- The intensifying Ukraine conflict and sanctions on Russia have pushed oil prices higher.
- Our bearish view on oil will depend on several factors, including a European ban and self-sanctions from Asian buyers.
- A nuclear deal with Iran will likely impact physical flows and long-term prices.
Oil prices have rocketed to nearly 14-year highs on concerns sanctions punishing Russia will curb supply in global markets. Futures for West Texas Intermediate (WTI), the U.S. benchmark, surpassed $130 a barrel this week, the highest level since July 2008. Brent crude futures, the benchmark in energy markets, surged to nearly $140 a barrel in early March.
But this price spike may be temporary. The geopolitical risk premium attached to oil is mostly driven by market fears and could dissipate if there is a resolution to the Russia-Ukraine conflict. In addition, Iran’s spare oil capacity could provide a supply boost. As such, we continue to have a bearish view on oil. We expect WTI prices to drop to around $75 a barrel over the medium term, with a risk of a deeper correction to $60 a barrel over the long term. The risks to our scenario include a European ban on Russia’s energy exports, self-sanctions from Asia, and a failure to reach a nuclear deal with Iran. These outcomes have been partially priced into oil markets.
Russia’s energy exports and sanctions
In our view, the risk to energy is not directly from the invasion of Ukraine but from the sanctions. The West is rolling out increasingly tough sanctions. U.S. President Biden announced this week the U.S. will ban imports of Russian oil and other energy products but will not be joined by many European allies. This is a challenging option for Europe. Energy sanctions could hurt Europeans more than Russians over the short term.
U.S. sanctions alone will have a negligible price impact. About 9% of U.S. imports of oil and other refined products, or 670,000 barrels a day, came from Russia in 2021. Of that, Russia’s crude made up roughly 3.5% of total U.S. consumption and 0.7% of the global supply (U.S. Energy Information Administration 2022). The oil is shipped via tankers and, therefore, likely to find other buyers. Moreover, U.S. orders have dried up since the Ukraine conflict started.
On the other hand, a European Union boycott or Russian embargo on crude flows would have a deeper impact. Europe imports about 3.76 million barrels of crude and oil products daily — about 52% of Russia’s exports and 3.8% of the global supply (International Energy Agency 2022). Redirecting such an order will not be easy. In the short term, China and India could absorb these exports. But this process may take more than a year, according to Russia’s Deputy Prime Minister Alexander Novak. During this period, Russia may have to cut production due to insufficient storage. If such an embargo isn’t offset by an Iran deal or the use of spare capacity by OPEC, we could see a significant tightening in the physical oil markets. This is an upside risk to our oil price forecasts.
Is an oil boycott feasible for Europe? If the main purpose is to reduce Russia’s oil revenues, and Europe applies the ban without finding alternative supplies, the answer is no. Russia will still sell some of its oil, and at much higher prices. Meanwhile, European economies will be affected by higher crude prices. Sanctioning Russian gas will be even more challenging for Europe. Such sanctions will be more harmful to Russia than oil because gas is shipped using pipelines, not tankers. European nations imported about 45% of their natural gas needs from Russia in 2021 (Bloomberg). Therefore, in our view, European oil and gas sanctions are a tail risk for now.
SWIFT channels — the global financial system’s payments infrastructure — remain open for energy payments. Still, sanctions on some of Russia’s banks make it difficult for trading companies to buy oil and gas due to counterparty risks. Those banks are used as intermediaries for transactions, letters of credit risks, and clearing services. It is possible to go around these hurdles, but there will be a cost.
Other problems, which are even more important than sanctions, include shipping and rising freight costs for crude delivery from Russia, a nation that relies on tankers for about two thirds of its oil exports. Currently, traders are struggling to find enough loading tankers. A prolonged shipment disruption would be a risk to the global oil marketplace. The shipping cost, for example, has increased fivefold for loadings in the Black Sea (in the week ended February 28, 2022). A shortage of buyers also poses a risk. Amid the current conflict, potential buyers are independent refiners from China and India. State refiners from these two countries have asked crude suppliers to stop offering barrels from Russia and Kazakhstan to avoid payment and insurance risks. In the short term, this will constrain Russia’s seaborne crude and product exports and keep oil prices at elevated levels. If this self-sanctioning continues for more than a few months, Russia may have to cut production. That could create longer-term problems.
Ultimately, Russia’s oil will still flow into the markets. In the very short term, we could see some volatility in prices. But over the long term, the risk premium on crude will weaken should there be no sanctions on energy exports and no prolonged self-sanctioning in shipping.
Iran’s forgotten role in global markets
A nuclear deal with Iran will help determine oil prices over the long term. Currently, Iran has about 60 million to 100 million barrels of light crude in floating storage that could hit the markets immediately. That crude can be swapped for Urals oil from Russia. Iran has the capacity to export about 2.5 million barrels of oil a day (Putnam calculations). That would translate into an additional 1 million to 2 million barrels of oil a day to global markets.
Iran has been in months of nuclear negotiations. Several parties involved in the talks, including China, have said progress has been made toward an agreement. Some remaining issues are the extent to which sanctions would be rolled back, guarantees that the United States will not quit the pact again, and resolving questions over uranium traces found at several old but undeclared sites in Iran. We believe there are incentives for both the United States and Iran to strike a revised deal. However, recently, Russia changed its stance and asked for written guarantees that sanctions would not block its trade with Iran. Russia plays an important role in removing and storing Iran’s excess stocks of enriched uranium. Alternative solutions are possible, but it could delay the deal. In our view, an agreement is still the most likely outcome. There is a 65% probability of a deal being reached by the end of March, in our opinion.
As for OPEC+, the oil alliance agreed to stick to its plans of a small output increase in April. The group agreed to adjust the upward monthly overall output by 400,000 barrels a day for the next month. We don’t expect a significant impact on long-term prices from this gradual hike.
The Russia-Ukraine conflict will eventually find an equilibrium. And shipping problems are short term. At current levels, the risk premium on oil is excessive and makes short oil trades even more attractive over the medium to long term. In our opinion, corrections to oil undershooting and overshooting fundamentals will be sharp and quick. We may revise our views further if geopolitical risks remain for more than a few months and Russia cuts its energy production.
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