Protracted Volatility:

Russian War on Ukraine Reshapes Energy Markets
Protracted Volatility:
May 26, 2022

Global energy markets are trying to find their footing even as the full impact of the Russian invasion of Ukraine on security and energy markets remains unclear. Initial fears of a Russian natural gas blockade of European markets have not yet materialized. However, Moscow is now facing increasingly stringent Western sanctions on its economy, targeting both Russian elites and the country’s military. At the same time, discussions are ongoing regarding the implementation of an EU 6th Sanctions Package, which would potentially suspend or terminate Russian exports of energy and petroleum products to the European Union.

Discussions inside European centers of power are heating up, but a clear and unanimous vote will be necessary to produce a real European sanctions regime capable of hitting Russia where it matters: the hydrocarbon sector. Thus far, several EU members have had cold feet or explicitly opposed the package, as was the case with Hungary. Meanwhile, Bulgaria and Germany’s economies are highly dependent on Russia and they are afraid of a severe economic downturn if sanctions are imposed.  The remaining EU members are largely in favor of the new package, even those that would take an economic or financial hit as a result. In Brussels and other European capitals, moral considerations and long-term geopolitical strategies are the decisive factors, as the West prepares to confront Russia’s aggression with unprecedented fervor.

Missing Direction

At a time that global energy markets are in dire need of direction and are beset by threats from all sides, oil and gas prices are still showing a strong upward tendency. Surprisingly, international and national oil and gas companies (IOCs and NOCs) have logged record high prices in recent weeks. As mainstream analyses indicate, the financial gains of companies like Shell, BP, ExxonMobil or the Saudi national oil company Aramco are linked to high oil prices, increased geopolitical risk, and the ongoing Russian invasion of Ukraine. However, some have forgotten that even in this bull market, bears are still around, hiding in plain sight. According to financial data reported by the top 10 oil and gas companies, it is clear that fundamentals will continue to drive hydrocarbon sector growth worldwide. Profit margins, net profits, and dividends will promote high visibility and interest from investments, pension funds, and sovereign wealth funds (SWFs). Contrary to popular belief, as crude oil markets become more visible and mediagenic, natural gas and liquified natural gas (LNG) will become attractive, due to their rising prices, LNG shortages worldwide, and Western interest in natural gas as a transition fuel.

Both oil and gas subsectors remain very strong, but risks lie ahead. Although Arab producers, especially the likes of Aramco, ADNOC or QP, have been able to ride the wave, most NOCs and IOCs face mounting geopolitical and geo-economic risks. As some have already warned, the most significant and overlooked risk at present is the continuing lack of investment in up- and downstream oil and gas at the global level. If this is not addressed very soon, the market will head towards a long-term price spike, leading to potential demand destruction, even with Aramco or ADNOC’s multibillion projects.

Transformed Markets

The Ukraine crisis is completely reshaping geopolitics and has led to new alliances. From a Western standpoint, the Ukraine crisis has been a wake-up call on many overlooked issues, such as EU security, internal cooperation, the EU’s role in the world, energy security, and the energy transition. Russian president Vladimir Putin’s actions have removed internal instability in the EU and NATO. After Obama’s soft-power democratization push and Trump’s anti-NATO positioning, a unified Europe has returned with a force. There are no longer concerns about the possible demise of NATO; on the contrary, it is expanding, as demonstrated by Sweden and Finland’s current membership applications. EU discussions with possible new member countries, such as Albania, Serbia, Turkey, and especially Ukraine, will be fast-tracked whenever possible. Putin’s strategy for Moscow has significantly backfired given Europe’s dramatic policy changes following its previous addiction to cheap Russian energy supplies.

For more than 60 years, Europe had been reliant on Russian energy due to low-cost long-term contracts and import stability. Even during the height of conflict between NATO and the Soviet-led Warsaw Pact, energy supply chains were safe. However, following the Russian invasion of Ukraine and Moscow’s weaponization of energy markets, Europe is going cold turkey. Given current sanctions and strategies, European countries will have weaned themselves off Russian oil and gas by the end of 2022. Temporary exceptions to this rule are already underway for Hungary and some other former Eastern bloc countries.

Putin and his advisors clearly underestimated the reactions from NATO, EU, and the UK following Russia’s disastrous military confrontation with Kiev. For the first time in history, Russia is facing a united front of European-Atlantic powers willing to overcome their Russian energy addiction. The price in the short-term will be high, with winter energy supply shortages expected during 2022-2023. However, Europe is willing to look for new energy options, which will be needed for years or even decades to come, since renewable energy is not yet able to replace the volume of Russian oil and gas. Europe has dealt Russia a blow as a rentier-state, but also exacerbated global instability in energy markets in general.

The COVID-19 Shadow

Last week’s volatility seems to stem from both geopolitical and supply-and-demand issues. When it comes to fundamentals, the verdict is still out. Due to an unexpected COVID-19 wave in China, Beijing decided to implement zero-COVID policies that shut down large parts of the economy in major cities and imposed a very strict lockdown on citizens. This lockdown has muted the still strong demand for oil and petroleum products on the market, but the situation could dramatically change again in June. As Beijing has stated, the country will open again after June 1, resulting in potentially higher demand from Asia. Looking at recent IEA and OPEC reports, global growth of demand is being revised down, but overall growth is still projected.

Global demand for crude oil is currently around 98.3 million bpd, but before the end of 2022 could reach or exceed 100 million bpd. Demand is still strong from Asia, even if it is not in Europe and the US, and all eyes will be on China. China’s return to the market in June, combined with India’s increased appetite for crude oil, will produce an upward bullish trend. At the same time, Asian and other non-OECD countries are still very interested in benefitting from discounted Russian crude oil, which is $30-35 cheaper per barrel. Russia has become India’s largest crude oil and petrochemical product supplier. China is also interested in Russian energy but is worried about possible third-party sanctions from the USA, UK, and the EU.

International Volatility

International natural gas and LNG markets are booming as never before. The market will need to make up the loss of up to 150-175 billion cubic meters (bcm) of Russian gas exports to Europe, as well as Russian LNG. Given the current state of natural gas markets, even with the volume of so-called Freedom Gas from the US, there will be a major gap in the market if no solutions are found quickly. Pipeline expansion in the short-term is not feasible, but Europe is hungry for LNG. The EU, EFTA and UK are in the market for other energy suppliers, not only to wean themselves off their Russian energy addiction but also to bolster the still very low natural gas reserves given winter demand. European governments are flocking to Gulf hotels, especially in Qatar and Abu Dhabi, to make short and medium-term plans for LNG and the future of green hydrogen. There is currently a lack of urgency to these discussions since US Freedom Gas (LNG) is mitigating market constraints, while the parties involved are wary of high market prices. Western consumers will need to compete with possible long-term contracts in Asia and the willingness of China, Japan, South Korea, and India to pay top dollar on the spot market.

However, one potential shift is that Europeans might redirect some of their efforts to historically-strong African gas exporters, such as Algeria, Nigeria and Angola, while also pursuing options in Egypt, Mozambique, or (in the long-term) Libya. Mozambique and Egypt’s East Med are viable options, but do not yet clearly fit into EU energy strategies. If an agreement is reached, this could be a geopolitical game-changer. Libya also holds vast potential, but the resurgence of military-political infighting will put this country on the backburner.

Conventional Approach

For most market players the current situation poses a problem of fundamentals based on conventional risks. The oil glut took a toll on profitability and stability for the parties involved, while the OPEC+ (which includes OPEC countries, Russia, and others) agreement helped create a new equilibrium by removing large volumes of crude oil reserves from the market. The lessons learned from the end of 2019-2020 and the COVID-19 pandemic, when an oil glut threw the market into turmoil, are still guiding both producers and consumers. OPEC+ is keeping to its existing oil export agreement and is not willing to substantially increase production to mitigate pressure on prices. At the same time, due to high reserve levels, markets are not yet heating up, since additional supply is still available.

Some are expecting or hoping for the so-called Iran JCPOA 2.0 deal, which market experts believe would increase supply quickly. However, according to Iranian sources, this is wishful thinking and would only provide a very short-term solution. In the long term, Iran will need billions of dollars to keep up or expand production. With crude oil prices hovering around $110 per barrel, there does not seem to be a real issue in most cases. OPEC’s main producers are reaping the rewards of stable supply and demand, while Russia is experiencing a surprisingly high budget deficit, and consumers are not showing any real signs of demand destruction. Stability is key, but maybe threatened by two major geopolitical shifts and market risks hiding in plain sight.

Geopolitical Shifts

The first major geopolitical shift, which is still underway, is the demise of Russia as a major geopolitical power, economy, and top energy supplier. Prior to Russia’s invasion of Ukraine, Moscow enjoyed political power not only due to the country’s size and perceived might of its armed forces, but also because of its role in energy markets. Europe’s addiction to Russian oil and gas increased during the energy transition, giving Moscow a stranglehold on the continent’s economic growth potential, in addition to leverage as a partner in OPEC+. The two OPEC kingpins Saudi Arabia and the UAE/Abu Dhabi joined forces with former adversary Russia to form this new market maker.

The US shale oil and gas industry experienced a boom during the twenty-first century but is not yet able to compete with OPEC+. Vladimir Putin, Saudi Crown Prince Mohammed bin Salman, and current UAE President Mohammed bin Zayed (the former crown prince of Abu Dhabi) seem to be a marriage made in heaven. These Gulf leaders have been shaping and redirecting oil markets during the last couple of years, but a possible bromance with Russia remains very weak. Riyadh and Abu Dhabi are not turning away from Moscow yet, but the diminishing prospects of Russian oil and gas may dampen the alliance. For now, OPEC+ remains alive, but if Putin’s misadventure in Ukraine continues to take a toll on Russia, MBS and MBZ are too politically savvy not to change their own course. Pressure from the US, UK, and EU on Riyadh and Abu Dhabi have had limited effect, and in the case of Washington, was directly rebuked.

Removing Russia from the bi-polar or tri-polar world order will pave the way for a confrontation between the West and China in the future. China has been hovering above the market for a longer time, but if Moscow is put back on ice, all eyes will be on East (China) vs. West (US/EU/UK/Australia) oil and gas strategies. For OPEC, the main supplier of energy to Asia, China will be a major point of concern. Power reshuffles are imminent, and OPEC could find itself in a weaker position than ever before. However, playing the China card is going to be tricky, especially without Moscow’s support or a potential Moscow-Beijing alliance. Energy remains key for all players.

OPEC’s producers, which are mostly Arab countries, remain crucial for all energy consumers. The loss of Russian energy supplies to the West has driven Western interest in reopening long-term energy ties with the GCC and North Africa. The same will be true if energy transition and net-zero strategies are implemented (via the BBB in the US or the EU’s Green Deal), as blue and green hydrogen emerge as possible new export options for MENA countries. Young Arab leaders who have been trained in Russian and Chinese will need to review their English and French.

India: A White or Black Swan?

India is another emerging geopolitical force hidden in plain sight. It is the world’s most populous country, could become Asia’s leading economic power, and is getting more aggressive in its geopolitical, military, and economic strategies. While remaining partially neutral in the Russia-Ukraine conflict, New Delhi is poised to become the world’s third strongest power and a major new force on the side of Western alliance.

India is very wary of the increasingly aggressive military-economic moves being made by China, especially in the MENA region, Sri Lanka, and Pakistan, and is very worried about its geopolitical position. Like China and other Asian economies, India is increasingly dependent on MENA and African energy supplies. At the same time, New Delhi understands its potential power in the Middle East, given short trade routes, its booming economy, and a vast expat community in the GCC. India has not previously found itself at odds with Chinese interests, but there are indications that New Delhi’s strategic moves could a lead to a future conflict with China. India’s former alliance with Russia is also being reassessed, as the war in Ukraine has become a headache for Indian investors and companies dealing with the West, and also revealed the shortcomings in Russian support and military technology.

If India pivots towards the West, this will fundamentally rearrange the geopolitical order and bring it into closer alignment with Western energy strategies, including with the MENA region. MENA countries will need to take this into account. MENA’s current “going east” energy strategies, largely via China, have come under pressure. India, as the second largest market in Asia, must be taken into greater consideration by OPEC and natural gas producers. Some regional countries will have to assess this situation on its merits before they are confronted by a new harsh reality.

High Hopes for Renewables

Beyond geopolitics or geo-economics, there is another major shift taking place. The combination of the COVID-19 pandemic, Russian intervention in Ukraine, and energy transition will be a lethal cocktail for the oil and gas industry if not addressed. Proposed new green or sustainable strategies in the West and India have immense potential and will directly impact overall energy demand in future.

Western efforts to reach net zero by 2050 might not yet be a threat to oil and gas but nevertheless indicate that energy supplies will change. The role of hydrocarbons in the energy mix will decrease, as current renewable and nuclear energy project expand. The speed of implementation will not only depend upon political support in the countries in question, but also on the competitive price situation for natural gas and crude oil. There has not yet been demand destruction for oil and gas at the global level, but current crude oil and gas prices in the market have become a strong stimulus for change. If all current renewable projects are implemented, including those still in the planning stages, the negative fallout for oil and gas demand will be significant.

OPEC’s statements that crude oil demand is going to grow until 2045 (108 million bpd) could still be true, but perhaps only with regard to petroleum products and Asia-Africa demand predictions. Western markets clearly want to go cold turkey very soon, and Russia’s weaponization of energy supply and markets is seen as the main driver for this change. The critical dependency on strongman energy supplies is now a fundamental issue at stake. Given the high costs of conventional energy for the foreseeable future, renewables are becoming very attractive. Several major new offshore wind and solar projects, among others, are on the horizon.

Until 2030, even if optimism regarding renewables stays high, mainstream crude oil and natural gas demand is unlikely to be significantly affected. Most new projects will hit the market in the late 2020s. A growing number of analysts are already forecasting that this transition will not be feasible, since the mineral and metals needed are not on the market: mining is far below the needed production volume, and the costs of all commodities are skyrocketing. At the same time, technical support and installation capacity in the market is also very limited, offshore vessels are not available, and engineers are lacking.

For OPEC/MENA producers, the future remains very bright while demand is strong. Possible demand destruction of fundamentals is not yet in sight, with renewables or nuclear energy posing the main threat. Geopolitically, these developments have been driven by the recent European energy crunch and the impact of Russia’s disastrous military adventure in Ukraine. As a result, the West wants to be less dependent on Russia and potentially other major producing regions. For MENA producers, these new facts need to be incorporated in their assessments, for there is no return to the world as we knew it before February 2022.

OPEC‘s Role

OPEC also will need to address its fledgling production potential. The ongoing discussions with regards to possible lack of spare production capacity in Saudi Arabia and other countries are not to be taken lightly. Any sign of weakness could be another step towards a diminishing geopolitical role. For companies such as Aramco, ADNOC or QP, the immediate future is bright, but they need to address how to become “ready for 2050.” Diversification of production, increased new exploration, and investment in new downstream opportunities, including in the West, will be necessary. If oil and gas supply hits a wall due to the lack of certain crudes, grades, or volume from key producers, the market will not be very kind.

As we know from physics, everything becomes fluid under pressure. Western economies are already witnessing these shifts, with further changes possible in the future due to high energy prices. For oil and gas producers, the time has come to take proactive steps. Current strategies are helping, but in the eyes of most consumers and investors, these measures are still too conservative.


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