February 24, 2022

Russian Invasion a Clear and Distinct Turning Point for European Commodity Markets

In this update Alex Booth, Kpler's Head of Research comments on the developments through the day in Ukraine and the potential market and geopolitical ramifications.

It is hard to understate the magnitude of the steps taken by Russia’s President Putin in the early hours of the morning of 24 February. Despite endless claims that an invasion of Ukraine was off the table and pressure from all sides of the international community, Russian troops rolled into foreign territory and attacked military targets. It could be argued that the developments were a more overt continuation of what has already been happening since the annexation of Crimea in 2014. Attempting to rationalise such behaviour is near impossible by “Western” standards and Putin’s end goal is all but unknown to anyone other than Putin himself.

Clearly, the ramifications on the global energy markets are immense and the moves in oil and gas prices through the morning, in addition to those seen in recent weeks, go some way to reflect this. At this point in time, it is not yet clear what additional steps will be taken by countries in the G-7, NATO or EU organisations but there is no doubt that heavy sanctions will surely follow. Considering the near-zero likelihood of foreign troops coming to the direct aid of Ukraine, there will likely be nothing left off the table when it comes to what financial and economic tools can be used.

The initial wave of sanctions was deemed by many as far too weak to be effective and Putin agreed. Aside from sanctions hitting the financial world, latest statements from Boris Johnson, the Prime Minister of the United Kingdom, point to far further-reaching impacts on oil and gas. Whilst this would have a significant impact on economic activity within Europe and the world at large, severely limiting energy sales from Russia might be the only tool at hand that can have a real impact. The pressure on the international community to impose sanctions on Russia approaching those felt by Iran after President Trump backed away from the JCPOA will be great. Whilst the appetite for sanctions to completely cut the flow of hydrocarbons from Russia may well be there, it will butt against the harsh reality of limited alternative supplies for European industry.

As covered in recent weeks, the European gas markets have been addressing the risks of reduced supply from Russia with the latest developments being the suspension of the Nord Stream 2 certification process. In the immediate term, Europe has been pulling incremental LNG cargoes into the region and looking at mid-term options from producers such as Qatar and the United States. Inventories remain low at just 30% of capacity but thankfully the region is coming out of a relatively mild winter period. Looking further ahead, Turkey recently demonstrated just how quickly new FSRU capacity can be brought online to overcome import bottlenecks.

The potential shock to the European refining system given a cutting-off of Russian flows would be quick and severe. Were pipeline flows to be cut, the impact would immediately be felt by central European and German refiners that have a high dependency on the steady flow of oil through the Druzhba network, operating at roughly 1 mbd, considerably below total capacity. In addition, refiners across the rest of the region make up the bulk of waterborne crude exports from Russia at 61% of total volumes in 2021. Russian crude and condensate constituted 27% of total European waterborne imports in 2021. Crude inventories in Europe reflect those across the world, with levels tracked by Kpler at the bottom of the five-year range and well below those for this time last year.

While sanctions could be imposed on Russian energy exports, it is not beyond Putin turning off the taps himself, putting incredible pressure on Europe. Up until now, it has been thought that the cutting-off of supplies by Russia would be unlikely given their need to be seen as a reliable supplier of both oil and gas in significant volumes. Recent developments will heavily test this theory.

Given the uncertainty around the extent of sanctions yet to be imposed or the potential for supplies to be cut by Russia, it is too soon to say what the longer-term impacts could be. Natural gas supplies into the region can be enhanced by incremental LNG flows, although there are logistical constraints that will take time to overcome. If crude and product exports are limited from Russia, let us not forget the ability for Iran to find buyers for its crude, products and LPG despite stringent sanctions, the oil markets will have a tough time addressing the shortfall going into peak demand season. The invasion of Ukraine could well be the catalyst to bring JCPOA talks to a head, releasing considerable volumes of Iranian crude held in floating storage and tanks overseas, and opening up the ability for Iran to return to the open market on a longer-term basis.

Looking further afield for alternative supplies of crude, Europe could see support come from the United States. US domestic producers have thus far been limited in their response to climbing oil prices through the last year, maintaining the mantra of capital discipline and shareholder returns. Whilst we estimate stronger returns to production in the US this year than are generally expected, political pressure could align with investor appetite to allow even greater gains in production. Whilst not producing comparable grades to Urals, refiners have become far more adept at altering their crude slates over the years given the steady stream of global crude supply disruptions.

All told, despite the high levels of uncertainty in what is to come, it is hard to see how the disruption to global energy markets, and by extension, extreme price action, will not persist in either the short- or medium-term. Volatility will remain high with any announcement having the potential for 5% swings in either direction in oil markets and even more in gas markets.

We will continue to produce analysis on the fast-evolving situation, covering all elements of the gas, crude, products and freight markets.

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