Only OPEC Can Help The West Replace Russian Oil

• Energy prices have skyrocketed since the beginning of Russia’s assault on Ukraine, and analysts expect them to continue rising.

• The United States has banned all imports of Russian energy, and other allies could be right on their heels.

• Replacing Russian oil will prove to be a difficult task, and it may not even be possible without the help of OPEC.

Last week, oil and commodity markets recorded their biggest weekly gains in years as shuttering of Ukrainian ports, sanctions against Russia, and disruption in Libyan oil production sent energy, crop, and metal buyers scrambling for replacement supplies. Crude prices have spiked again this week on fears that the U.S. and its allies were seriously mulling a ban on Russian oil and gas. 

Well, the Russian boogeyman has not been imaginary, after all: on Tuesday, President Biden imposed an immediate ban on Russian energy imports while the United Kingdom said it would phase out imports by the end of 2022.

In a speech on Tuesday, President Biden announced measures to eliminate Russian oil imports into the United States, and also addressed the U.S. oil & gas industry directly while also alluding to further conversations with producers. 

"To the oil and gas companies and finance firms that back them, we understand war is causing prices to rise, but it's no excuse to exercise excessive price increases ... it's no time for profiteering or price gouging. it's not true my policies are withholding production ... companies are making the decision not to drill," the president said in his speech.

In 2021, the U.S. imported an average of 209,000 bpd of crude oil and 500,000 bpd of other petroleum products from Russia, according to the American Fuel and Petrochemical Manufacturers trade association. This represented 3% of US crude oil imports and 1% of the total crude oil processed by U.S. refineries. For Russia, this represented 3% of its total exports.

While Biden's statement alludes to the need for more production, it does not point to a coordinated effort from the White House. 

At a time when the majority of U.S. producers are opting to return excess cash to shareholders, a few like Exxon Mobil Corp. (NYSE:XOM) are planning to significantly grow production. Exxon says it plans to increase Permian production by as much as 25% in 2022. Meanwhile, Devon Energy (NYSE:DVN) and Pioneer Natural Resources (NYSE:PXD) have indicated a willingness to increase production, with Pioneer CEO Scott Sheffield recently saying that the industry could grow production by ~1mb/d annually for three years. Sheffield went on to say his firm would participate in a coordinated effort to accelerate U.S. production growth.  And now a cross-section of analysts is warning to expect even higher oil prices.

Replacing Russian Crude

Indeed, energy analysts have warned that prices could go as high as $160 or even $200 a barrel if buyers continue shunning Russian crude, leading to U.S. gas prices of more than $5 a gallon.

But is that even possible? Can Europe completely eschew Russian oil and gas?

According to commodity analysts at Standard Chartered, replacing Russian oil flows into Europe is doable, but would come at a huge cost. Although Russian energy exports have--up to now--been exempted from global sanctions, oil prices and energy stocks have been soaring after international refiners adopted a self-imposed embargo, with many reluctant to buy Russian oil and banks refusing to finance shipments of Russian raw materials. Refiners and banks are unwilling to do business with Russia due to the risk of falling under complex restrictions in different jurisdictions. Market participants are also concerned that measures directly targeting oil exports could soon come into place as fighting in Ukraine escalates.

StanChart estimates that at current prices, the value of Russian oil exports to EU countries clocks in at $550 million per day, which equates to $200 billion on an annualized basis. Replacing all Russian oil exports to the EU is possible, but would likely involve a period of severe dislocations and the utilization of almost all the slack within the global oil system, with associated high prices. Russian crude oil and oil products to the EU are about 4.5 million barrels per day (mb/d), dwarfing flows to the US and UK. Some of the displaced flow is likely to move, heavily discounted, into Asia and release other volumes. However, StanChart says this process would still leave a 3mb/d gap in global balances.

Dependency on Russian Oil, OPEC Spare Capacity and U.S. Flows

Source: Standard Chartered

Filling the gap left by the net reduction in Russian exports without relying heavily on demand reduction through higher prices requires a combination of new flows. Sharp output increases from OPEC countries with spare capacity could play a key role, which would require the effective end of the OPEC+ agreement. 

A deal in the Vienna talks could, over six months, allow a further 1.3mb/d of Iranian oil onto the market. The largest potential short-term cushion comes from large but temporary flows from strategic inventories while other supplies ramp up; the U.S. Strategic Petroleum Reserve (SPR) alone has a theoretical maximum drawdown rate of 4.4mb/d. 

In other words, whereas it's possible to replace Russian flows to Europe, the dislocations would be significant. There are considerations of timing, sustainability, and location as well as differences between crude flows and product flows. Replacement is not without significant costs, and the task for politicians is to weigh these against the multi-faceted costs of continuing to pay Russia for oil.

The decision to reduce imports from Russia has to some extent been taken out of government hands, with StanChart estimating that at least half of Russian exports to Europe will be halted by buyer reluctance in the short-term, and by year-end, the flow from Russia might be reduced to a trickle. 

In the final analysis, OPEC+ will have to reverse its current production strategy if the world is to avoid a full-blown energy crisis. Re-establishing the organization's credibility as a stabilizing force in the oil market would require jettisoning its OPEC+ baggage. OPEC has historically prided itself on a commitment to market stability. However, oil price behavior over the past week seems to illustrate what happens when traders think OPEC has abdicated its stabilizing role, on the grounds that adherence to the OPEC+ deal would make spare capacity inaccessible to the market even in the current extreme circumstances. Front-month Brent settled at USD 123.51 per barrel (bbl) on 7 March, a w/w increase of USD 25.24/bbl (25.8%). The intra-day high on 7 March was USD 139.13/bbl, which was the first time Brent had been above USD 130/bbl since 22 July 2008. It has only been higher on the 15 trading days between 26 June 2008 and 16 July 2008. Price gains along the curve remain relatively modest, with Brent for delivery five years out gaining USD 4.21/bbl w/w to settle at USD 75.35/bbl on 7 March.