Energy Markets: Volatility is the new normal

The Bottom Line

> The EU’s sixth sanctions package and a G7-led price cap on Russian crude (implemented on December 5) aim to restrict Moscow’s ability to fund its war against Ukraine while limiting the impact on global oil supplies and prices.

> Slow global economic growth and OPEC+’s rollover of lower production quotas have moderated the effect on prices of the moves thus far, but volatility is expected as markets contend with unprecedented measures against the world’s second largest crude exporter.

> Chinese demand is down but there are early signs of an economic recovery in 2023, which will place pressure on supply and push up prices – especially if Russia follows through with its threat to cease trading with any country that adheres to the cap. This would lead to shut-ins of Russian production due to insufficient storage and inability to export.

> The EU and other coalition states believe that Russia and its consumers will be unable to facilitate the trade of oil without using Price Cap Coalition country maritime services and hope that the risks associated with circumventing sanctions will deter consumers from negotiating directly with Moscow. However, an increase in illicit trade is expected, particularly given the challenges of enforcing such widescale restrictions.

On Monday December 5 the EU implemented its sixth sanctions package against Russia. Member states – with some exceptions – will cease direct and indirect seaborne crude imports either originating in or exported from Russia. In parallel, a price cap on seaborne oil exports from Russia was also agreed and enforced by the Price Cap Coalition: the G7 nations, the EU, and Australia.

The price cap allows entities from participating countries to continue to provide services – insurance, vessels, trading and brokering assistance, and technical and financial support – to third country buyers of Russian crude, provided that the oil has been purchased for less than $60 per barrel. The plan is to restrict Moscow’s ability to fund its war against Ukraine while trying to entice it to keep providing oil to global markets, to both stabilise prices and ensure sufficient supply.

With Russian crude selling at an average of $67 per barrel to date, the agreed lower figure will have some impact on Russian revenue streams, although it still allows Moscow to profit from the sale of its oil. The cap will be reviewed every two months to assess “the effectiveness of the measure, its implementation, international adherence and alignment, the potential impact on coalition members and partners, and market developments”, as stated by the European Commission.

Market’s reaction tempered by sluggish demand – but greater volatility expected

Markets are struggling to anticipate the impact of the measures, which represent an unprecedented intervention by EU and G7 countries.

News of the proposed cap gave rise to fears of supply disruptions and prompted a consumer rush to purchase crude in September and October, but this has slowed now that the cap has been set at a relatively high figure. Sluggish global economic growth has tempered the immediate effect on prices, with Brent settling at around $87 per barrel after the two packages came into force.

OPEC+ had already cut production quotas by 2m b/d last October, citing impending global economic slowdown due to China’s ongoing Zero Covid policy, and maintained this position at December’s meeting in the face of supply and demand uncertainty. But the repercussions of this reduction are yet to be reflected in the market, mostly because several OPEC producers were already pumping under their quotas, meaning the cut – in real terms – was closer to 0.5m–1m b/d. The move has thus far supported prices as global demand for oil has slowed. But greater price volatility is expected – both in terms of fundamentals and geopolitical reactions – as markets contend with the latest round of sanctions and the price cap

Wildcard Russia creates further uncertainty

Oil flows should, in theory, be able to be reorganised to satisfy all markets. Thus far, Russian crude exports have remained resilient against sanctions, falling by 400,000 b/d since the start of the war, according to the International Energy Agency (IEA). China, India, and Turkey have absorbed re-routed Russian production – Turkey alone has tripled its pre-war import volumes from Russia. But the new measures will force Russia to find a new home for some 1.1m b/d that previously went to Europe. The IEA anticipates that an additional 1.4m b/d of Russian production will be shut in by early 2023 because the restrictions placed on maritime services will curtail exports.

Provided the cap is accepted and adhered to by non-signatory states, Russia could continue to sell to China and India – the latter has imported around 900,000 b/d since the invasion from a starting point of zero – freeing up Middle Eastern crude to flow to the European market to replace embargoed Russian barrels. Europe will also seek additional barrels from the US (set to add 1.1m b/d to global markets in 2023) and West Africa, alongside efforts to accelerate the energy transition and reduce demand at home.

But this reshuffle is contingent on Russia’s cooperation. Unsurprisingly, Moscow has condemned the cap and announced it will refuse to sell to countries that implement it – even if doing so means reducing production. New Delhi and Beijing have both indicated they intend to continue buying oil from Moscow, but it is not yet clear how Moscow’s position will affect their trade. As most services required in the sale and transport of crude are based in G7 countries – over 95% of cover for oil spills and collisions is routed through the UK-based International Group of P&I Clubs, for example – it is difficult, but not impossible, for Russia to sell at a higher price and to convince its buyers to take the risk of doing so.

If Russia cuts production and refuses to sell under the terms of the cap, it would be hard pressed to develop a maritime ecosystem of its own overnight and risks damaging both its infrastructure and its reputation with longstanding customers. Doing so at the same time as Chinese demand recovers would cause prices to skyrocket in response to supply shortages. Such a scenario is likely to result in one of two outcomes: either Russia will be forced to sell under the cap to sustain its economy amid rising inflation, or other major producers – notably the Gulf states (as the holders of most spare capacity) through the mechanism of OPEC+ – will face pressure to step in and manage markets.

There is also a third likely outcome: a surge in illicit trade to evade sanctions. Mixing crudes to obfuscate origin, doctoring paperwork, using “shadow fleets” of tankers, and finding contractual loopholes have been used effectively to bypass sanctions on crude exports from countries such as Iran and Venezuela. The scope of the price cap will make its enforcement challenging, and signatory parties will need to act swiftly and decisively against violators to ensure, and maintain, impact.

Demand trajectory in 2023 hinges on speed of Chinese economic recovery

But even if Russia – and its customers – find creative ways to circumvent sanctions, the demand picture in Moscow’s key market is looking uncertain. Chinese demand was down 62,000 b/d in Q4 off the back of rising Covid-19 cases and will have declined 550,000 b/d in 2022 overall, according to estimates from Standard & Poor. Reports that Beijing will relax some pandemic restrictions as early as this week following widespread protests have given hope that China’s economy will start to re-open again next year; however, it is unclear when, or how quickly, its demand will recover.

Even with an economy at full speed, China is not a guaranteed market for Moscow’s extra barrels. Beijing slowed purchases of Russian crude for December in anticipation of the EU and G7 sanctions packages, indicating that it intends to step carefully until it can be confident that its energy trade with Russia will not be caught up in the web of Western sanctions. Fear of reprisal – particularly from any future US secondary sanctions in the finance space – appears to be influencing its decision-making. All eyes are on the impact of sanctions on payment mechanisms, shipping availability and insurance, with some independent Chinese refiners seeking supplies – at higher cost – from Brazil and West Africa to hedge against potential disruptions to Russian exports.

China’s economic recovery will have a significant impact on the trajectory of global demand, and it is at that point that the stresses on the international energy order will begin to show as competition for supplies surges once again. The US will continue to seek price stability alongside political and economic retribution for Russia, and the EU will do the same while scrambling to meet its immediate and future energy needs in a landscape absent of Russian oil and gas. Russia, meanwhile, will continue to act outside the norms of convention, predictably unpredictable, but always in pursuit of its national ambition. Petro-diplomacy should be more important than ever, but is fast on its way to becoming a dying art.