RUSSIAN ATTACK ROCKS OIL!

Samantha Amerasinghe assesses the impact of the Ukraine war on oil prices

Russia’s invasion of Ukraine was a watershed moment for the world economy. Although geopolitical risk has been a constant over the past decade or so, it has not rattled the markets to this extent before.

The immediate global implications this time around will be lower growth, higher inflation and some disruption to financial markets as economic sanctions take hold.

In the longer term, global supply chains and integrated financial markets that have dominated the world economy since the collapse of the Soviet Union in 1991 will be impacted. And this war has tilted the risk of energy prices upwards.

Russia is the world’s 11th largest economy and one of its biggest commodity producers. It’s also a key supplier of industrial metals such as nickel and aluminium, as well as the dominant provider of gas to Europe.

This is why a commodity shock is inevitable.

Russia, which roughly accounts for 12 percent of the world’s supply of crude oil and a hefty 17 percent of global natural gas production, still needs the hard currency from these export receipts.

While it’s reasonable to assume that it is in the best interest of both Russia and the West to keep the flow of oil and gas moving (as was the case when Russia annexed Crimea in 2014), it isn’t difficult to imagine that this uneasy economic relationship will somehow be fractured.

The hard part for the West, particularly Europe, is that it cannot quickly cut itself off from Russian oil and gas without causing prices to soar. Oil prices, which recently touched a seven year high and continued to soar beyond US$ 130 (a barrel of Brent crude oil) for a while, as well as other commodity prices – especially aluminium and nickel – will likely climb higher this year.

Although West Texas Intermediate (WTI) has likely benefitted from the Russia-Ukraine war and accompanying sanctions being imposed on Moscow, it’s the growing risk that global oil supplies could increasingly lag behind the recovery in demand that is underpinning the surge.

Oil supply simply isn’t growing fast enough to constrain prices, partly because OPEC has been unwilling and potentially unable to boost production. Several of its members are not adding as much supply as they were expected to under current limits and US oil companies have slowed production growth to preserve their balance sheets.

Demand is growing much faster and showing little sign of slowing down even as oil prices rise. Global oil demand has nearly reached pre-pandemic levels and is likely to shift higher in line with the International Energy Agency’s (IEA) projection of 100.6 million barrels a day (mb/d) in 2022 as restrictions to contain the spread of COVID-19 ease.

The wild card lies with the US shale sector, which has the proven reserves and technological capabilities to quickly ramp up supply.

So will American exploration and production businesses meaningfully increase output, which sits well below pre-pandemic levels? Or would shareholders’ demands to maintain financial discipline, and rising environmental, social and corporate governance (ESG), pressure prevail?

As for natural gas, we are likely to see an array of producers ramp up LNG export capacity further or quicker to help Europe reduce its reliance on Russian supply.

There’s still plenty of uncertainty as to what will happen in the Russia-Ukraine conflict and its economic consequences. The largest impact of higher oil costs will be on consumer price inflation as liquid gold impacts almost everything. It also adds further pressure on the US Federal Reserve to be more aggressive.

Oil accounts for three percent of global GDP – and this implies that three percent of the world’s GDP will be twice as expensive tomorrow. Clearly, this will have some impact on inflation. However, inflationary pressures would largely depend on the severity of sanctions.

As energy and commodity prices rise if the war drags on, developing countries will be hardest hit by inflation as food and fuel make up a larger share of household consumption than in developed economies. Central banks in emerging markets have already shown a willingness to raise interest rates to avoid a repeat of the runaway inflation that has plagued them in the past – even at the cost of growth.

The war will be a major issue for the Fed, which is already on track to begin raising interest rates in an effort to combat inflation and otherwise rollback some support mechanisms for the economy. A tightening of financial conditions triggered by the conflict may cause it to slow the pace of interest rate increases – but if rising energy prices keep inflation higher, the opposite may happen.

So what does the future hold for oil? Is the current surge temporary or does it mark a more permanent shift?

My expectation is that oil prices will fluctuate in the long term; and over this period, it’s plausible that demand will plateau and perhaps start falling at a certain point. The key uncertainty is when that will happen – experts differ strongly on this matter.