The latest run higher in oil prices is predominantly the function of unplanned supply and export disruptions and there is a cornucopia of events that falls into this category. US sanctions waiver on Venezuelan oil exports will expire this month and India has already halted the purchase of crude oil from the Latin American country. Mexico’s Pemex has announced this week the cancellation of 436,000 bpd of its oil exports as the company is preparing to refine domestic crude oil at its Olmeca refinery. The country’s president announced that the ultimate objective is to process all the 1.88 mbpd production in Mexico, which, of course, would not create shortage but re-direct crude oil and product flows. Although no supply shortage is observed due to the Israel-Hamas conflict the tension in the Middle East adds a several dollars of risk premium to the price of oil. Attacks on Russian oil infrastructure, on the other hand, materially impact the supply of crude oil and products and, in our view, this is the most salient reason behind the rally that has taken the price of front-month Brent from $72/bbl in mid-December above $90/bbl yesterday.

Russia excels at obfuscating its oil (and other economic) data and therefore piecing together the impact of resolute Ukrainian drone strikes on refineries is a cumbersome task. Looking back at 2022, the country’s invasion of its western neighbour had not impacted global oil flow, it merely re-aligned it. After the initial shock two years ago, which pushed the price of oil close to $140/bbl, nerves were calmed and with the help of friendly and transactional allies Russian oil found home in countries ranging from China through India all the way to South America. India, for one, which did not appear on the list of Russian crude oil buyers pre-invasion ramped up its import and bought as much as 30% of its total crude oil needs from Russia in 2023. Its monthly purchases peaked at 1.99 mbpd in July last year.

Conversely, Europe, the traditional customer of Russian oil exporters has undergone equal and opposite changes. Energy Intelligence has methodically summed up the shift in priorities and possibilities. Between 2021 and 2023 EU’s crude oil imports from Russia dropped by 1.878 mbpd and increased by a combined 1.961 mbpd from the US, Norway, Brazil, Guyana, Canada, Angola, UAE, and Algeria. Outright prices nearly halved between March 2022 and March 2023 whilst the Urals discount in the Mediterranean region, for example, plunged to $40/bbl in July 2022 it has now narrowed to $13/bbl.

Trade adapted to the new status quo, but this fragile balance has been upended in the past few months as Ukraine started to launch pernicious assaults on Russian refineries. More than ten refineries have been affected, one as far as 1,300 km from the front line. Reuters calculates that the refining capacity that has been knocked out by the strikes reached 14% by the end of March. This is the equivalent of 900,000 bpd. Output of products has been halted and exports are inevitably feeling the pinch. Take ultra low-sulphur diesel exports from the port of Primorsk this month. It is seen falling 16% on March and other products are also impacted as domestic supply is being prioritized.

Refinery problems should lead to increased exports of crude oil, but it is unlikely to materialize either. The Russian government has ordered domestic producers to cut output by 500,000 in the second quarter to fulfil the country’s OPEC+ obligation, the official narrative states. It sounds like a convenient explanation for the move, which, at least in part, might have been triggered by lack of storage and falling demand from abroad due to sanctions. Novorossiisk oil loading will probably plummet as much as 17% in April (Reuters).

In the light of these developments there are two pivotal questions: when will Russia’s refining sector resume normal operation and what will be the medium-term price impact? The Russian energy minister is hopeful that it would be business as usual by early June latest but of course one can never know how long the Ukrainian strikes will continue.

As for the price impact, it is plain to see. Outright prices have been on the ascent since the attacks started, backwardation on the crude oil contracts has widened, Brent CFDs are getting perky implying genuine physical tightness and refining margins look buoyant. Thus, it is reasonable to bet on elevated prices unless the Russian refining sector recovers unreservedly, correct? Not quite. Expensive oil will re-ignite inflationary pressure pushing rate cuts further out. Demand will suffer, most importantly from the US and China. The former faces presidential elections, the latter struggles to put its economy on an upward trajectory. The Saudi fiscal breakeven price is somewhere below $86/bbl. Setting aside the unplanned supply disruptions, our base case supply-demand balance shows that Brent ought to peak just above $90/bbl. Current prices are right there. Of course, the unforeseen and geopolitics could push oil above it briefly. Just look no further than yesterday’s jump. However, this rally is not driven by demand consideration but supply disruptions. In fact, there is no shortage of oil, only 5 mbpd of yet unutilized spare capacity, which could and plausibly will mitigate the seemingly inexorable rally towards $100/bbl. Market and political forces should intervene in case of protracted strength. It might turn out to be a brazen call, but the summit could easily be near price and timewise.

Increasing Israeli Isolation

Clearly, the envisaged trend reversal did not arrive yesterday. The market rallied hard in the last hour of trading and both WTI and Brent closed at their highest levels since October last year. It appears that Israel has shot itself in the foot by obliterating the Iranian consulate in Syria and the same day killing seven aid workers in Gaza as their convoy was hit in what Israel described as a tragic and unintentional incident. The international outrage, nonetheless, continues unabated. The US President, the staunchest ally of the Jewish state called for an immediate ceasefire and admonished Israel that the US support now depends on concrete steps to ensure the safety of civilians and aid workers amidst the ongoing humanitarian crisis. With rising threats of Iranian attacks on Israeli diplomats the geopolitical temperature has climbed to level since the Hamas attack on Israeli civilians. Economic considerations, such as inflation, rate cuts, falling equities or today’s US job data are being dwarfed in significance by global conflicts, yet unless oil output is explicitly affected, those who have hedged themselves against every eventuality will soon feel tempted to liquidate.

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