23 March, 2022

Oil supply squeeze: How energy security could be the catchcry for years ahead

Balancing oil supply and demand has always been delicate, and even more so with increasing economic activity and easing pandemic restrictions over the last few months.

The price of oil skyrocketed to nearly US$130/barrel on 8 March following widescale economic sanctions on Russia in response to the conflict taking place in Ukraine. The last time oil prices rose this high was in 2008 and again in 2011, when crude oil prices peaked at around US$145/barrel and US$110/barrel respectively.

The price since came off that high, as rising Covid-19 cases in China sparked concerns on the demand side, and some supply disruption fears eased. At the time of writing, the price of crude oil was sitting at about US$115/barrel.

While the upwards climb in oil prices may have eased for the time being, it has highlighted that despite developments in renewable energy during recent years, the world is still heavily reliant on oil as an energy source, particularly in transportation.

In fact, pre-pandemic it was calculated that a third of the world’s energy consumption was from oil, according to the BP Statistical Review of World Energy 2021, with a further quarter coming from natural gas.

Impacts beyond the petrol pump

If the supply of oil falls short of demand, then oil prices rise as a means of rationing or reducing demand - and in time, bringing on new supply.

The price of petrol at the forecourt closely follows the rises and falls in the price of crude oil and is the immediate impact that many experience. Since March 2020 when the oil price troughed, the average price of unleaded 91 petrol in New Zealand rose from around $2.05/litre to around $3.10/litre, tracking closely to the price of crude oil.

The temporary $0.25/litre reduction in fuel excise duty, and the easing in crude oil prices provided some relief to recent price highs.

However, the almost immediate ripple effect of global price movements demonstrates the impact that oil supply and demand volatility can have on the economy. For example, if oil price rises had continued or do spike back up again, they could potentially slow down overall economic activity. This would create an especially difficult situation when coupled with rising interest rates set out by the RBNZ and other central banks around the world.

On the other hand, in early 2011 crude oil prices jumped to US$110/barrel and stayed there for four years without any material adverse impact on the world.

In assessing this situation, it is important to consider that while any sustained period of rising oil prices could weaken global economic growth, it is currently relatively robust as the adverse impact of Omicron recedes. As we have seen across the first half of March, there are many factors that can quickly influence pricing.

How did we get here?

Crude oil demand in 2022 is expected to be just under 100 million barrels of oil per day (BOPD), according to US Energy Information Administration, with less than half being used to fuel road transportation. Russia is an important oil producer, making up about 10 per cent of global oil production and itself consuming around 3 per cent of global consumption.

While the US is close to being self-sufficient in oil production (once Canadian and Mexican production is taken into account), the same cannot be said for Europe, Japan and many other countries, including New Zealand. The EU recently released data showing Russia supplied 27 per cent of Europe’s oil in 2021. Even more important to Europe is the supply of Russian gas, which accounted for 45 per cent of European gas imports and 40 per cent of total gas consumption.

In the background, investment in oil production has been reducing during the past few years. Spurred on by the significant drop in demand in 2020 due to mobility restrictions from the pandemic, the level of spare oil production capacity is limited.

It is estimated that the Organization of the Petroleum Exporting Countries (OPEC) currently has spare production capacity of under 4 million BOPD, well short of the 5.4 million BOPD that Russia exports to the world excluding China.

The supply response so far

In an effort to calm the nerves of the oil market, the US, Europe and Japan decided to release 60 million barrels of oil from their strategic reserves (representing 4 per cent of that stored). This had almost no discernible impact on the oil price, which is not surprising as it represents only six days of Russian oil production or 11 days of Russian exports ex China.

At best, strategic reserves can only buy time. Without increasing production or reducing demand, strategic reserves would only last around five months if all Russian production was curtailed.

Even though the mid-March rise in Covid-19 cases in China caused concern about demand levels, there remains a lack of spare overall oil capacity occurring at a time when inventories globally are low. The prospect of incremental oil supplies arising from the pandemic-induced lockdowns in China may not eventuate if other countries use this opportunity to reduce their reliance on Russian oil.

Many countries enforcing sanctions on Russia have been reticent to entirely exclude Russia from SWIFT (Society for Worldwide Interbank Financial Telecommunications) as this would limit the ability for Russia to be paid for oil and gas exports. So far, seven Russian banks have been excluded from the SWIFT system. The ban has not been extended to Sberbank and Gazprombank as they are the primary payment channel for Russian oil and gas exports.

While Russian oil and gas is important for global supply, the revenue generated is important for Russia. Crude oil represented around 30 per cent of Russian exports in 2019, according to the Observatory of Economic Complexity (OEC), with refined petroleum and gas another 16 per cent and 7 per cent respectively.

OPEC+ (OPEC plus Russia) has been lifting production limits each month by 400,000 BOPD since last August. This was reconfirmed at its meeting at the end of February. The next meeting is scheduled for 31 March, where all eyes will be on the amount by which Saudi Arabia, the United Arab Emirates and Kuwait can raise production.

The road ahead

In the short term, we expect growing uncertainty over oil and gas supply security may lead Europe to revert to a greater utilisation of nuclear and coal, and then increase US liquefied natural gas imports in the medium term as it seeks to wean itself off Russian energy supplies.

The current situation is also likely to prompt more investment in oil and gas over the next two years, as many nations will be forced to assess their readiness to manage supply interruptions. Some may look to expand strategic oil and gas reserves.

Looking further afield, we see the increasing emphasis on energy security to amplify the push towards electrification. Alongside environmental efforts, this may well end up prompting an acceleration of renewable energy and hydrogen solutions around the world.

The invasion of Ukraine has shone a light on the fragility of global oil supplies. Irrespective of how events unfold from here, we may need to get used to paying more for petrol at the pump. As frustrating as it may be, these events have highlighted a realisation that the world has much to do before it can move away from its reliance on oil.

John Norling is Head of Wealth Research and Nik Burns is a Director of Equity Research at Jarden. This article reflects the opinions and views at the time of publication, and is not to be relied upon as a basis for making any investment decision. Please seek specific investment advice before making any investment decision. 

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