Looking ahead at the implementation of Russian oil sanctions … a new, precarious development … following the bread crumbs of higher oil prices
In one sense, it feels like things are beginning to stabilize:
Last week, news reports suggested that the Russian offensive in Ukraine is running out of steam and Russian President Vladimir Putin is becoming slightly more realistic in his ceasefire demands.
Meanwhile, the Fed has showed us its cards for 2022, and the market responded positively. Last week, stocks posted their best weekly performance since 2020.
Even oil has pulled back from its recent nosebleed price of $130 a barrel, though it’s climbing as I write Monday. West Texas Intermediate Crude (WTIC) is at $110 a barrel.
But let’s not celebrate prematurely – particularly when it comes to oil.
The global oil supply remains in a precarious position thanks to Russia’s role in production. And over the last several days, things have grown even more precarious.
That’s because there’s a new twist that most investors aren’t talking about yet. It’s concerning, from both inflationary and global recession perspectives.
We’ll get to that in a moment. First, let’s start with the immediate challenge facing the oil market.
***What will sanctions on Russian oil do to global energy prices?
In less than two weeks, three million barrels per day of Russian oil output are at risk due to western sanctions.
Here’s CNBC contextualizing this amount:
In January 2022, total Russia oil and products production stood at 11.3 million barrels per day, or bpd, of which around 8 million bpd is exported.
Looking forward, the IEA said 2.5 million bpd of exports are at risk. Of that, 1.5 million bpd is crude, with products making up the other 1 million bpd.
So, three million barrels per day is not insignificant.
But beyond official sanctions, we’re also now seeing many western oil businesses backing away from doing business with Russia due to reputational risk.
BP and Shell? Out of Russia.
Exxon? Gone, willing to abandon an operation valued at more than $4 billion.
Between official sanctions and these corporate self-imposed, de facto sanctions, the oil markets could soon be knocked off balance yet again.
From the International Energy Agency (IEA) last Wednesday:
The prospect of large-scale disruptions to Russian oil production is threatening to create a global oil supply shock…
The implications of a potential loss of Russian oil exports to global markets cannot be understated.
The IEA report went on to add that we could face “the biggest supply crisis in decades.”
***Where do we stand with the global ability to make up this missed oil output from Russia?
Let’s jump to The Wall Street Journal:
The oil market will slip into a deficit as early as the second quarter unless the OPEC group of oil producers increase their supply levels, the IEA said.
Beyond the spare capacity of leading OPEC members Saudi Arabia and the United Arab Emirates, there are no other sources of additional supply that can balance the market.
Oil inventories have already been depleted to multiyear lows and the prospect of additional supplies from Iran seems a long way off.
Regular Digest readers are already familiar with a big contributor to these multi-year inventory lows. That’s because we’ve been featuring research on the topic from our macro specialist and the editor behind The Speculator, Eric Fry, for months.
From Eric:
Because so many oil companies around the world have slashed investment in both exploration and production, they cannot boost supplies… no matter how high the oil price soars.
As I’ve pointed out previously, data from Rystad Energy shows that global investments in oil and gas exploration and production peaked eight years ago and has plummeted about 65% since then.
Source: Rystad EnergyThat’s no way to boost production!
Even though Rystad expects oil-industry investment to increase slightly this year, those efforts will be too little too late to impact near-term supplies. In all likelihood, the supply picture will not improve until after multiple years of increasing investment.
Therefore, the only factor that could “rescue” the oil market and halt crude prices in their tracks would be a sharp drop in demand.
With sanctions kicking in, as well as a tight global supply, a “sharp drop in demand” seems unlikely.
But let’s now pivot to the news we referenced at the top of this Digest that most investors aren’t yet talking about.
***The end of Russian oil as we know it
Peter Zeihan is an expert geopolitical strategist and author. He analyzes data science, demographics, and global politics to make predictions about our world.
His latest oil prediction raises the eyebrows.
$170 a barrel – at least.
But why?
Earlier in this Digest, we pointed out that the massive oil conglomerates have now exited Russia.
Well, last Friday and over the weekend, we added three huge names to that list – Halliburton, Schlumberger, and Baker Hughes.
For readers less familiar, these are the world’s three largest oilfield-service providers. We’re talking drilling components, trucks, machinery, pumps, containment systems, manifolds…
These companies provide the actual machines needed to get oil out of the ground (as well as the plenty of “how to” technical experience). And they’re about to close up shop in Russia.
Now, to be clear, Russia has its own state-owned oil production infrastructure that does most of the heavy lifting for Russian production. But the departure of these western companies is going to be felt.
JPMorgan estimates Russia makes up as much as 8% of Schlumberger’s total sales. Baker Hughes and Halliburton have less exposure, but collectively, their operations in Russia are not insignificant. Perhaps most of all, their presence is felt when it comes to their technological expertise and how that impacts oil output looking forward.
With this as our backdrop, let’s turn to Zeihan:
Most of Russia’s oil fields are both old and extraordinarily remote from Russia’s customers.
Fields in the North Caucasus are either tapped out or were never refurbished in the aftermath of the Chechen Wars, those of Russia’s Tatarstan and Bashkortostan provinces are well past their peak, and even western Siberian fields have been showing diminishing returns since the 2000s.
With few exceptions, Russia’s oil discoveries of the last decade or three are deeper, smaller, more technically challenging, and even farther from population centers than the older fields they would be expected to replace.
Russian output isn’t in danger of collapsing, but maintaining output will require more infrastructure, far higher up-front costs, and ongoing technical love and care to prevent steady output declines from becoming something far worse.
While the Russians are no slouches when it comes to oil field knowledge, they were out of circulation from roughly 1940 through 2000. Oil technology came a long way in those sixty years.
Foreign firms—most notably supermajors BP and Shell, and services firms Halliburton and Schlumberger—have collectively done work that is probably responsible for half of Russia’s contemporary output.
We just went over how the oil majors and the big three oil production companies are now leaving Russia.
So, what’s at risk of happening?
Back to Zeihan:
The result is as inevitable as it is damning: at least a 50% reduction in the ability of Russia to produce crude.
(No. Chinese oilmen cannot hope to keep things flowing. The Chinese are worse in this space than the Russians.)
The outstanding question is how soon?
Sooner than you think.
Zeihan details the risks related to infrastructure and climate. We don’t have time to get into those details in this Digest, but the takeaway is that should something happen, oil flows would back up through literally thousands of miles of pipes, right up to the drill site.
And because Russia doesn’t have storage capacity to handle a backup, they’d have to shut down operations and check everything manually.
Let’s jump to what Zeihan sees as the end result:
The disappearance of some four to five million Russian barrels of daily crude production will all by itself kick energy prices up to at least $170 a barrel. A global energy-induced depression is in the wind…
The first rule of geopolitics is place matters. To populations. To transport. To finance. To agriculture. To energy. To everything.
The second rule is things can always get worse. The world is about to (re)learn both lessons, good and hard.
We reached out to another geopolitical expert to get his take on Zeihan’s comments.
Fortunately, he believes it’s not quite as dire. He sees Russia as having a certain baseline of production capacity that won’t be hampered by the departure of western oil companies.
But that’s not to say we won’t see a reduction in output that is felt in the global energy markets. But exactly how much, and how painful it will become, isn’t currently clear.
We’re diving into this and will bring you what we find here in the Digest.
***In the meantime, look big-picture and recognize the potential impact of higher oil prices on the global economy
Let’s follow the breadcrumbs if Zeihan is right…
$170+ oil prices won’t just hurt drivers at the gas pump.
As we’ve pointed out here in the Digest, less than half of a 42-gallon barrel of crude oil actually goes to gasoline. Much of it is used in a wide variety of consumer products:
Solvents, ink, upholstery, bike tires, basketballs, purses, deodorant, pantyhose, shoe polish, soap, football cleats, motorcycle helmets, cortisone, life jackets, paint, skis, tool racks, hand lotion, luggage, antifreeze, shower curtains…
There are loads more, but you get the point.
The risk of another massive disruption in the oil market threatens to send the prices of all of these consumer goods much higher.
So, in this scenario, inflation stays elevated.
And what do we know about how such an environment would impact the Fed’s plan for interest rates?
They tell us that as long as inflation stays high, they’ll be raising rates. The schedule they’ve provided suggests this would mean a “fast” rate hike schedule (we dug into “fast” versus” “slow” in last Friday’s Digest).
And history tells us that the average stock doesn’t perform well in the first year of a fast cycle. Meanwhile, significantly higher rates also threaten global economic growth. So, we’re talking stagflation.
Clearly, there’s lots riding on global oil prices, ranging from the global economy to your specific portfolio.
We’ll keep you updated here in the Digest.
Have a good evening,
Jeff Remsburg
