Putin's war triggers the third oil crisis
Oil embargo. Younger generations have been lucky enough to live through times when they didn’t have to grapple with the impact of this condition. In the decades that came after the huge oil embargos in the 1970s and early 80s, governments around the world produced energy policies to attempt to deal with them, including setting aside hundreds of millions of barrels of petroleum in strategic reserves, investing in alternative sources of energy, and incentivizing the pursuit of energy efficiency, as policymakers around the globe promised “Never again”. Yet, a 21st century world that until a few weeks ago was abuzz with energy transition plans and pledges, with the primary aim to contain emissions and turn decisively towards a renewables future, is now scrambling to understand the impact of a large disruption in oil and gas trade flows – a market upheaval that may result in a significant oil shortage right at a time when many economies are already facing high and rising inflation. Suddenly, the world’s second-largest oil producer is shut out of the biggest oil consuming market, with prospects of other major economies, particularly in the West, increasingly prone to follow suit – this is the topic of this month’s REview note.
Well before Putin decided to invade Ukraine on February 24, oil markets were already on red alert because of the widening gap between an increasingly strengthening post-Covid-19 oil consumption surge and an alarmingly limping production growth, particularly on account of OPEC+ indecisiveness. Emphasis on capital discipline among US produces, unreliable African and south American supply, and a dwindling investment outlook in the upstream sector as ESG initiatives came under the spotlight had together created the perfect conditions for an imbalanced market in the ride-up to the current crisis. In our previous letter, we highlighted this emerging crisis and the role the US might play to solve it.
It took less than four weeks for the oil market outlook to take a turn for the worse. In the immediate aftermath of the invasion of Ukraine, the West imposed severe sanctions on Russia’s financial system, making it virtually impossible for the country’s citizens to conduct business abroad and also quite difficult for non-Russians to deal with Russian assets, including oil and gas. Canada and the US decided to formally embargo Russian fossil fuel imports, and although the associated volumes are low, their decision carries symbolic importance. Three weeks into the war, some clear evidence has already emerged. Financial sanctions are making it extremely hard for Russia to place its barrels in the open market, especially in the West, as traders and brokers shy away from trading them for fear of liability down the line. As the war intensifies, sanctions could be tightened further, exacerbating the situation. Other producing nations have been in similar situations before, but the ripple effect of the latest pronouncements have been more far-reaching. Russia’s crude exports are massive, the second-largest in the world after Saudi Arabia’s, averaging between 4 million and 6 million barrels per day (bpd), depending on whether or not former Soviet Union (FSU) producers are added in the mix¹. Most FSU exports (more than 60%) are delivered to Europe via the Druzhba and the CPC pipelines, and the ports in the Baltic and Black Seas. China is also a major importer via the ESPO pipeline and the port of Kozmino in the Sea of Japan.
Against that backdrop, the environment is likely to turn this situation into the Third Oil Crisis. If Europe were to follow the US in banning Russian shipments, it could result in a vast shortfall in oil supply, potentially equal to all Russian imports into Europe. This is equivalent to 5% of the current global crude supply. Even if individual EU countries decide to phase out the imports over time, say over the next four to six quarters, it would still be a major shock to the supply and demand balances.
Let’s compare this potential shock to the most memorable ones in oil history. In November 1973 – 49 years ago – the First Oil Crisis was triggered by the OPEC decision to embargo exports to a range of Western nations for their support for Israel during the Yom Kippur war. This resulted in a cut of 25% of OPEC output, or 8-10% of global production. The embargo lasted until March of the following year, when Israel withdrew its troops from the west side of the Suez Canal. Meanwhile, it generated a hike of 300% in oil prices – from $3 per barrel to more than $10 per barrel in the money of the day. Six years later, in 1979, the Second Oil Crisis resulted from the Iranian revolution, which removed around 4% of global oil supply due to the ensuing embargo of Iranian crude. Oil prices more than doubled in a matter of weeks to $40 per barrel. This second crisis was a wake-up call for many importing countries, with governments deciding to diversify away from oil as a source of energy by investing in nuclear power, natural gas and coal, and lowering oil consumption by boosting efficiency – remember those smaller, lighter and nimbler cars in the 1980s and 90s? That strategy was effective, as it took global oil demand nearly 10 years to surpass the previous peak reached in 1979, even though global GDP grew by more than 50% in that decade. The oil price shock had triggered a structural oil demand shock!
Another crisis occurred 11 years later, when Iraq invaded Kuwait in August 1990. This resulted in 10% of the then global supply getting temporarily embargoed, and prices quickly doubled for a brief period. This is not remembered as the Third Oil Crisis, as the effects were temporary. Prices collapsed in the aftermath of Kuwait’s liberation in the spring of 1991 and didn’t grow much for the next 10 years, until China joined the World Trade Organization. That marked the start of a highly oil and energy-intensive process of industrialization, probably the fastest and the most massive ever to have occurred. In 2008, Brent briefly reached what still holds as the highest value ever in nominal terms ($140 per barrel) due to a supply squeeze and financial speculation, but the price collapsed soon after as a result of the Great Financial Crisis.
Finally, the Arab Spring movement in 2011-2014 resulted in a civil war in Libya, removing 1.0-1.5 million bpd of oil supply, adding a serious risk of revolts spreading throughout the Arab World. While that never materialized, it threatened to put at risk up to 25% of global oil production. Prices averaged well above $100 per barrel for that period, triggering the US shale boom, which in the span of just four years added 4 million bpd in crude production. The Arab Spring is not remembered as an oil crisis despite the elevated market, as supply curtailments were relatively contained – at about 1.5% of global supply – and the surge in US shale acted as a timely cushion to the shock.
Given this backdrop, Putin’s war in Ukraine has many of the hallmarks of another oil crisis. Russia is the world’s second-largest crude oil exporter and is currently embargoed financially by the West and many countries in South America, Africa and Asia, which together represent 60% of global GDP. Traders and brokers – at least for the time being – look unwilling to deal with Russian crude. At the same time, very few alternative supplies of oil can be found in a short period of time. We don’t know yet by how much the 6 million bpd of FSU exports will be reduced in the coming weeks. In our worst-case scenario, as much as 4.3-4.5 million bpd could be shunned, matching the whole supply to the West, while China/India would not necessarily increase their intake from Russia for fear of being indirectly sanctioned by the US and its allies. This would result in a global supply drop of 5% at a time when inventories are already historically low due to market dislocations triggered by the pandemic and the ensuing underinvestment in oil and gas.
So, how can we at least partially close this gap? Let’s review in order:
OPEC production increase. This is by far the most credible and consequential option in the next three to six months. The UAE announced its intention to increase production by 800,000 bpd on 9 March, which resulted in Brent prices dropping 15% at the time of announcement. This pledge is far from filling the supply gap but is highly significant for two reasons: a) it demonstrates that the UAE indeed has spare capacity, as we argued in our previous letter; b) it may prompt Saudi Arabia to follow suit, under the assumption that the country also has significant spare capacity, which seems highly plausible.
Deals with Iran and Venezuela. These appear necessary in the case of a long-term embargo on Russian oil. Two previously designated rogue countries could soon be rehabilitated to make room for an even more rogue one. The Iran deal is likelier to occur as it had been worked on by the US Biden administration even before the invasion of Ukraine and could result in an additional 1 million bpd. Yet, it will take at least 9-12 months to ramp up production and exports. The Venezuela deal could also occur, but it won’t deliver much of an uptick due to the derelict state of its production infrastructure, blighted by decades of underinvestment and mismanagement.
US production increase. This option is also necessary, but it won’t be quick. As we wrote in our previous letter, any material change is unlikely in the country’s current growth profile in 2022, even amid extremely high oil prices. US oil production will come close to its pre-pandemic levels by growing by about 900,000 bpd from December 2021 to December 2022. The big difference could be in 2023 – if oil prices remain well above $100 per barrel – when US production could rise by up to 2 million bpd, far exceeding the pre-pandemic peak of 12.9 million bpd.
Strategic petroleum reserve (SPR) releases, coordinated globally by the IEA. This option has been attempted already, but the 60 million barrels pledged just a few days after the invasion of Ukraine was a damp squib. We believe that a much more significant release should be attempted, possibly in the order of 120 million barrels over 30 days, or 4 million bpd. Operationally, these release rates are achievable and such a release size would be a credible option as it would represent no more than 10% of the global combined SPR capacity. Theoretically, up to three or four similar releases over the next six to nine months could be initiated, and for the duration of the release they would in theory close the gap left by Russia in the worst-case scenario. Yet, these measures are only a temporary fix and not structural as SPRs are finite and must be replenished before long. Still, I argue that if the SPRs are not used in a crisis such as the current one, when will they be used?
Non-OPEC, non-US production uptick. This is already in the “pipeline”, so to speak. Canada, the North Sea region and a variety of smaller producers are planning to increase production in 2022, but the aggregate impact won’t likely surpass 0.5 million bpd and is mostly insensitive to high oil prices. While these additional barrels are essential to the global balances, the scale is too small to make a difference by itself in the current crisis.
Global demand destruction. This is an ultimate solution, where all the other alternatives fail, and it would bring us back to the 1980s and the aftermath of the Second Oil Crisis. Our simulation suggests that in the worst-case scenario, with a global supply response in the short term – over the next 6 to 12 months being muted – the only available option to rebalance the markets is a colossal price spike to $240 per barrel by the third quarter, resulting in a demand destruction of 4 million bpd by December 2022. The war and related sanctions are already most likely destroying 1.0 million bpd in demand in Russia and Ukraine, but this should be reversed as soon as the arms go quiet and the reconstruction process begins. This option comes with a nasty corollary, though: such a price spike would generate a global economic slowdown, which in the fourth quarter could be as large as a 1.6% reduction versus our base case growth. This could easily turn into a global recession in 2023. This outlook shows stark similarities with the Second Oil Crisis, when a massive supply shock was followed by an equally massive inflation spike and GDP recession, and eventually a structural demand destruction.
In conclusion, Russia’s invasion of Ukraine could indeed turn out to be the Third Oil Crisis. As with Iran in 1979, Russia is a major oil exporter, which suddenly finds itself isolated by the international community. On March 2, the United Nations General Assembly condemned Russia’s war with an overwhelming majority (141 members out of 193). Only five countries voted against (Russia, Belarus, Syria, North Korea, and Eritrea) while the rest abstained (notably China, India and the UAE amongst them). As with the aftermath of the Iranian Revolution, additional sources of oil supply are unlikely to prove sufficient in the short term, with the only exception probably being Saudi Arabia’s and UAE’s spare capacity. Back in the early 1980s, high oil prices spurred production growth in the North Sea, but that only hit the markets after a few years, when oil demand had already been curtailed by a recession, high oil prices and structural changes in consumer and business preferences. Right now, a production increase would still occur with high oil prices from US shale, but again it would not hit the markets before 2023 at the earliest.
As with the previous crisis, extremely high oil prices appear to be almost inevitable in order to rebalance the market via a dramatic slowdown in demand growth, which could indeed be accompanied by a global recession at some point. Again, oil importing countries – China, the EU and India being the most important ones this time around – would face extremely high incentives to diversify away from oil, like Western countries did back in the 1980s. That would potentially generate a significant and structural demand slowdown before long in those countries, and an impulse to further accelerate their energy transition towards renewables.
At the same time, Russia risks being isolated by the international community for the foreseeable future, and as a result being largely marginalized in the global oil market and forced to shift its fossil fuel exports to Asia – primarily China and India – if these major oil and gas importers decide to lend Russia a hand in exchange for discounted energy. This shift would be costly for everybody, as refineries would need to be reconfigured to process different crude qualities in Europe, Asia, and elsewhere in the world. Above all it would be massively costly for Russia, as its major export market – Europe – would close indefinitely.
The next few weeks will be essential to try and avert such a catastrophic scenario for Ukraine, Russia and the rest of the world. The first step would be to stop the war and immediately after that to find an acceptable peace agreement for all the parties involved. Yet, the longer the war goes on, with immense human suffering and unnecessary deaths, the more likely we are to be entering the Third Oil Crisis.
Our hearts and thoughts go to the people of Ukraine.
¹This has to do with the Caspian Pipeline Consortium (CPC) and the fact that crude shipped on that pipeline cannot be easily segregated, making it difficult to separate Russian crude from Kazakh and Azeri.
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Senior Vice President of Oil Markets, Head of Americas Research