Oil prices – falling now, but upside risks on the anvil from further sanctions
• Brent crude oil price dips just below US$100/bbl, as recession fears dominate in topsy-turvy environment
• But talk of price cap sanctions on Russian oil exports keeps upside risks on the horizon
• In a bear case scenario of further spiralling sanctions/retaliations, we could see Brent testing the waters at around US$140-150/bbl
• Further sustained upside beyond US$150/bbl unlikely in our opinion
High volatility in oil markets persists. In our previous two reports on oil prices, we talked about the push and pull of various conflicting factors in the oil market, but we had still viewed the push factors as having a slight edge and upped our oil price assumptions for the rest of 2022 to US$102 – 107/bbl, up from US$97 – 102/bbl previously. Right now, we are seeing oil prices being pulled down by demand side concerns, but it is the risk of further push factors, going forward, that is probably more worrying for the world, in general, as inflationary risks get heightened. Both as analysts and consumers, we could live with oil prices at around US$100/bbl or lower, but oil prices at US$150/bbl or upwards is not something we would look forward to.
Oil has fallen sharply on two occasions in the last 10 days on demand destruction fears. On 5 July, Brent crude oil prices dropped by around 9% and more recently, on 12 July, Brent dropped by around 7% again to below US$100/bbl, on the back of heightened global recession concerns as well as fresh restrictions in China to control COVID outbreaks. Markets are increasingly worried that aggressive rate hikes to combat inflation will lead to an economic downturn by 2023. The increase in the US dollar index to fresh highs is also putting pressure on oil prices. We have factored this slower demand growth into our assumptions already and indicated earlier that this will put a lid on oil price bullishness. Therefore, we expect oil prices to moderate in the medium term, but not fall off a cliff, as demand growth will still be a positive number (coming off a low base, we are still below preCOVID levels) and the supply side is very tight (OPEC production in June was actually lower than in May, despite the purported production increase agreement).
But the Ukraine crisis and retaliatory actions add to potential upside risk. The Russia-Ukraine war is on for 140 days now, with no end in sight. Having taken control of most of the southern parts of Ukraine, the Russian offensive is now focused on the eastern Donbas region, where they have occupied Luhansk province and are now looking to overcome resistance in the Donetsk region. Western sanctions on Russian oil have not had the desired impact so far, as higher oil prices have meant higher revenues for Russia to fund their war efforts. Hence, G7 countries are now exploring imposing a price cap on Russian oil exports to reduce Moscow’s revenues. If such a move comes to fruition, Russia may retaliate by lowering oil exports.
Will a price cap on Russian exports work? Last Friday, Russian President Vladimir Putin warned the western allies that continued sanctions against Russia over the war in Ukraine risked triggering catastrophic energy price rises for consumers around the world. Putin considers the sanctions as a form of economic warfare and may not shy away from harsh retaliatory actions if further sanctions are imposed on Russian energy exports. On the gas side, the Nord Stream 1 pipeline, which supplies critical natural gas to Germany from Russia, is under scheduled maintenance from 11-21 July, but maintenance could be extended on any pretext to hold the G7 countries at bay over any further sanctions.
Russian gas supplier Gazprom had already cut supplies through the pipeline to 40%, citing delays in equipment servicing by Siemens in Canada. Russia has already cut off gas supplies to Bulgaria, Poland, Finland, and some suppliers in Denmark, Netherlands, and Germany for failing to pay in rubles.
The US and allies will also have to convince Asian countries, especially China and India, who together are
now importing around 3mmbpd (million barrels per day) of Russian oil at discounts, to accept the price caps, which will not be easy. Thus, we are not ascribing a very high probability to the idea of imposing the price cap sanctions, as not only does Putin have enough leverage via the gas market and eventually the oil market to retaliate even before such a sanction becomes reality, but other major importers of Russian oil may not agree as well.
US$300-400 per barrel oil if price caps are imposed? This is purely a sensational comment from Russia’s former president Dmitry Medvedev last week in response to a reported proposal from Japan to cap the price of Russian oil at around half of current levels or US$40- 60/bbl, a level which will incentivise production but limit profits. We can only say these are just fearmongering headlines and at this juncture, risks of this happening seem very low, as it will be tough for the US and its allies to convince other countries to accept any decision which could result in spiking oil prices further, especially as they fight against inflation in an already high oil price environment, amid a shaky economic outlook.
So, what’s the bear case assumption? Given Russia’s belligerent stance on natural gas exports to Europe, with Nord Stream 1 supplies disrupted, spot TTF gas prices have again shot up above US$50/mmbtu (million British thermal unit), driving up spot Asian LNG prices as well, to close to US$40/mmbtu again, even as we are in the low demand season for gas. Filling the storage ahead of winter seems to be a challenge as of now. We expect Russia to continue to weaponise its hold on the global energy markets on the oil side as well, if further sanctions are discussed. Hence, such sanctions will only lead to higher oil prices, rather than lowering oil prices, which is the goal for the west as far as limiting Russia’s war financing options are concerned.
Russia could lower exports by 1mmbpd or so to retaliate, which could drive oil prices towards the US$140-150/bbl range in the interim, instead of the US$100-120/bbl range we envisage in the near term in our base case assumptions. Only in a very extreme scenario of Russia limiting oil exports by 3-4mmbpd do we see oil prices spiking to US$180-200/bbl, but that would be momentary and not sustainable. Real demand destruction would set in if oil prices are above US$150/bbl and stabilise the market downwards.