Karim Fawaz
The history of oil markets is littered with watershed moments. Some are succinct points in time, like the 1973 and 1979 oil shocks; others are protracted phenomena like the U.S. shale revolution. But what they all have in common is that they fundamentally altered market conditions and the framework used by market participants to form forward price expectations. The events of 2022, culminating in the implementation of European sanctions on Russian oil on December 5, mark the dawn of a new age for oil markets. These events warrant a fundamental rethink of the global oil map, how oil prices are set, and how political and economic motives of various stakeholders interact in a deeply fractured market.
The oil market has followed a path of consistent but managed globalization for nearly 50 years. This process can be best encompassed in the three f’s: free (largely unconstrained trade), fungible (oil of different grades and origins are largely interchangeable), and financialized (with a deep, liquid financial commodity market facilitating hedging and price discovery). The emergence of shale was set to cap this process by ostensibly creating a just-in-time supply function that could stabilize prices closer to the marginal cost of production and help erode the influence of geopolitics on oil price formation (the “depoliticization” of oil). The more the oil crises of the 1970s faded from collective market memories and the more sophisticated the global oil market became, the less politics were perceived to drive oil prices beyond a shrinking “risk premium.” That was an illusion, however. Oil remained too intertwined with geopolitics for depoliticization to last.
The shale sector has transformed and surrendered its price elasticity in the process. More importantly, it has become clear that the free, fungible, and financialized global oil market was a construct propped up on political and commercial pillars, several of which are now being hollowed out. Three are worth highlighting.
The first of these pillars was the notion of Organization of the Petroleum Exporting Countries (OPEC) as a market-stabilizing and consumer-responsive construct, holding and managing the oil market’s spare capacity buffer to avoid severe physical imbalances and price extremes. A core tenet of that idea was the political alignment between the United States and Saudi Arabia, and responsiveness of the latter to the pressures of the former in the oil arena. In 2022, the posture of the broader OPEC+ group, an organization co-helmed by Russia that is in direct confrontation with the West, shifted this dynamic. The OPEC+ decision to cut production by two million barrels per day in October despite U.S. pleas is a manifestation of this trend. For oil markets, OPEC and its partners transitioning from a stated objective of market stabilization to outright resource monetization by targeting higher prices adds a more motivated and potent force dictating supply.
The second was the relatively minimal role of oil consumers and large importers (mainly the West and Asia) in oil price formation. Consumers acted largely as price-takers, with mandated Strategic Petroleum Reserve (SPR) holdings (for International Energy Agency members) used solely for acute emergencies and shortages. Today, out of necessity and desperation in the fight against inflation, consumer countries and especially the United States have uncovered pathways to influence price formation. The massive SPR draws of 2022 were one such pathway, the price cap may be another. That also goes both ways, exemplified by the U.S. intent to use the refill of the SPR to support domestic producers above a certain price ($67–$72 per barrel) and establish a de facto target price range. The newfound interventionism of consuming countries—even if nascent and capacity-constrained—suddenly gives them a seat at the table in oil-price formation.
The third was a set of core, dedicated trade flows and commercial trunklines that underpin price discovery and leave spot oil markets liquid but not unwieldy. The largest was Middle Eastern crude exports to Asia, followed by Russian crude and refined product exports to Europe, and Canadian crude to the United States. In the context of the physical oil market, the rerouting of the majority of Russian crude and soon refined product imports away from the European Union represents a tectonic shift. The reshuffling of global oil flows that started to unfold in 2022 will be far-reaching. Russia’s efforts to circumvent sanctions on maritime insurance and services have led to the broadening of the global tanker “dark fleet.” The fracturing of the physical oil market and remapping of global oil trade that is currently unfolding is redrawing commercial relationships, adding opacity to price discovery, and upending price differentials in profound ways.
What comes next? Creative destruction. Through this process, oil will flow less freely, be less fungible, and potentially suffer from lower financial liquidity, all of which will cloud price discovery and reinforce price volatility. Mismatches in producer and consumer price objectives could translate into dueling interventions and widen the amplitude of supply and demand outcomes. Eventually, new structures and a new equilibrium will emerge, but first, the unknitting of the present patchwork will continue to unfold. The oil market that emerges is unlikely to look anything like the market at the start of 2022.
Karim Fawaz is an oil market analyst and research and analysis director at S&P Global Commodity Insights and aparticipant in the CSIS Energy Security and Climate Change Program’s 2023 Energy Futures Forum.
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