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Why oil prices have fallen despite tighter restrictions on Russian supply

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The implementation of a European embargo and a G7 price ceiling on Russian petroleum this week marked a turning point in world geopolitics. Russia vowed to cease exports to any nations adhering to the price cap after being humiliated by western powers setting the price it receives for its oil. Within hours, tankers were backed up in the Bosphorus strait, signaling supply difficulties. All of this would typically have resulted in a substantial increase in oil prices, especially since it was just a few weeks ago that the Opec+ cartel shocked the market by announcing significant fresh production cuts. However, the international benchmark Brent oil price on Thursday reached a new low for 2022 of $76.15 a barrel. What is happening?

 

Russian supply remains robust

The European Union’s embargo on importing crude oil from Russia, the largest oil exporter in the world, is an actual restriction meant to compel Moscow to reroute supply and prevent the unflattering appearance that Vladimir Putin’s allies are paying him with petrodollars. However, the G7’s agreement to control prices tries to soften the blow. There was concern in certain western capitals that the EU’s sanctions would cause a drop in Russian exports and a rise in oil prices when it declared it would embargo any tanker carrying Russian crude, including one bound for Asia. More inflation would have a negative impact on Western leaders. Putin might make more money from energy.

However, the price cap aims to prevent Russian oil from reaching consumers and higher oil prices. Other price cap-related restrictions have also been reduced, providing traders with some comfort that flows will mostly continue unabated. For instance, the US convinced the EU to remove a provision from its sanctions that would have permanently barred ships from using European maritime services if they violated the price cap. A 90-day suspension has been imposed as the penalty. According to Amos Hochstein, senior energy adviser to US president Joe Biden, the cap, set at $60 per barrel, was created “to make sure that a sharp increase in price is not used to divide the alliance and weaken the ability to support Ukraine [and] to make sure that there is not an ability to surge the income of the aggressor to pay for continuing the aggression.” Western authorities claim that even while Russia has refused to deal with any bidder who wants to use the cap, the $60 level is still assisting Asian refiners in negotiating cheaper pricing. According to Florian Thaler, CEO of OilX, which tracks movements of oil throughout the world, “Russian supply to the market remains as high as at any time throughout the year.” He noted that any decline wouldn’t be apparent until later in the first quarter of 2023.

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The deep Opec+ cuts aren’t that deep

The west responded quickly in October when Saudi Arabia, Russia, and other Opec+ allies proposed a reduction in production limits of 2 million barrels per day, or on paper, around 2% of the world’s supply. The White House asserted that Riyadh was supporting Russia in a world oil conflict. The group was charged by the International Energy Agency for jeopardizing the global economy. Although energy-driven inflation continues to be a problem in western economies, the past five weeks indicate that the Opec+ group’s decision was rather wise. Oil prices have declined rather than increased, supporting Prince Abdulaziz bin Salman’s claim that preemptive cuts were necessary to prevent a dramatic market decline in the face of a faltering global economy. Additionally, Opec+’s actual reduction have been less than the headline figure stated in Vienna, in part because some countries, including Angola and Nigeria, were already having trouble meeting their quotas. According to analysts, the overall amount taken from the market is closer to 1 million b/d rather than 2 million b/d, which is still significant but insufficient to dissuade oil bears.

 

Demand fears are trumping supply fears

As the effects of Russia’s invasion and energy war on the EU spread and central banks race to raise interest rates to rein in rogue inflation, markets are increasingly preoccupied with fears of a worldwide recession after months of worrying about supply disruptions. Banks on Wall Street have released cautious economic projections for 2023. David Solomon, CEO of Goldman Sachs, remarked this week, “When I talk to clients, they seem exceedingly wary. “Numerous CEOs are keeping an eye on the data and waiting to see what transpires.”

The oil market’s shift from backwardation, a market structure in which spot prices are higher than the price of contracts to supply oil months in the future, to its mirror image, contango, demonstrates the gloomy attitude. This turn shows that traders believe the market is oversupplied, and the action is occasionally seen as a sign of anticipation for a coming recession in the economy. The two countries that consume the most energy globally, China and the US, are the main concerns for the oil market. According to the IEA, China will experience its first yearly decline in oil consumption this century as a result of its zero-COvid policy and slowing economy. While the US economy may avoid a recession, the country’s consumers’ appetite for gasoline also appears to have peaked. Only once in the previous 20 years has consumption for this time of year been this low: in the year 2020, when there was a coronavirus epidemic. The total US oil demand has not yet reached pre-Covid levels.

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But prices could still rebound

Oil market bearish believe that all of this indicates to a sustained cyclical unwinding of oil prices. Bulls are baffled, though. They argue that if demand keeps increasing, even slightly, years of supply under-investment will finally catch up with the market. Another risk is the US shale oil patch’s slow growth in production. Some analysts claim that any decrease in Russian production won’t be apparent until the following year. They also claim that China’s weak demand would not last.

According to Dan Klein of S&P Global Commodity Insights, “We basically are going from zero energy demand increase in 2022 [in China] to roughly 3mn b/d equivalent energy demand across the fuels next year.” Going forward, there will be a significant increase in Chinese energy demand. The government is currently winding down months of oil sales from its emergency stockpile, and if US crude prices fall to $70 per barrel, it aims to start refilling the stockpile. On Thursday, the price of West Texas Intermediate crude reached $71.46. In reference to the amount of emergency oil released this year, Bill Smead, chair of Smead Capital Management, stated that “at the margin, a seller of 200 million barrels in 2022 would become one of the top buyers of oil in 2023.” History contends that years of increased oil and gas costs are still to come.

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