Long Oil on Russia/Ukraine Conflict

The Russia-Ukraine conflict has escalated dramatically in recent days. The Russian military advance is likely to become more destabilising. Meanwhile, we have seen dramatic sanctions by the West. However, so far, the financial sanctions, whether on banks, the use of SWIFT, or the central bank have included carve-outs for trade in energy. So, while natural gas prices have surged, the increase on oil prices has been more muted in recent days (oil has yet to breach the intraday highs of last Thursday). We think this is likely to be change for three reasons:

1. Oil supply is limited. Investors are expecting sanctions on Iranian oil to be lifted. Currently Iran is producing around 2.5 million barrels/day, but they could have capacity to go to 3.8-4 million barrels/day (Charts 1 and 2). Moreover, both Saudi and the US appear to have capacity to increase oil production by 1.5mn barrels/day each. However, we would be cautious in expecting this to lead to lower oil prices. For one, it is well priced. But more importantly, the US has been pressuring the Saudis to increase supply and trying to increase its own supply for the last year, neither to any avail. This could be due to pandemic-related production and supply chain issues, over-estimates of capacity, or a fear by shale producers of overinvesting right now. On top of this, inventory levels are running low (Chart 3). We need to remember that Russia is one of the largest oil producers in the world with daily production of around 11mn barrels.
2. Financial sanctions could restrict Russian oil supply. Even though the current financial sanctions have exemptions for energy trade, we would still expect financial institutions, transportation companies and energy traders to be cautious in interacting with Russian entities. This could be due to uncertainty around whether a transaction could later be determined as illegal, or whether sanctions will get worse. Therefore, we could see Russian oil move less freely than before.
3. Next stage is energy sanctions or Putin to use oil as weapon. Given that we have already reached an extreme stage in the current crisis, the question is what is next? On the Western side, one of the few courses of escalation would be to sanction Russian energy exports. This would remove the last remaining source of dollar inflows to Russia and could cripple the economy. Meanwhile on the Russian side, Putin may counter with a pre-emptive curtailment of oil supply to trigger a global oil shock, which could tip the global economy into recession.

Given the above, we are adding a long oil position to our portfolio. The oil curve is heavily backwardated (Chart 4). Therefore, we choose to pick a later dated contract (Brent, August 2022) which should be less volatile than the front contract and would allow for some positive roll.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)