Oil market’s cross currents

On 5 December, the price cap on Russian oil and the European embargo on Russian oil imports came into force. The G7 countries and Australia have stipulated that their shipping and insurance companies will not be allowed to serve tankers transporting Russian oil unless its price is less than USD60 per barrel, and in any case 5% less than the market price.¹

Notably, since the implementation of the new measures, the price of the Russian Ural oil benchmark has fallen by almost 15% to less than USD55 per barrel. Indeed, since the beginning of the war in Ukraine, the price of Ural has traded at a discount of between 20% and 30% to Brent oil, the European market benchmark (see Figure 1). Notwithstanding this, Russia has still been able to sell its oil at a profit, albeit reduced, thanks to its low production costs, estimated at between USD20 and USD30 per barrel.

Figure 1. Oil prices (USD per barrel)

Source: Refinitiv and EFGAM calculations. Data as of 07 December 2022.

The continued fall in oil prices suggests Russia is expected to export as much oil as it can to those countries - including China, India and Turkey - that do not apply the Western sanctions. If this proves correct, the G7 price cap will reduce the Kremlin’s ability to finance the war in Ukraine and support the domestic economy. It would also minimise the risks of a new energy shock for Western economies.

The EU embargo on Russian oil imports affects about 1.5 million barrels per day. Finding alternative suppliers for such a quantity could increase tensions in global energy markets. Although EU countries have already secured alternative supplies from the US, Norway and OPEC countries, the full effect of the embargo on the oil price will only emerge over time as the stocks built up in anticipation of the embargo are consumed.

The outlook for oil demand is also uncertain. OPEC and the International Energy Agency noted that oil demand has been weaker than expected and it has been lower than supply since the second quarter of 2022. The decline in demand was caused by the high prices of petroleum products in Western countries and by the tight anti-covid measures imposed in China. Compared to the beginning of 2021, Chinese oil imports fell by about 1 million barrels per day, and a quarter of the fall followed the lockdowns that began last spring (see Figure 2). It is therefore not surprising that oil prices have decreased since June and are now lower than when Russia invaded Ukraine.

Figure 2. China crude oil imports

Source: Refinitiv and EFGAM calculations. Data as of 07 December 2022.

Against this very uncertain backdrop, on 4 December OPEC+ confirmed the reduced production quotas agreed in November. The OPEC+ Joint Technical Committee will not meet again before February and the next official OPEC+ meeting is scheduled for June 2023, suggesting OPEC+ target output will be stable for several months.

In November, OPEC countries subject to production quotas undershot the target by 0.8mbd. Nonetheless, oil prices fell, implying that the market remains sufficiently supplied (see Figure 1). Furthermore, the decline in OPEC oil production has increased the spare capacity in case of an unexpected surge in demand from China or a sharp decline in Russian supply.

To conclude, the oil market faces unusually high uncertainty. The OPEC+ decision to confirm production quotas for the coming months is reasonable and leaves oil producing countries room to address any supply shortages. In the short-term, downward pressures on demand seem to prevail, which should extend the current supply surplus. While oil prices will likely be volatile in the next few weeks, the underlying trend should remain to the downside at least until signs of reopening in China are more evident.

¹ The price cap does not apply to oil transiting through pipelines. The mechanism will be re-evaluated in a few months in the light of the results obtained. There is a 45-day grace period for cargoes already embarked on 5 December which must be delivered by 19 January 2023. Furthermore, Turkey now demands that any vessel navigating its straits is fully insured, a request that is causing bottlenecks in the Black Sea.