Sanctions on Russian energy exports would be highly disruptive to global oil flows and tanker markets
This article was written in collaboration with Jane Xie.
While a full ban on Russian oil exports would undoubtedly have a severe impact on the Russian economy, it would also cause widespread disruption to the global oil market. Europe would be the worst affected, relying on both Russian crude and product to a large extent. As the market is under-supplied already, there are serious doubts there is sufficient spare capacity that could be brought to the market rapidly. The current market conditions serve Putin well and make an energy export ban undesirable and therefore unlikely.
Following the annexation of Crimea in 2014, the US and EU imposed sanctions on Russia which, along with the crash in oil prices, played a part in the Russian financial crisis. The sanctions, which remain in place, were deliberately limited and primarily covered financial transactions and travel bans on various business entities and individuals. While the sanctions impact Russia’s largest oil and gas producers, they do not restrict the export of energy products. Sanctions on energy exports may be an option tabled by the US should Russia invade Ukraine, Europe would likely strongly oppose such a move. However, there will be a “red line” on Russia's actions, where all options will be considered. But, assuming there is not a full invasion, given the extensive outreach of Russia’s crude and oil product supplies not just to Europe but globally, we do not anticipate sanctions banning the export of energy products. Any restrictions would further lift oil prices and inflationary pressures, a scenario Europe and also the US will be keen to avoid.
The disruption to global refining activity due to a loss of Russian supplies could be widespread, potentially causing a further tightening of oil products supply balances. Refiners heavily reliant on Russian feedstock supplies would also be harder pressed to diversify their crude import sources. For the tanker markets, European Aframax trade would be hit severely due to the loss of Russian crude volumes, which, combined with DPP, account for 30% of global Aframax loadings. Overall, we expect sanctions to have a net negative effect on tanker demand, except for some short-term spikes in certain markets such as the VLCC sector.
Meanwhile, a restrictive measure on Russian oil exports would also pressure other OPEC+ members to increase production to compensate for the shortfall in Russian supplies. The issue is, spare capacity is already limited among OPEC+, even when including Russia. The group is supposed to boost production by 3.8 mbd between January and September 2022, but not all members will be able to contribute to this, despite higher prices. We believe OPEC+ production is already around 800 kbd above its schedule (excluding exempt countries), and that, as a result, only 3 mbd could be added in the next nine months if the group sticks to its terms. Russia also accounts for about 400 kbd of spare capacity, while the two OPEC+ members with the largest spare capacity, Saudi Arabia and UAE, have between 1 and 1.5 mbd, and 1 to 1.2 mbd, respectively.
European, Asian refiners at risk of a cut in Russian crude supplies
In 2021, Russia’s seaborne oil exports averaged 4.28 mbd, covering 4% of global demand, and volumes are estimated to rise to a near two-year high of 4.70 mbd in January, up by 890 kbd y/y, though this is still about 300-500 kbd short of pre-pandemic highs of above 5 mbd.
Europe, for which about 65% of Russia’s seaborne crude exports are bound, is the biggest customer, with Netherlands, Italy, France, and Finland among the top recipients. Asia (mainly China, Japan, and South Korea) accounts for about 30%, though it has risen to as high as 54% (in April 2020 during the fight for market share) when arbitrage economics were favourable.
Seaborne Russian crude exports are just part of the story. Its piped exports to Europe are also significant. According to Transneft, it piped 721 kbd of crude to Germany, Poland, Czech Republic, Slovakia, and Hungary, in 2021 and has announced plans to ramp this up to around 913 kbd this year.
What alternatives to Russian oil?
Urals is a medium sour crude grade and there are few alternatives of similar quality within the Europe and Mediterranean region of sufficient volumes to make up for a loss of exports. A disruption in Druzhba crude supply in 2Q19 due to pipeline contamination led to Germany and Poland’s seaborne crude imports surge to record highs in May and June, surpassing 1 mbd for the first time. The volume of seaborne Russian Urals crude shipped to these two countries jumped, while supplies from the North Sea, Saudi Arabia (through Sidi Kerir), and Libya also rose. These could be possible alternative crude sources if Russian supplies are disrupted, while the US and West Africa could also step up as viable replacements.
The difference now, however, is that supplies from Libya have also become volatile in recent months, and Libyan grades a lighter and sweeter. Also, any imposition of sanctions on Russia would remove seaborne Urals as an alternative. Given most Urals exports to Asia are mainly arbitrage-driven, Asian refiners are comparatively less affected but like Europe, their reliance on Saudi Arabian and other Middle Eastern oil producers will increase. More marginal barrels to Asia will also likewise be sourced more from the North Sea, the US, and West Africa.
Middle East grades including Arab Medium, Basrah Medium and Kuwait are the most likely alternatives. With some interest also likely to come for Brazilian Tupi and Buzious. Within Europe, Johan Sverdrup, which began production in 2019 would also likely be tapped by European buyers as a Urals replacement. Over 50% of the grade currently heads to China.
Therefore, disrupted Russian supplies could add pressure on OPEC+ to increase staggered production volumes from the current 400 kbd to alleviate price and inflationary concerns. With crude inventories in Europe hovering at multi-year lows, the cushion is thin and this would mean affected refiners will need to source alternative supplies promptly or risk refinery run cuts.
VLCC rates would spike but quickly fall back
For dirty tankers, the impact on Aframaxes will be spread across the three major load regions: the Baltic Sea, the Black Sea, and Russian Far East, with the Baltic the hardest hit as nearly all volumes from there, are shipped to Europe. European refiners will be the most sensitive to any sanctions imposed as compared to Chinese companies, which dominate the Kozmino market.
The repercussions on the Suezmax market would be mostly in the Black Sea, where Russian crude exports made up 43% of the market at 731 kbd last year. However, the impact for Suezmaxes would be mixed as the loss of trade from the Black Sea could be minimized by an increase in longer-haul voyages from the Middle East, the US, and West Africa.
Very little crude is lifted from Russia on VLCCs, so there is likely to be no drop in demand. We would expect to see an increase in demand for the Middle East crude grades (as good Urals replacements) from Europe. Assuming Russia’s OPEC+ partners are willing (and able) to increase output to try and meet higher demand, VLCC demand would likely spike initially following a rush to source cargoes. In addition to the switch to VLCCs, the increase in exports from the Middle East to Europe would increase ton-mile demand significantly.
The impact would have some similar characteristics to the March 2020 freight rates spike, during the Saudi-Russian dispute of market management. However, at that time, demand surged as buyers were happy to store low-priced crude. This time, with crude prices expected to rise in response to the supply cut, there will be no contango market and the increase in output from other sources may fall short of existing demand. As a result, we expect a rate spike to be short-lived, with the initial surge in demand and increase in ton-miles offset by the overall decline in the volume of oil transported.
Since the spike in rates in 2020, freight rates across the dirty sector have steadily declined and over the last year, they have remained weak. A decline in seaborne crude volumes would push the tanker market further into oversupply. Although VLCCs would be in high demand, the abundance of Aframaxes would make maintaining high rates in the VLCC market difficult. Charterers would likely seize on the availability of the smaller vessel classes to bring the VLCC market down.
Feedstock woes extend beyond Europe and Asia
Europe and Asia may be Russia’s top crude and condensate customers, but the US is also a significant consumer of Russia’s vacuum gasoil that is used in secondary refinery units. When the US’ VGO imports hit a peak in September 2019 at 408 kbd, Russia supplied about 60%. While US VGO imports have declined in recent months to around 100 kbd, Russia’s share is still at an estimated 44%. Alternative VGO sources are limited, with Saudi Arabia and Estonia the two other regular suppliers in recent months. A drop in trans-Atlantic VGO volumes would be mainly to the detriment of Aframaxes and Panamaxes, which dominate this trade flow.
A more limited VGO supply would likely weigh on run rates at US secondary refining units and cut production of oil products such as diesel and gasoline. As of mid-January, onshore finished gasoline and distillate inventories in the US are about 3 mb and 24 mb below the seasonal five-year averages respectively, according to the EIA.
Russia is also a major products supplier
Besides being a heavyweight in crude and VGO supply, Russia is also a dominant supplier of refined oil products such as naphtha which is used in producing petrochemicals, diesel for road transport, and fuel oil that is mainly used as a marine fuel and to a lesser extent, feedstock for some Chinese independent refineries.
Russia makes up roughly a fifth of global naphtha exports, with South Korea, Belgium, and the Netherlands the main recipients. While South Korea has typically been the biggest market for Russian naphtha, it is the least dependent on the country as it has several other suppliers onto which it can fall back, including the Middle East and India. The most vulnerable is Belgium, which imports at least half of its naphtha requirements from Russia.
For gasoil/diesel, Russia holds about 15% of global supplies, and Europe (Germany, UK, France, Turkey, the Netherlands as the top five importing countries) is its main market. Alternative suppliers would be the Middle East and India. While the US has traditionally been a significant distillates supplier to Europe, volumes have dropped in recent months amidst a closed arbitrage window and relatively low distillates stocks there. The tighter distillates market in the US has drawn products from Europe more regularly than before.
With control of 20% of the global fuel oil market, the outreach of Russian heavy distillate supply extends to Rotterdam and Singapore, key bunkering hubs in the world. Any disrupted supply will likely result in higher refueling costs for ships, although alternative supplies from the Middle East (UAE, Iraq) and Brazil would help.
On the clean tanker side, the loss of diesel and naphtha exports to Europe would weigh heavily on the MR market in Europe. Over 70% of Russian Baltic exports are on MRs and within the wider northwest Europe and the Baltic Sea zone, Russian exports on MRs accounted for 36% of all MR exports in the region in 2021. Although these are some of the shortest voyages as most are to Europe, compared with transatlantic shipments from ARA, the large share makes it a crucial driver of MR demand.
In the Black Sea, MRs are again the predominant export vessel of Russian products at 50% but here LR2s also make up a sizeable share. This is primarily because the average voyage distance is longer, as more product heads to Asia. As seen with the crude market, alternative supplies would most likely come from the Middle East. This would lift LR demand, pushing rates higher initially, but the huge loss in demand for MRs would provide a ceiling and eventually bring rates lower.
A full ban on Russian energy exports is not impossible, but it would be used as a tool of last resort when actions taken by Russia far outweigh the cost of a ban to the US and Europe. Where the US and Europe deem the “red line” to be, however, is less clear.