Russian Energy Embargo 2/6

Part 2 - Energy markets structure and the role of Russia.

< < < Part 1 - General considerations

Energy markets structure and the role of Russia.

Russia is one of the most, if not the most, important players in the global energy trade. Russia happens to be a major player in every combustible energy source market – and this is an important consideration. In all the previous major disruptions to energy supply (1973, 1979-1980, and 1991 energy crises, Fukushima nuclear disaster) shortfall was partially alleviated by fuel switch. Full-force Russian energy embargo assumes banning all Russian energy exports, and it has to be so to be effective, therefore it is important to consider the Russian energy sales portfolio in its entirety, before delving into details. It is also important to look not only at the share of production but also at the share of global trade in commodities. We may assume, that Russian domestic demand would be covered by Russian domestic production in any scenario and therefore concentrate on the “rest of the world” picture.

Russian share of the global energy market

Russia currently sends a sizeable share of its energy exports to Asia – oil via the East Siberia – Pacific Ocean pipeline ( 1.6 mbd), gas via a newly built pipeline to China – 11 bcm in 2022, supposed to ramp up to 38 bcm in the next few years, and equivalent оf 25 bcm of LNG, and 175 MMtons of coal to Asian-Pacific markets in general. On the other hand, Russia supplies Europe with 25% of its crude oil demand, 40% of gas, and 20% of coal (source BP Statistical Review of Energy).

Energy is an extremely capital-intensive industry, and because of that, there is very little spare capacity – collieries, oil wells, refineries, and gas pipelines are developed and built with market niches in mind. Energy developers may miscalculate, and if this happens, there is overcapacity and energy price goes down, but this was not the case in the last few years, energy supply was relatively tight, except for the COVID lockdowns of 2020.

Coal

Logistically, coal is an easy commodity and Russian supplies could be easily supplanted with South African, Indonesian, or Australian volumes. It is also a commodity with some spare capacity in the system, albeit it was tightening up in 2021 and the prices tripled to over 300 $/ton, running away from the customary band of $50-$100 per ton that held for more than a decade until 2021.

Oil

Oil logistics creates a challenge to some of the European refineries. Roughly a third of Russian crude is supplied via the Druzhba pipeline to refineries in the Czech Republic, Slovakia, Hungary, Poland, and the eastern part of Germany. All of them have backup routes of varying capacity, which were put to test in 2019 when Druzhba traffic stopped for 3 weeks due to stream contamination, however, they also had to rely on the stored crude as well, which would not work for prolonged disruption. The rest of the continent is supplied by marine routes and logistically substitution is possible. Some refineries are tooled to work with the Russian Urals blend and would lose some throughput if they would have to switch to different crudes.

There is also a structural problem – Europe does not manufacture enough diesel, which at the moment comprises roughly half of all liquid fuels in Europe, and 10% of this volume comes from Russia, with US imports covering an additional 3-4%. If European refining output would fall due to undersupply of Druzhba-fed refineries and loss of productivity due to a switch from Urals to less optimal blends, this problem would be exacerbated. On the other hand, there is limited diesel-exporting capacity in the world to cover for the problem. This problem is already being felt at filling stations across the EU, with diesel losing its price advantage to petrol and becoming more expensive.

At the same time, Russia is also facing a peculiar problem – as the market for diesel shrinks, diesel storage starts to fill up, but the only way to make substantially less diesel is to reduce refining run and thus reduce the amount of produced gasoline, and Russia makes just enough gasoline to cover its needs from its full refining run.

But what would happen if Europe would like to stop buying Russian crude altogether? Technically it is possible – there are enough tankers in the world to carry crude from the Persian Gulf to Europe, instead of China and India, where it goes at the moment. Question is, what would happen to the Russian oil and Chinese and Indian demand.

There are two extremes – one is that Russia keeps its production, but sends its volumes to Asia, to replace the volumes that were diverted to Europe. In this case, there will be increased freight costs to both markets, Russia would probably lose some small share of its revenue to cover additional cargo costs and would have to offer a discount to Asian buyers, as they would be able to buy from any source, but Russia would be able to sell only to Asia. At the same time, Europe would also pay more – also to cover additional freight charges, and to offer a premium to Arab sellers, who could choose among markets and would have to be enticed to sell to Europe. In short, there will be some deadweight loss and value transfer to tanker owners, Asian buyers, and Arab sellers at the expense of Russia and Europe. However, in this case, Russia would keep most of its oil revenues. In practice, Russia might face certain difficulties trying to push all former Druzhba volumes through Baltic and Black Sea ports, so there might be some export reduction, but not substantial. This is probably not the outcome that Europe is seeking.

Another extreme – the Russian embargo is similar to the ones imposed on Iran or Venezuela – there are enough deterrents created to make third countries, including China and India, stay away from Russian oil, and Russian oil exports are excluded from the global balance. This would deprive Russia of $0.5 bln a day of revenues (at the current volumes, prices, and discounts), but also create an unprecedented oil crisis.

The shock to global supply will be 2 times higher than what was encountered during the 1973 and 1979-1981 energy crises. In 1973 Arab embargo applied to only a few countries and lasted a few months, its real role was less of a supply shock, but more of a mechanism to discover the real value of Arabian oil to the world which established the new price levels. Both 1973 and 1979 were times when production outside the Arab world was growing and oil was being replaced in the energy sector by natural gas and nuclear energy. By 1979 many energy-saving measures introduced after 1973, were bringing their fruits.

Would it be possible to replace Russian oil in the market? There are several potential sources:

• Release of oil from storage

• Spare capacity in Saudi Arabia, UAE and Kuwait (this is pretty much the only spare capacity in OPEC at the moment)

• Amnesty to Venezuela and Iran and lifting sanction placed on these countries with hopes of swift restoration of their production

• US shale production growth

At the moment OECD countries hold 2.6 bln barrels of oil in storage or a year’s worth of Russian oil and oil products exports,  and China holds additional 1 bln barrels. On the other hand, OECD net import is 17 mbd, and this storage comprises 150 days of net imports or only 60 days over recommended 90 days minimum. This would be enough to weather an abrupt disruption in oil supplies like in 1973 or 1991, but not enough for a protracted shortage. US crude inventories are below 5 years minimum.

Persian Gulf spare capacity is assumed to be at roughly 3-3.5 mbd, and this is the amount that Saudi Arabia has kept idle in the past as a reserve to moderate supply shocks and maintain orderly markets in the past. The rest of OPEC production has been declining, most OPEC and OPEC+ countries could not even keep up with the gradual increase in their production quotas that were supposed to bring production back to pre-COVID levels.

The state of the Venezuelan and Iranian oil industries and their ability to spring back after the lifting of sanctions is a bit unclear. There is a consensus that Venezuela can probably bring back a few hundred thousand barrels per day after almost a decade of no investments and probably scavenging of oil field equipment for scrap metal by the hungry population. Iran is in a better position, but probably it could bring no more than 0.7 mbd of production in a few months’ time.

The US could indeed be a source of growth, but this would require a major speed-up in drilling. At the moment US drill-rig count is nearing immediate pre-COVID levels but still is just about a half of 2018 levels and a third of the 2014 peak. It takes at least several weeks to bring an oil well online and judging by US production ramp-up in 2010-2020 when production was going up at 1-1.5 mbd per annum, we can expect growth at most of 1.5 mbd in the next 18 months.

In short, global oil production capacity is quite tight, and the reason for it is the lack of investments since 2014 and in particular since 2018. First, it was caused by the oil price drop in 2014, then by growing pessimism over US shale producers’ business model and investor disappointment, and later by decarbonization and “fossil fuels stranded assets and capital” sentiment.

It is probably safe to assume, that in the case of a cold turkey Russian oil embargo, the world will be short of 4-5 mbd oil crude and products initially, and 2-3 mbd after 6 to 12 months. This will lead to a major global oil crisis and price growth that we will discuss later.

Gas

Natural gas is the market where Russia holds the most prominent role for European buyers and where Europe is an extremely important market for Russia. LNG is a fungible commodity, it can be sourced from anywhere and sent anywhere, but pipeline gas, which comprises the bulk of the Europe-Russia energy trade, is a very specialized asset. If Europe decides to stop buying Russian pipeline gas, or Russia decides to cut Europe, Russian gas will just stay in the ground and will be subtracted from the global gas balance. China gets its Russian gas imports from East Siberian fields, unconnected to the Russia-Europe gas pipeline system, and Russian LNG plants also get their gas from different sources, but for a very small exception. Therefore, the first scenario, described in the oil chapter, of logistical shift, is unapplicable, we can go straight to the “cold turkey” version.

Europe currently gets 20% of its gas from Norway, 35% from Russia, 20% as LNG, 5% from North Africa, and the rest (20%) produced domestically. The total gas consumption volume is ~500 bcm

The degree of dependence on Russian gas in Europe decreases from East to West. Former Socialist countries and Germany are predominantly dependent on Russian gas, while France, Italy, Spain, and Portugal have several LNG terminals and pipelines from Algeria and Libya. Gas plays a major role in power generation, and countries with a large share of coal, like Poland, or nuclear, like France, have a lower share of gas in their full energy mix and will be more resilient in a case of gas shortage.

LNG terminals are relatively inexpensive and have substantial economies of scale, so total terminals utilization is around 50% capacity, so from that standpoint Europe as a whole could probably cover all its import requirements with LNG. Distribution within Europe, however, might be a problem.

The gas industry tends to work on a seasonal basis. Winter peak demand may be twice as high as summer trough, and when in April demand goes down, gas storage facilities start to fill up, until October, when heating season starts and import pipeline flow has to be augmented with storage drawdown.

In the 2010s Europe has built several interconnecting pipelines allowing to bring gas from LNG terminals to Central Europe. In 2019, when there was anxiety over supply interruption due to the Russian-Ukrainian conflict over gas transit, the EU energy commission has run a modeling exercise, which suggested, that with LNG supplies and storage drawdown even the most vulnerable European countries would be able to carry over for a few weeks.

But the main issue is the availability of LNG. Russian pipeline gas supplies to Europe at the moment are equivalent to 1.3 times the amount of LNG Europe gets at the moment, or combined volumes of Japan and South Korea, or a third of the global LNG supply.

LNG availability is a 2-fold problem – gas availability (relatively easy and quick to solve with additional drilling) and liquefaction plant availability, which takes several years to build and requires multi-billion dollar investment. Existing LNG facilities are working at full capacity and no major additions are expected before 2025.

Norwegian and Azerbaijani exports might go up by 6-7 bcm, or cover 1-1.5% of European demand.

In short, Europe has no chance to replace the full amount of Russian gas imports with alternative gas sources and would have to fight a bidding war with other gas buyers for every additional billion cubic meters it is going to get. Having said that, there are chances that some volumes might come to the market – last summer the market was tight due to extreme weather events – cold spring in the Far East, that jacked up demand in Japan, drought in Turkey and Brazil in the summer, which reduced availability of hydro electricity and created additional load at gas-fired power plants. This year the weather may be cooperative – but the scale of additional availability is an order of magnitude less than what’s needed to replace Russian pipeline gas.

Part 3. Economic consequences of the embargo in the short to medium term > > >