$200 Oil is Not Too Far-Fetched

The 2022 Energy Crisis – Is $200 oil really that far-fetched?

05 March 2022

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The tensions in Ukraine, followed by West-led sanctions on Russia, have thrown energy markets in a crisis not seen since the 1970s Iranian revolution.

In the aftermath of Iranian revolution in 1970, crude oil production fell by around 4.5-5 mb/d or around 7% of the world’s total production. Partial mitigation by other producers still meant a net loss of around 5% of the world’s total crude oil production – and this resulted in a near-tripling of oil prices from $13 to $35/bbl (with some barrels going for even $40+/bbl).

According to IEA, in Dec 2021, Russia exported around 7.8 mb/d of oil – 5 mb/d of crude and 2.8 mb/d of products (including 1.1 mb/d of gasoil). This is around 7.5-8% of total global oil demand.

Of this, >5.5 mb/d went to OECD countries (~3.9 mb/d crude/feeds and ~1.6 mb/d of products). This means >70% of Russian oil exports are at risk unless they find alternative homes – this works out to >5% of global supply – eerily similar to the Iranian Revolution, but prices were already at $80 and not $13 before the current crisis!!

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How much crude oil production can be made up by others?

The world has limited spare capacity.

Iran: Assuming sanctions are lifted quickly, 1 mb/d can be added over 3–6-month period.

Saudi: The maximum ever produced in a particular month was 12 mb/d (once) and 11.1 mb/d (once). Sustained production at 12 mb/d is untested. With current production around 10 mb/d, there is between 1-2 mb/d spare capacity here – of this, 1 mb/d can come on immediately, but the remaining 1 mb/d will likely take 3-6 months to come onstream and be sustained.

Other OPEC (Kuwait + UAE): Around 0.5-0.8 mb/d spare capacity expected.

Venezuela: Unknown, but much of it is super-heavy capacity which will require a lot of lead time.

US: US total crude production is currently at 11.6 mb/d, and its all-time peak was 12.97 mb/d in Nov 2019. Hence, just around 1 mb/d or so of potential spare capacity could be available – assuming investments start going in right away. However, this is a wild card – and sustained investments could even raise it beyond the historical highs.

Hence, total spare capacity is no more than 4.8 mb/d – and only around 2-2.5 mb/d can really come onstream immediately.

This means the world has a net deficit of around 1-3 mb/d overall, assuming all these producers can agree to increase production. This is assuming that global oil demand stays constant and not increase due to Covid recovery.

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Can SPR’s help?

IEA member countries have announced a release of 61.7 million barrels from their emergency reserves (30 mb from US and balance from other countries) – this works out to ~2 mb/d over 1 month (assuming this is indeed released over 30 days). Is this sustainable?

US Strategic Petroleum Reserve (SPR) is currently at its lowest in 20 years – at just 580 million barrels. Assuming 1 mb/d continues to be released from SPR, the reserves could deplete to below 400 mb in just 6 months. As a reference, the last time SPR was at this level was in 1984 when the process of filling SPR was going on (in the aftermath of Iranian Revolution).

Other major countries holding crude stocks include Japan, Germany, and Korea – in that order. They could also look to continue releasing another 1 mb/d in theory – but here we are in uncharted territory, and the do-ability of this remains to be seen.

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In any case, this will be a short-term step and if carried out, the world will run out of oil stocks AND spare capacity in 6 months. This can potentially lead to a panic buying – leading to price rises instead of falls. The last time this happened – you guessed it – in 1980 right after Iranian Revolution.

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Prices do the talking – to balance supply/demand imbalances

There are 2 ways in which this deficit can be met – reduction in oil demand and increase in supply. Both are structurally longer-term levers, and a short-term reduction in demand by 2-3 mb/d is usually only seen during a big event, e.g., recession or pandemic.

At the same time, the trend of reducing oil & gas investment means that a significantly higher threshold of returns is required to incentivize longer term investment.

Hence, a significant price rise is inevitable. If nothing changes, $200 oil is not far-fetched.

This could imply around $8/gallon gasoline pump prices in US (and >$10/gallon in California).

In the developing world, the impact on the retail buyer would be significantly higher than US. This is because many developing countries, by and large, have raised taxes on petroleum products over the last few years as a means to bridge budget deficits, and hence, in most places, oil prices are already at their all-time peaks. Hence, a doubling of crude prices from current levels will inevitably result in an oil price shock for the end-consumer.

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What else can change?

If the US administration determines that it needs to keep retail pump prices in check, there is only 1 realistic solution – allow a sub-section of Russian crudes and products to continue flowing into the market. Of course, this effectively means a dilution of sanctions by explicitly allowing energy trade to continue, and will have its own share of significant political opposition.

At the same time, this means there is a massive upside risk, in the event of any adverse geopolitical issues happening at the same time in major producing countries, e.g. Saudi Arabia or UAE. This car does not have any shock absorbers left.

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Implications on the market

Freight: With an overhang of Russian barrels, there could be a pull of barrels from other regions into NWE, and Russian barrels could try to sail to Asia in an effort to clear. This would result in tighter shipping availability, hence raising freight rates.

Inflation: As Russia/Ukraine are also major producers of agricultural goods and commodities, sanctions would imply a sharp rise in commodity and agricultural produce prices. This would necessitate sharply rising interest rates to curb inflation.

If history is a guide, inflation in the US in the aftermath of Iranian Revolution touched almost 15%. Such inflation rates will necessitate a sharp increase in interest rates, possibly to above 10%, and hence cause global growth to collapse.

Refining Margins: Russian gasoil exports to Europe of >1 mb/d are immediately at risk, with no obvious home. But the world refineries will need to produce this extra 1 mb/d of gasoil to meet demand – this means an extra 2 mb/d crude runs at the very minimum, or alternatively, an yield switching towards gasoil. The world doesn’t have so much spare refining capacity. In either case, it implies significant upward boost to refining margins, especially gasoil cracks, is imminent.

However, there could be significant headwinds on this front in case there is any sort of agreement to allow Russian oil to continue flowing, or in the event of a demand collapse due to a price shock. Hence, refineries will need to watch out and hedge their exposure where feasible, with the right instruments, to capture this advantage.

Working Capital Costs: Refiners will likely face a double whammy here - rising interest rates, coupled with high oil prices. Oil prices have already increased from $80 to $120 – which means that a standard 200 kb/d refinery, with a crude turnaround cycle of 30 days, faces an increase of $240 million in working capital in a month just to maintain operations. If interest rates rise by 3% at the same time, this implies a USD 26 million increase in working capital cost, or about $0.36/bbl. This will further double to >$0.70/bbl if oil prices were to touch $200/bbl.

Impact on developing economics: Many countries have increased taxes on retail petroleum fuels in the last few years, as a means to improve their fiscal situation. As a result, the current retail prices at the pump are at their all-time highs currently in many countries. A further increase in oil prices could bring back demands for re-introducing fuel subsidies. We have seen multiple examples of this play out in the past – this would mean a steady deterioration in the fiscal position, and could possibly impact the relative value of their currencies.

Impact on oil trading/prices: Approx 3 mb/d of Russian crude from Baltic/Black Sea will need to price itself to clear – the last barrel will need to find a home in Asia and will act as the price setter. This also means that Europe will be net short of oil and will need to price to attract barrels. This opens up the possibility of both arbs – into and out of Asia – opening up at the same time – an event that has never occurred before. This implies significantly higher costs for Asian refiners, as even the Mideast barrels will find support at current high levels, and similarly also for European refiners.

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It also means that timespreads will rise sharply to reflect the prompt shortfall in supply, and inter-region differentials (e.g. Brent-Dubai EFS and swaps) will also find strength at the current all-time high levels, until a viable alternative emerges. A return of Iranian barrels to the market will temper Dubai timespreads, but widen Brent-Dubai differentials. Hedging these can be an extremely tricky affair for anyone looking to avoid drawdowns.

There will be 2 key factors that differentiate the winners and losers in the market –

a) Presence of a well-established trading arm as opposed to a purely marketing-based focus, and

b) Extent of digitalisation of refinery and trading. ?

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What’s the end-game here?

A continuation of the full scale of Russian sanctions would inevitably mean extremely high oil prices that the world has to brace for, and more so Europe, due to the proximity of the bulk of these crude and product exports. If 5% of the world’s supply continues to remain shut, then $200 oil is very much within sight.

If we see the aftermath of Iranian revolution for clues, inflation in US rose to ~15% and unemployment crossed 7% in early 1980. This caused a demand-side impact, with global oil demand falling by close to 10% subsequently, and this led to an oil glut and prices crashed. Are we headed in the same boom-bust cycle here?

Tushar Tarun Bansal

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This op-ed article aims to objectively understand the implications of the current crisis on oil markets. It is not intended to make any political statement in any way.

Tushar Bansal is a Senior Principal with Team Future Energy at Consistency Gmbh, a Germany headquartered consultancy, and is based in Munich.

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Tushar has over fifteen years of industry experience in various roles in downstream oil including front office trading, management consulting, operations, long and short-term oil supply and demand forecasting. Tushar has advised many C-level executives in business environment, transaction support, M&As, valuation of oil products, market strategy etc. in various markets including Asia, Middle East, Mediterranean, North America and Europe.

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Prior to joining Consistency, Tushar was an Expert with McKinsey’s Downstream Energy Insights Team, based out of Singapore. Apart from McKinsey, he has industry experience with Shell Trading (Front Office), Koch Trading (Front Office), Wood Mackenzie and FGE.

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Tushar has led various global studies in downstream oil covering diverse areas, such as the feasibility of setting up new grassroots refining projects, impact of new commercial oil storage terminals on global trade flows, valuation and marketing/trading strategy for new crude oil streams, refining M&As, impact of refinery closures on margins, trade flows and storage etc.

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Tushar is a prominent speaker at various international conferences, forums, workshops and training programs and is often cited by the press on important issues affecting the oil industry. He is also actively sought by the leading industry players for expert consulting advice on oil and gas markets.

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