric vehicles are getting a boost from higher fuel prices, and may even stay high upon an end to the crisis, though shortages in chips and battery materials muddy the EV outlook. To be sure, the United States has not yet hit peak oil demand.

Finally, don’t get too excited for a trip to Tehran or Caracas. Remember what passed for pariah states before Putin invaded Ukraine? It seems likely that the end of the war — and return of Russian oil — would reduce somewhat the desire to end or lighten sanctions on Iran and/or Venezuela. An Iran deal could add perhaps 1 million b/d to the market within weeks. Venezuela could add 500,000 b/d within nine months. The negotiations with Iran preceded the war in Ukraine and could be successfully concluded but are currently stalled by Iranian insistence on guarantees from the U.S. that it wouldn’t back out of the deal again in the future. That would almost certainly require a formal treaty and ratification from the U.S. Senate, which is beyond unlikely. A face-saving compromise could be reached, but if Iran can increasingly evade sanctions on its oil exports, they will be less inclined to do so.

The upshot is that an end or lessening of the conflict in Ukraine would mean more oil on the market and lower inventories at sea and in Russian storage, which will certainly cause oil prices to drop, especially if traders are convinced the prospect of European oil sanctions has sharply receded. With little or no demand effect, oil prices should drop at least $10 from current levels, and WTI could even test $80 by early summer if it appears the oil demand during the U.S. driving season will be weak. By the second half of the year, with higher production from the U.S., Canada and others—including Mideast OPEC+ members—$80 could be the new ceiling, not the floor. However, it is unlikely that global inventories will recover far enough to bring prices much below that, at least this year.

Russian Oil Exports Are Forced on Longer Voyages to Find Buyers – Bloomberg