🛢Unintended impact of Russian oil price cap?

EU and G7 countries decided to implement a price cap on Russian oil while OPEC+ left production unchanged. Will oil surprise investors this year?

Price cap on Russian oil

There was quite a lot of action on the oil market as of late. EU and G7 countries decided to implement a price cap on Russian seaborne oil exports. What does it mean, at least in theory? Third-party countries will be able use a fleet of tankers registered in G7 and EU and take advantage of insurance contracts only if they ship Russian oil purchased by $60 per barrel or less. Price cap agreement is to be reviewed every 2 months to ensure cap remains at a level that is at least 5% lower than average market price for Russian crude. Some countries, like for example Poland, wanted cap to be placed even lower - as low as $20-30 per barrel - but the United States did not agree in order to not create too big a supply gap on the oil market.

What does it mean in practice? Currently, not much. Russian oil benchmark Urals is currently being traded at levels below price cap. Moreover, Russia can also use its own tanker fleet to ship oil, what would allow it to completely bypass sanctions. There is also a high chance that more creative ways to circumvent sanctions will be implemented, as it was the case earlier this year in some European countries.

Russia is already selling Urals oil at a price that is below Western price cap. Source: Bloomberg, Argus Media

Embargo on Russian oil

It should also be noted that apart from the introduction of a price cap on Russian oil, today also marks the introduction of the EU embargo on Russian oil. While imports of Russian oil to the EU dropped to just 1.0-1.5 million barrels per day, the EU will still need to find an alternative seller for this supply. Embargo on oil derivatives, that is set to go live on February 5, will be a much bigger issue for Europe. This embargo will see a complete halt to imports of oil derivatives, including diesel, which Europe is seeing a shortage of.

What will be the Russian response?

Russia said that it does not plan to sell oil to countries that implement Western price cap and said that it will cut oil production if it has too. It should be noted that lack of Western technology would likely lead to a drop in Russian oil output anyway. The base case scenario is for global oil supply to drop by 1.0-1.5 million barrels per day in the coming months. Average cost of production in Russia has gone up significantly over the past year and is estimated at around $50 per barrel currently. However, the budget breakeven price is much higher. Moreover, more than 50% of production cost is made up by taxes, so Russia's financial wellbeing is likely to be further impacted.

OPEC+ leaves production levels unchanged

The latest decision from OPEC+ did not come as a surprise. Oil producers decided to leave production unchanged with the whole-group quota staying at around 41.8 million barrels per day. However, as only few OPEC+ members are able to produce in-line with quotas, production of whole OPEC+ stays just slightly above 40 million barrels per day.

Chinese demand - key uncertainty

Uncertainty relating to the global economy, especially outlook for China, led to significant price drops on the oil market in November. China is a global leader in terms of oil imports, and economic deterioration in the country may have a huge impact on crude prices. However, as China looks to be easing Covid restrictions in response to mass protests, the situation may be set to improve. 

Elsewhere, the US Department of Energy is halting strategic oil reserve sales, with reserves now sitting at the lowest level since 1984! DoE would like to start filling up inventories again but current price levels are seen as still too high to do it.

US oil reserves dropped to the lowest level since 1984. US DoE does not want more inventory releases and is looking for ways to refill stockpiles. This is another sign that supply in the oil market is dwindling. Source: Bloomberg

What's next for prices?

Brent prices are holding firm in the $85-90 per barrel range. Risk of a demand drop in China has diminished significantly and one cannot rule out that a supply gap will surface on the market, should third-party countries implement a price cap on Russian oil. Attention in this case will be paid mostly to China and India. However, it is expected that both of these countries will find ways to work around sanctions without drawing an ire of the West. Embargo on oil derivatives, that is set to go live at the beginning of February 2023, is likely to be the biggest issue and turn of January and February may be a period of high volatility in oil and gasoline prices. 

Brent (OIL) dropped to the lowest level since January 2022. However, we can see a rebound as uncertainty over supply eases and lockdowns in China are being lifted. Nevertheless, volatility may stay elevated in the coming weeks. Source: xStation5