MFS - Severely Disrupted Oil Market — Now What?

The war in Ukraine has disrupted supply in the oil market, a market already facing capacity constraints. This, along with sanctions and the uncertain nature of the conflict, will continue to support a highly elevated and volatile oil price in the period ahead.

The pace and magnitude of the recent price rises will, in our opinion, have a large negative impact on the global economy. Long term, we expect that the higher oil price to induce more capex, which ultimately will help address supply shortages, but higher energy prices will be a feature for some time to come. Meanwhile, renewables and energy efficiency will rightly remain front and center, but in the near term, we expect a greater focus on energy security, reliability and affordability to influence decision making.

Energy prices have become a concern for investors, consumers and politicians alike.

While Russian oil and gas production continues, sanctions risks have caused shippers and traders to shun Russian supplies. In the near term, we expect price volatility to remain high given the fluidity of the situation and the inability of other producers to step in and make up for Russia’s 9.5-million-barrel-per-day global supply.

In our view, elevated oil prices will likely lead to some demand destruction.

The crisis in Ukraine has resulted in energy costs as a percentage of global gross domestic product, soaring from 2% in April 2020 to 8%, according to Bernstein Research. A shock of this magnitude and speed will damage economic growth as energy is ubiquitous and energy prices flow through to all aspects of the economy. Typically, gasoline prices above $4 a gallon force consumers to change their habits, leading to declining demand. Businesses, too, face difficulties in absorbing and managing prices rising this swiftly.

Many emerging markets are being hit with a one-two punch.

Prior to the invasion, demand for energy and a range of commodities was already increasing as the world economy recovered from the worst of the pandemic. Emerging markets are particularly impacted as a rising dollar exacerbates inflation through higher import prices, further slowing growth and demand. Fuel prices in emerging countries were at all-time highs in local currency before the conflict added to concerns over demand destruction.

Venezuela has the reserves to provide a significant increase in supply.

But there are obstacles: Venezuela remains under sanction, although there has been recent outreach to the country by US officials. Extraction would be costly and require significant capex after years of neglect by the national oil monopoly, but once it is running, operating costs would be low. Venezuela could make a significant difference in global supplies, but given the significant obstacles, we remain concerned, and hope is not a good strategy.

Increased Iranian supply is a possibility as part of a renewed nuclear deal.

However, given the opacity of Iran’s current supply, there are doubts over how much more the country will provide to the open market. Elsewhere, OPEC members, specifically Saudi Arabia and the United Arab Emirates have limited spare capacity to step up production to fill the void.

Listed oil majors have pivoted to clean energy, leading to falling capex and limiting supply.

Capital has become scarcer for listed energy companies amid the rapid growth of fossil fuel exclusions and climate concerns among investors. Given the long duration of energy projects, oil companies fear being left with stranded assets. This has slowed exploration industry-wide despite sizeable capex budgets for state-run oil companies such as Saudi Aramco.

Oil is fungible and over time supply lines will shift.

Some countries will be willing to take Russian oil, particularly given the discounts likely on offer. This will free up supply for those countries looking to reduce their exposure to Russian oil. Given existing pipelines and transport routes, this is complicated, but ultimately oil will find its level.

The war in Ukraine has highlighted the need for energy security.

In the near term this should not change the shift toward renewable energy sources. The crisis has demonstrated anew that while renewals remain an imperative, the energy transition is fragile and needs to be better managed. Policymakers need to focus on the balance between near-term energy security and their long-term sustainability goals. These should not be viewed as mutually exclusive, and we expect further support for renewables but also the need for secure and cost-effective base-load energy sources given the significant impact high energy prices have on many.

The nuclear option remains an alternative to a reliance on Russian gas.

This is despite gas replacing coal as an energy source, as it is significantly cleaner. Germany has raised the possibility of opening a debate on extending the life of its nuclear program, and other European countries are reconsidering nuclear. The adage “, yes, but not in my backyard” remains, as do nuclear waste disposal issues. Much will depend on how attitudes develop on these two issues, but nuclear should be part of the conversation.

Politics matters.

High pump prices, rising inflation and slowing growth are not good for any reelection campaign, and the French elections and US midterms are just around the corner. High energy prices carry social and economic externalities, so we expect to see a concerted effort by policymakers globally to try to reduce the pressure on energy prices by reducing fuel taxes and introducing temporary subsidies.

Longer-term, higher prices may be sustainable at current levels.

Energy prices are likely to remain volatile due to the current uncertainty. Structurally, supply issues and a lack of ready capacity will likely keep oil prices significantly more elevated than we have become accustomed to. We anticipate demand to be curtailed by shifting consumption patterns, leading to slower economic growth as high energy prices crowd out other productive parts of the economy. The industry has a saying: “The best cure for high prices is high prices,” and longer term, additional supply will come online and supply lines will adapt to the new world order.

Important Notes The views expressed are those of the author(s) and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading intent on behalf of any MFS investment product. No forecasts can be guaranteed.