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Vladimir Putin just threw a spark into the powder keg of the global oil market.
The Russian invasion of Ukraine has sent oil prices soaring above $100 per barrel, and without a quick resolution, we could see even more explosive gains ahead.
While the geopolitical situation is complex, the market impact distills down to basic supply and demand. Even before the Ukraine conflict, the world was running short of oil – evidenced by prices rallying above $90 per barrel at the start of this year.
Now, the market risks losing millions of barrels of Russian exports at the worst possible time. In today’s article, I’ll explain why this supply disruption could make today’s $110 oil prices seem cheap. Absent a quick resolution, we could face the prospect of $200 per barrel, or even higher.
Finally, one quick note before getting started…
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With that said, let’s begin by analyzing the scope of potential disruption in Russian oil supplies.
An Unprecedented Supply Shock
Russia is the world’s third largest oil producer, with output of 11.3 million barrels per day (bbl/d). The country consumes about 3.5 million of those barrels domestically, while exporting more than 7 million bbl/d of crude oil and refined products daily (the term “oil” will refer to both crude and refined products in this article). That makes Russia the world’s single largest oil exporter.
Before the Russian invasion of Ukraine, 4.8 million bbl/d of Russian oil exports went to countries that are now backing sanctions against Russia. This primarily includes western European countries that are part of the EU, plus the U.S. and a few others. Meanwhile, another 2.3 million bbl/d goes to countries not backing sanctions – primarily China, along with several eastern European countries (see here for a graphical breakdown of who buys Russian oil exports).
While we can likely count on China and Eastern Europe to continue buying Russian oil, that still leaves a massive 4.8 million bbl/d of exports at risk from the escalating tensions between Russia and the West.
Outside of coordinated OPEC actions – which typically occur in bear markets – the world has never suffered a supply disruption of this magnitude before. Of course, Western leaders appreciated the critical nature of Russian exports in balancing the global oil market. That’s why the politicians initially avoided direct sanctions on Russian energy in the wake of the Ukrainian invasion.
The problem is, scope of the financial sanctions leveled against Russia were the most sweeping of any kind ever implemented. So despite these intentions, the Russian oil trade got caught in the crossfire as collateral damage.
Russian Crude Caught in the Sanctions Crossfire
Physical oil trading is a complex business that involves multiple layers of transactions and counterparties. So even where Russian crude is still technically legal to trade, the sanctions package has gummed up the inner-workings of transactions on the ground.
As one example, physical oil traders often use letters of bank credit to finance the purchase of crude oil cargoes. But as the Wall Street Journal reports, the “banks that grease the wheels of international commerce are refusing to finance Russian commodity deals.”
Without this critical source of financing, traders can’t buy Russian crude and deliver it into the global market. Meanwhile, we’re hearing similar reports of refiners, insurance providers and other key cogs in the physical market stepping away from dealing in Russian oil. Even if the transactions aren’t technically illegal, these players simply don’t want the risk or headache involved. As one trader at a major commodities broker simply explained: “the market is starting to fail.”
Meanwhile, even if Western companies are willing to take the legal/financial risk of buying Russian crude, they now face huge reputational risk. Case in point – oil supermajor Shell purchased 100,000 barrels of Russian crude at a record discount last Friday. The backlash was enough to spark a public apology from Shell by Tuesday of this week, along with a commitment to “stop all spot purchases of Russian crude oil.”
The situation escalated further on Tuesday, when the Biden administration took direct aim at Russian energy – announcing a ban on Russian oil imports into the U.S. The U.K. followed up with a similar ban on imports of Russian crude oil. Russia quickly responded with the prospect of banning Russian commodity exports in response to Western sanctions.
So already, a substantial portion of the 4.8 million bbl/d of Russian oil exports to Western economies is disrupted from sanctions and popular pressure. But now, escalating tensions threaten to directly impair the entire 4.8 million bbl/d of export volumes. That puts roughly 5% of global oil supply at risk of impairment.
This would be a massive disruption during normal times. But it’s an even bigger problem for today’s already-undersupplied oil market.
Let’s consider the inventory situation…
Global Oil Inventories Running on Fumes
During the initial COVID-19 outbreak, economic shutdowns around the globe briefly took up to 20 million bbl/d of demand offline. This created a historic build in crude inventories. However, the market quickly flipped from surplus to deficit as supply came offline and demand rebounded. By Q3 2020, the market entered into a structural deficit, with global crude inventories drawing down by an average of 1.8 million barrels per day (bbl/d) through Q4 2021:
On the surface, a 1.8 million bbl/d deficit might seem modest in the context of a 90 – 100 million bbl/d global market. But this shows why the price of oil (and all other commodities) is set by the marginal barrel. It only took a roughly 2% daily supply deficit, compounded over 18 months, to erase a record oil surplus in record time.
So, you can imagine the catastrophic impact of a 5% supply deficit from a major disruption in Russian oil exports. Especially given today’s starting point of depleted inventories.
But the truth is, today’s inventory situation could be even worse than pictured above. Let me explain…
You see, the public forecasting agencies that report on global oil stockpiles aren’t measuring tank levels. Instead, they estimate supply and demand, and take the net result as an implied inventory change. That means a faulty read on either supply or demand could produce a faulty inventory estimate. And it turns out, that’s exactly what’s happened in recent years.
200 Million Missing Oil Barrels
The international energy agency (IEA) is a key source for information on global oil supply and demand used the world over. So it raised more than a few alarm bells when the IEA recently admitted to massively underestimating global oil demand in recent years. After revising up their demand figures, the agency reported that global oil stockpiles are about 200 million barrels lighter than previously expected.
That means today’s global oil market could actually be much tighter than the numbers reported by agencies like the IEA.
For a more accurate measure of inventories, we can look at the weekly storage levels in Cushing, Oklahoma – the key hub that sets the West Texas Intermediate (WTI) oil price. Unlike the global inventory data that comes from supply/demand guesses, the storage tanks at Cushing are directly measured each week.
The bottom line: today’s oil market has very little margin of error.
Next, let’s analyze the supply and demand trends that got us here, which will provide a roadmap for what we might expect going forward.
Oil Demand on Track for New Record Highs
As recently as late 2021, the fashionable opinion on Wall Street said that oil demand had peaked with the pandemic, and it was all downhill from here. One well-known asset manager overseeing tens of billions of dollars famously called for crude oil to go the way of “whale oil”:
Fast forward a mere 18 months later, and the oil skeptics couldn’t have been more wrong – with U.S. demand running consistently above pre-COVID levels and clearing new record highs just last month:
Even more impressive, these new highs showed up before peak seasonal demand kicks in during the summer driving season, which could unleash more upside from here.
Looking ahead, another source of potential demand upside could come from a further rebound in air travel. The chart below shows that U.S. air travel remains about 15% below the pre-COVID levels of 2019:
With COVID restrictions fading into the rearview, many analysts expect U.S. air travel will stage a full recovery at some point in 2022. If true, this could help secure further new highs in U.S. crude demand from here.
The rest of the world is following America’s lead. The IEA’s latest estimates indicate global demand will grow by 3.2 million bbl/d this year to 100.6 million bbl/d. Meanwhile, the U.S. energy information agency (EIA) projects a new record high in global demand by Q3 of this year, with further new highs in 2023 and beyond:
In other words, peak oil consumption is nowhere in sight. And with economies re-opening around the world, the world will need over three million bbl/d of new supply this year alone.
Next, let’s consider the supply side of the equation…
US Oil Production Stalled, Despite Higher Prices
Even with the best pricing environment of the last decade, U.S. oil production remains stalled out at 11.6 million bbl/d. That’s about a million bbl/d shy of pre-pandemic highs:
This reflects a 180 degree change from the dynamics of the last decade, when shale drillers unleashed millions of barrels of new production growth at $50 – $60 oil prices.
The reason for this change is two-fold: lack of capital investment, and perhaps more importantly- a lack of inventory. Shale drillers have simply exhausted core inventories in many of key basins that boosted U.S. production during the shale boom, like the Eagle Ford and Bakken shales.
Today, the Permian basin in Texas is the last bastion for U.S. production growth. Despite adding over half a million bbl/d in new production since mid-2021, the Permian is struggling to offset declines in conventional production and the stalled output from all other U.S. shale fields:
Given the exhausted inventory in shale basins outside of the Permian, it’s not clear that higher prices can solve this problem. Meanwhile, even if operators want to put rigs to work, the oil patch is dealing with an acute shortage of inputs across the board, ranging from labor to steel piping to frac sand.
The same supply chain constraints slowing down auto manufacturing and home construction is showing up in the oil patch, and there’s no easy fix here. This confluence of factors explains why, despite the biggest weekly gain in crude prices ever, the U.S. oil rig count actually fell by three and remains 24% below pre-COVID levels:
Finally, there’s the OPEC+ coalition, which is also struggling to boost output.
OPEC+ Capacity Hit by Global Capital Retreat
In the wake of the COVID-19 outbreak, OPEC+ balanced the oil market by cutting a record 9.7 million bbl/d of output. As demand rebounded, the group agreed to release 400,000 bbl/d of new supply each month, starting in July of 2021.
But for the last several months running, many of the participating countries have struggled to hit their production targets. In January, the IEA estimated that OPEC+ undershot its production quota by 900,000 barrels per day.
A big part of this shortfall can be attributed to the Western backlash against fossil fuel development. Historically, a substantial portion of OPEC+ oil production has been developed by western capital – primarily from the global supermajors. But now, slashed capital budgets among Western oil companies is creating ripple effects around the globe, as energy expert Julian Lee explained to Bloomberg:
“Persistent production shortfalls in countries like Nigeria and Angola are not the result of maintenance… rather, they reflect dwindling capacity resulting from lack of investment in exploration and development. So the shortfall will persist. In fact, it’s going to get worse, as more and more countries run up against capacity constraints and struggle to lift production.”
Thanks in part to downgraded estimates for OPEC+ production capacity, Morgan Stanley forecasts the world’s spare capacity will shrink from 6.5 million barrels a day a year ago to below 2 million barrels a day by mid-2022:
Critically, these space capacity estimates were made before the Russian invasion of Ukraine. So even assuming zero disruption to Russian supplies, the oil market was set up for a dangerous drop in spare capacity to under 2 million bbl/d by year-end.
Finally, let’s consider the potential impact on the market in the case where Russian exports remain impaired going forward.
A Demand Destroying Price Spike Could Take Oil to $200+
Every commodities bull market is born from a supply/demand imbalance. The price mechanism attempts to solve the imbalance in one of two ways: incentivize more supply, or reduce demand.
Over the past year, the oil market has signaled the need for more supply (or less demand) through a steady grind higher in prices. And yet, despite oil reaching multi-year highs of $90, producers have struggled to add enough supply. As discussed in today’s article, many of these production struggles can’t be solved by higher prices in the short-term.
Meanwhile, demand continues rebounding across the globe. Now, the threat of losing up to 4.8 million bbl/d of Russian exports could take the supply side of this balancing act off the table. In the event of a total loss of these Russian exports, even with every OPEC member maxing out their production capacity, the market could still face a crippling supply deficit exceeding a million bbl/d.
In that scenario, wide scale demand destruction would become the only mechanism available to balance the market. It’s anyone’s guess how high prices would go in this scenario, but $200 could be just the beginning.
Given these risks, domestic oil and gas production has never been more important.