Oil Markets in 2023: The Year of the Aftershocks

Oil markets were subject to a series of large shocks in 2022. Russia’s invasion of Ukraine in late- February and the ensuing sanctions, embargoes, and the price cap on Russian oil imports; a coordinated response by oil-consuming nations (led by the US) to control prices by a massive release of strategic stocks; recessionary and inflationary pressures weighing on the global economy; China’s demand shocks from its strict zero-COVID policy; and the massive transformations in crude and products trade flows just to mention a few. Of course, oil markets are not unused to shocks – throughout the years they have been subject to both supply and demand shocks. But 2022 saw an increase in government intervention in global energy markets, including oil markets, as energy security and affordability concerns became key drivers of energy policy. Increased government interventions elevated key uncertainties which did not only impact physical markets, but also the oil futures markets, which in 2022 witnessed a decline in liquidity and open interest in both Brent and WTI as interest rates and the collateral required by major exchanges increased, raising the costs of using these markets for risk management and hedging and lowering participation rates.

These shocks and elevated uncertainties shaped balances and market expectations and these were in part reflected in some of the extreme price movements in 2022 (Figure 1). The daily Brent price ranged from $76/b to $133/b and averaged $99.8/b annually from $70.4/b in 2021 (see Figure 1A). The Brent- Dubai EFS spread fluctuated widely reaching $17/b on March 3, 2022, and ending the year at $5.8/b, and West African crude differentials spiked near $10/b mid-year before declining towards the end of the year (see Figure 1B). The time spreads for WTI and Brent also fluctuated with heavy backwardation in June/July easing into contango ending-2022. These were not only limited to crude. Products markets also experienced some extreme movements. Perhaps this is best illustrated in the diesel margins which in October reached a record level of $75/b and above $80/b in Northwest Europe (NWE) and the US, respectively, before easing (see Figure 1D).

That said, the global oil market adjusted relatively quickly to a series of shocks and physical supplies were little impacted. In fact, the market built a small surplus of around 470,000 b/d in 2022 following a -2.3 mb/d deficit in 2021. The unwinding of OPEC+ cuts, the release of oil from the SPR, the ability of Russia to redirect its exports away from Europe to other parts of the world which limited the losses in Russian supplies, and weak y/y demand growth particularly in Q3 and Q4 all contributed to a fairly balanced market in 2022.

The events that unfolded in 2022 have set the stage for another unpredictable year ahead. Figure 3 below shows the balance of risks surrounding our reference outlook for 2023 (in our reference case, Brent averages $92.7/b in 2023). Even in the bearish scenarios (e.g., deeper and prolonged recession, lower realization of Russian supply disruptions, stronger US production growth) the oil price remains supported at around $70/b as the low buffers in the system in the shape of low spare capacity and low commercial stocks keep prices supported in our outlook. The bullish scenarios in which prices move above $100/b capture a perfect storm where large supply disruptions from Russia amid heightened geopolitical risks elsewhere are confronted by a very mild economic recession and a strong rebound in China’s demand in the second half of 2023.

This Energy Comment highlights some of the key factors that shaped oil market dynamics in 2022 and how these factors are likely to play out in 2023.

The Russia-Ukraine war and its wider implications on the oil market

The Russian invasion of Ukraine has generated shock waves in global energy markets and energy relations, including the oil market. In terms of volume of oil supplies, the impact has been rather limited so far and much lower than initially expected. At the start of the Russia-Ukraine war in February 2022, Russian crude production fell by nearly 1 mb/d, but against most expectations, Russian production proved to be resilient, and output recovered quickly as Russian sellers were successful in finding new buyers outside the G7. The decline in Russian production (crude and condensates) has been limited with Russian output in December 2022 down by 230,000 b/d to 10.8 mb/d compared to its pre-war January and February (Jan/Feb) levels of around 11 mb/d (Figure 4), and crude exports falling below 3 mb/d for the first time in the year but averaging marginally higher in the period March and December at 3.4 mb/d compared to 3.3 mb/d pre-war.

Russian oil supplies will remain at the center stage in 2023 with the EU embargo on the imports of Russian crude and products coming in full force in 2023. Russian seaborne crude exports in December declined to their lowest level in the year (partly impacted by weather disruptions) but they have recovered in January. The full impact of the EU embargo and the price cap on Russia’s production and exports will not be fully understood at least until the end of Q1 2023 when the embargo on Russian products comes into effect on February 5. For 2023 as a whole, our scenarios assume that Russian supply losses will range between 700,000 b/d and 1.5 mb/d, with our reference case at 1.2 mb/d but as in 2022, Russian supply disruptions could prove to be smaller than even our lower range as Russian crude exports continue to flow to Asia.

But beyond the limited impact on supplies, oil markets have been subject to deep transformations which will only accelerate in 2023. These transformations have been reflected in a number of key areas:

§There has been a massive shift in oil trade flows with some of these shifts likely to prove long lasting (see Figure 5). EU-27 seaborne imports of Russian crude have fallen from 1.8 mb/d in Jan/Feb 2022 to 180,000 b/d in December. The decline in EU-27 imports of Russian products was less severe from 1.6 mb/d in Jan/Feb to just below 1 mb/d in Sep/Oct before rebounding to 1.15 mb/d year-end ahead of the upcoming EU ban in February. In contrast, India, China and Turkey’s imports of Russian crude (Russia’s top 3 main buyers) have increased from 1.1 mb/d in Jan/Feb 2022 to 2.4mb/d in December, up by nearly 1.3 mb/d. To fill the loss of Russian supplies, EU-27 crude imports from the US, the Middle East and West Africa were higher by 830,000 b/d in December compared to Jan/Feb, while another 340,000 b/d were sourced domestically from the North Sea. That said, replacing the medium sour Russian crude that has been the staple for European refiners in the past years with lighter and sweet grades from WAF and the US forced refiners to adjust their crude slates including, for instance, blending high sulphur Iraqi crudes with lighter US grades to create a synthetic Urals blend. EU-27 imports of products such as diesel/gasoil and jet/kero from the Middle East, India, China and the US have increased by 650,000 b/d in December 2022 compared to Jan/Feb levels. Taken together, this represents a massive reshuffling in oil trade flows and oil trading relationships within a very short period.

§Oil markets have become more segmented with wide divergence in the prices of sanctioned and non-sanctioned crudes. For instance, Urals have been trading at large discount in Asia impacting the pricing of other crudes destined to Asia including those from the Middle East. This also applies to products where Russian and non-Russian products cargoes are priced differently. So does the cost of storage, where storing Russian barrels now commands a premium in some storage hubs such as Fujairah, which is now becoming a major hub for Russian products (initially residual FO and increasingly now naphtha and gasoil; see Figure 6). This is also impacting commercial transactions with some crude trading firms requesting a proof that the hired tankers have not carried Russian-origin cargo for a specific period of time, as well as exchanges such as ICE who banned low-sulphur gasoil of Russian origin. This segmentation will intensify in 2023.

§The disappearance of Russian Urals in Europe also impaired the price discovery process for sour crudes reducing the efficiency of arbitrage between regions. Urals central role as a major marker for pricing sour crude exports into Europe has ended. For decades, Urals –a baseload for European refiners that freely traded in a transparent European spot market– was used by producers in the Middle East to price their exports to Europe accurately (and a key part of their OSP methodology). With Urals no longer reflecting the economics of European refining, this has impacted the price discovery process.

§To redirect its crude and products and to avoid the EU restrictions on insurance and shipping, Russia had to rely on its own fleet but also on ‘shadow’ and ‘dark’ fleet which meant that tracking trade flows has become increasingly challenging. Alongside the increased trade in sanctioned Iranian and Venezuelan crude and the increase in the use of diversion tactics to hide the origin of the crude such as ship-to-ship transfers and blending, oil trade flows have become less transparent. Also, most of the energy companies and traditional trading houses have ceased trading Russian crude and products. These have now been replaced by new entities that operate outside the G7 restrictions. These entities, with no credit history or trading experience, will play an increasingly important role in 2023, developing new supply chains, infrastructures, and trading routes for Russian oil with little information about their activities.

§As China and India continue to increase their imports of Russian crude, the share of oil trade conducted in currencies other than the US dollar is poised to rise and there will be increasing calls from these countries to conduct oil and gas trade in their local currencies. During his visit to Saudi Arabia, President Xi Jinping called for oil and gas to be traded in yuan. The Reserve Bank of India has devised a rupee trade mechanism for the purchase of Russian crude. However, the shift away from the US dollar is likely to be very slow. So far none of the gulf exporters have committed to selling oil to China in yuan. Also, the rupee trade mechanism has not gained much traction and payments for Russian imports are still made mainly in US dollars.

§Even though Russia has been successful in redirecting its oil flows, Russia has lost most of its customer base with the fate of its exports being very dependent on few countries (mainly China and India). Except for Turkey and some EU destinations exempted from the ban, buyers of Russian crude are now in the East of Suez. Within Asia, almost 90 per cent of Russia’s exports now go to these two countries (see Figure 7). This gives refineries in India and China huge market power. Also, the fact that Russian crude now must travel to further away places (with a major increase in ton-mile demand), pricing of crude should discount for the higher freight rates and insurance premiums.

§Russia is unlikely to maintain its current productive capacity in the face of current sanctions as it loses access to services of western companies and to high quality equipment. As a result, Russia’s production will most likely fall over time.

Among other things, this will impact Russia’s position within OPEC+ especially that other countries within the Group have ambitious plans to increase their productive capacity and export potential. In fact, in December 2022, Russia’s production was well below its quota and much lower than its baseline.

In short, although Russian production proved to be resilient and the oil market did not experience a large loss in supply so far and unlikely to experience a persistent supply shock as Russian sellers will eventually find a way around the current restrictions, the oil market has undergone some structural transformations in terms of shifts in trade flows, pricing, market segmentation, transparency, commercial and geopolitical relations, and Russia’s position in oil market.
Source: The Oxford Institute for Energy Studies