Rystad Energy - Energy Knowledge House
Rystad Energy - Energy Knowledge House

REview

The great trade-flows reshuffle, and the fragmentation of supply chains

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After months of inaction over what, in hindsight, now looks like a serious policy mistake, does the phrase – catching a tiger by its tail – aptly describe the state the US central bank and others around the world find themselves in? With inflation at multi-year highs, the Federal Reserve announced a sharper increase in interest rates than what it had earlier outlined and signaled that more rises may be made to cool the runaway surge in prices.

The motive and the urgency are all clear, and the goal, of making an overheated system let out some steam, is understood. But what about the ripple effects? Those would be plenty, but key among them include – a steady strengthening of the dollar. As the dollar climbs, emerging nations will find it challenging to pay for imports of grains, oil and everything else that is priced in the greenback as the value of their local currency shrinks. Raising interest rates will make it difficult for businesses, particularly small- and medium-sized enterprises – often the backbone of an economy – to both borrow to grow and service their existing debt, and this phenomenon won’t be limited to emerging nations alone. Households will struggle to repay their loans. Taken together, these factors could come to a head to tilt the US and other economies into recession.

But what about gasoline and diesel prices? Acting as key drivers of the surge in inflation, with the notorious list of US states with average gasoline of over $5/gallon steadily expanding. As economies slow, fuel consumption will decline. That will surely weigh on retail prices, but will it be enough to bring inflation back to levels the US Fed is comfortable with. Or are today’s oil and gas markets being governed by a set of unique factors where the macro levers being pulled by the Fed have very little to no influence? If so, would the Fed’s move really help or eventually end up hurting the economy even more. In this month’s REview, we take a deep dive at the factors influencing the global oil and gas market against the current macro backdrop.

For nearly two years – and worsened by the pandemic’s successive waves – global commodity markets have tirelessly tried to crawl out of one of the deepest market dislocations in living memory. Ongoing supply issues were expected, but those have seen a downward spiral from the direct impact of the Russia-Ukraine war and its ripple effects so far this year.

Global oil and gas markets have taken center stage for months now, as Europe makes each calculated move against Russia in what seems to be a never-ending game of chess where consumers have, unfortunately, become the pawns. But just how permanent are the market changes that we have witnessed so far and what more is to come? Who will benefit now and in the long run as the dust settles? We look at not on the cause of events and how we got to where we are, but rather, on how today’s actions are rewriting the so-called playbook for the global transport market, particularly the maritime landscape we thought we knew well. A dynamic shift in the direction of flows has already begun to unfold, but the evolution of geopolitical power will continue to steer the ship, quite literally. 

Let’s start with an analysis of the gas and LNG market, as its global reorganization will prove significantly harder than oil in the short term, given the shortage of infrastructure, but its long-term outlook is not unlikely to prove more stable than the oil one.

Global LNG markets pushed to their limits
Additional pressure on all import and export facilities has led to terminals running close to or above maximum utilization and even that is not enough. The pressure could in turn persuade operators to defer maintenance programs, stressing the equipment, or worse, potentially resulting in unplanned outages that further stifle the already limited capacity and supply.  Infrastructure and capacity constraints have become such large issues that even with the limited LNG supply available, the fuel cannot get to markets fast enough. The UK has become the poster child for this negative effect, as LNG vessels are now becoming floating storage because of pipeline bottlenecks. So, what does this mean for gas markets and how are we seeing this affect prices and the consumer? With vessels unable to efficiently offload, they are not making it out of the EU to support demand elsewhere, which is significant. In other words, if it weren’t for pipeline and liquefaction/regasification constraints, we would be in a substantially better position – but that takes planning, investment and most importantly, time.

Will Russia and China team up?
What will Russia do with its excess gas as Europe shuns purchases? The quick answer: supply will have to shut in. That is because there is limited upside for Russia’s domestic demand from fields currently supplying Europe and they cannot send all the extra gas to Asia through the current infrastructure network.

Russia’s gas export facilities are primarily directly towards Europe, with a large amount of new investment required to target China, not to mention the cross-border risk and long distances. Existing pipelines have the capacity to ramp up. And while that will happen, it is still going to take more than five years for new pipelines to get built even if they are sanctioned tomorrow. At this point, LNG facilities are running above max capacity so there is simply no scope to take feedgas from elsewhere. If Arctic LNG 2 Train 1 moves forward, that might change, but even that has upstream fields earmarked. Still, that’s not to say Russia and China will not foster a new friendship through gas in the coming years, but it will certainly take time. If it does happen, we will undoubtedly witness an even stronger divide between Western and Eastern geopolitics, which could negatively impact not just the Americas, but also Europe, with the Middle East caught in the center.

The battle between the US and Qatar to take crown
Continued gas infrastructure buildout will be critical to meet global requirement and US projects are on track to supply this demand. The US is set to see more growth in LNG capacity expansion than any other country and more than Qatar and Australia – the other two top exporters – combined. Even before the war, we had a bullish LNG outlook and had expected a higher need of natural gas in our energy mix that would trigger a stronger wave of final investment decisions (FIDs). With planned US projects stacking up over the next decade, we expect US LNG production will increase 1.5 times by 2030, positioning the country as the lead exporter in the long term.  

This may be an ideal situation from a geopolitics perspective. Having the US dominate the global LNG trade flow would be beneficial to markets like Europe who seek destination flexibility and US LNG contracts can provide it. If demand in Europe is lower one specific year or if LNG demand is structurally lower in the 2030s, cargoes can be resold and diverted to other markets. Additionally, this can cause a downward pressure on prices in that specific period if many countries see lower LNG demand in the same period. So, not only would the US be a source of reliable supplies, but global markets could greatly benefit from flexible US cargoes.

Still, Qatar could potentially expand its LNG capacity beyond our current forecast of 126 Mtpa, especially given the recent interest from supermajors like TotalEnergies who have exited Russia, from the North Field East project, for example. Qatar has been clear that if they see the demand and the right characteristics of offtake – such as long-term contracts, prices and destination clauses – they will make it happen. If that plays out, the US and other western regions would have less of an influence geopolitically speaking, increasing supply chain fragility.

The great oil trade flows reshuffle
Let’s now move to the oil supply chain, where the ‘great trade flow reshuffle’ has already begun. Traders, refiners, shippers, producers, policymakers – and not least researchers – have been scrambling to grasp the consequences, opportunities, and the associated risks of the epochal change.

Fundamentals first. Europe currently imports 2.7 million barrels per day (bpd) of Russian crude - down from the 3.5 million bpd prior to the invasion. Around half of that, or 1.5 million bpd, in clean oil products, which have not changed in volume after the war. Urals, the main crude exported out of Russia to countries to its west, has been selling at a $30-40 per barrel discount to Brent, on western banks’ skittishness to lend money to trade Russian assets. That has made Urals particularly attractive to Indian refineries, who have increased their intake from virtually zero in February to 1 million bpd in June. As Europe initiates the great trade-flows reshuffle, the process will force almost all of its current Russian crude imports to the east, which will then push out Middle Eastern grades from the region and re-route it Europe. The logistical consequences will be massive. Crude that was previously delivered via the “Friendship” – the Druzhba pipeline – and short, coastal navigation from the Baltic ports to Rotterdam and from the Black Sea to the Mediterranean, will now need to be shipped half-way through the globe to the ports of Shanghai and Jamnagar. Arriving at those destination will take two months rather than two weeks and will, most of the times, need a costly ship-to-ship transfer from smaller vessels to Very Large Crude Carriers (VLCCs), which will circumnavigate Africa, or a smaller Suezmax, which will go through the Suez Canal. This reshuffle will be costly as a significantly large volume will be on the water for longer periods. In addition, Middle Eastern crude will be displaced by heavily discounted Russian barrels in the Asian markets, which will force the former to find buyers in Europe, at an additional cost in terms of delivery fees and time. European refineries will pay the price of this re-routing as they forgo discounted Urals and swap with Middle Eastern crude at full price, while Chinese and Indian refineries become net beneficiaries by replacing part of their Middle Eastern supplies with Urals.

Was a different strategy worth considering?
Could Europe and the West have adopted a different strategy to target Russian oil and gas revenues? Perhaps they could have. Putting a price cap could have achieved the goal of limiting Russia’s revenues from selling oil and gas to Europe – and elsewhere – without having Europe pay the full price for it. Surely, that would not have been an easy game to play. In retaliation, President Vladimir Putin could have shut the deliveries of natural gas to the continent, thus wreaking havoc to region’s economies, even though that would have also been a self-inflicted wound. He has already tested the waters over the past couple of weeks, with smaller than agreed deliveries to Germany and Italy. And he could have also diverted crude shipments to Asia in search of higher net back. While this is already happening, the advantage of a price cap would have been to push the Urals discount even lower than it currently is, potentially to a threshold of 40-50% of Brent, whose cost would have been borne almost entirely by Russia, with the financial benefits split amongst the buyers of the crude. Surely, that could have risked a large production drop in Russia, with a potential run-away surge in Brent. But then again, the advantage of a price cap is that it can be quickly tweaked to address market dislocations.

But that is history now. The EU decided to shun Russia’s crude, setting off an epochal change in trade-flows and in the global geopolitical configuration. A global crude trade system that was configured to pursue maximum efficiency after the fall of the Berlin Wall – and one that has so far been highly interconnected (see map) – is now being balkanized and divided along political lines. Russia has lost the Western market, its largest outlet, for the foreseeable future and likely forever, and is gradually but inexorably falling into China’s grip. Perhaps this shift was going to occur anyways before long, as Europe doubles down on greatly reducing its carbon footprint following the Paris Agreement, irrespective of the war in Ukraine, while China and India increase their oil & gas consumption for the next two decades. Yet, the EU decision has made this shift inevitable and imminent.

A more Balkanized world will emerge – the Middle East will be even more central
The world that will emerge after the great reshuffle will be saddled with a more fragile and more fragmented supply-chain, and will be more polarized. Europe, which decided 40 years ago to wean itself off its dependence on Middle Eastern crude exports – and established an increasingly tight relationship with Russia to do just that – will be back to square one. The West in turn will find itself more isolated, as it will have lost a key supplier and become more dependent on the Middle East, which will no doubt look forward to flexing its muscle. Asia, primarily China and India, will have made financial gains by bringing Russia under their sphere of influence as a supplier of cheaper commodities, but by doing so will likely antagonize the West, the main markets for their sophisticated exports, prompting them to find alternative supply chains, possibly closer to home.

This is a path to a global trade flows balkanization, which while aiming to make supply chains more robust to geopolitical risks in periods of conflicts and increasing global polarization, will end up raising costs by making it more inefficient. The Middle East may well emerge as the ultimate winner in this polarized world, as it would be the only large supplier of oil and gas to both the West and the East, being the last region to have preserved a flexibility typical of the globalization era.

What can be done to avert such an outcome? Maybe very little, as time is running out with the EU ban getting completed by December.

REview 1 Pre-invasion crude trade flows.PNG

REview 2 Post-EU ban on Russia's crude - chart.PNG

Authors: 

Claudio Galimberti  
Senior Vice President of Oil Markets, Head of Americas Research 
claudio.galimberti@rystadenergy.com

Emily McClain
Vice President of North America Gas Markets Research 
emily.mcclain@rystadenergy.com 

(The data and forecasts contained in this column are Rystad Energy’s and the opinions are of the authors.) 


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