High Fluctuations

In 2022, we witnessed an unprecedented wave of government interventions by Western countries in the energy market and specifically the oil market, the root of which can be seen as prioritizing energy security and affordability compared to other goals such as sustainability. The aforementioned shocks, along with increasing uncertainty regarding the future of the oil market in 2022, caused oil prices to experience significant fluctuations.

The price of Brent varied within the range of $76 to $133 per barrel in 2022, and the difference between the price of Brent light oil and the heavy crude oil of the Dubai index increased to $17 a barrel. In addition, the oil market in 2022 was mostly in a very deep backwardation situation, which reflected the expectation of a severe supply shortage for market participants.

However, in the last months of the year, especially in December, the oil market returned to the contango situation, which indicates that traders expect the oil market to face an oversupply in the short term. Another significant consequence of the big shocks of 2022 in the oil market has been the sharp increase in the price of petroleum products, especially diesel. Diesel refining margin reached $75 per barrel in October. Of course, in Northwest Europe and American markets, it exceeded the $80 dollar in the same period.

But despite these extreme and unprecedented fluctuations in prices, the global oil market quickly adjusted against these shocks and the oil supply did not undergo much change. Even surprisingly, in 2022, the oil market faced an oversupply of 470 tb/d. This is despite the fact that in the previous year there was a supply shortage of 2.3 mb/d. The complete cancellation of the OPEC+ oil production reduction program, the release of strategic oil reserves in consumer countries, especially the United States, and the ability of Russia to replace new customers for crude oil and oil products in Asia instead of Europe made it possible to not see oil supply restrictions in 2022. In the meantime, the relative weakness of oil demand in 2022 is also the reason for the oil market to be in a balanced state last year.

Although from the point of view of the balance of global supply and demand, the oil market is in a proper condition and has resisted the mentioned big and deep shocks, but it should be noted that this resilience resistance was not without cost. The oil market has undergone fundamental changes in 2022, which has an important impact on its analyses and forecasts in 2023.

The present piece of writing is aimed at briefly reviewing the most important fundamental developments in the oil market following the shocks created in 2022.

Trade pattern Shift

Undoubtedly, the most important evolution of the oil market could be seen in the shift in the pattern of oil trade, especially from Russia to Europe. Crude oil imports via EU marine routes from Russia fell from 1.8 mb/d in January and February (before the Ukraine war) to 180 kb/d in December. The decline in imports of petroleum products from Europe was more limited, falling from 1.6 mb/d in January and February 2022 (before the Ukraine war) to 1.15 mb/d in December 2022. In contrast, the import of Russian crude oil by India, China and Turkey increased from 1.1 mb/d in January and February last year to 1.4 mb/d in December.

Europe has also increased the purchase of crude oil from the Middle East, North Africa and America to replace the import of Russian crude oil. According to statistics published by Kpler, the volume of EU imports from these three sources increased by approximately 830 tb/d between January and December 2022. Of course, it should be noted that a part (340 tb/d) of Europe's crude oil consumption is supplied internally through the North Sea.

Another important point that should be noted is the dependence of European refineries on medium and sour Ural crude oil as feed, which has traditionally been used as an index crude oil for years and is not compatible with the light and sweet crude oil of America and North Africa. To overcome this challenge, European refiners used to blend Iraqi sour crude oil with American light crude oil in order to reach crude oil of the same quality as Urals as feedstock.

It is noteworthy that Europe has increased the import of petroleum products, especially diesel and jet fuel from the Middle East, India, China and the United States in from January to December 2022 by about 650 tb/d. Therefore, it could be seen that in a short period of time, we have witnessed a great paradigm shift in the oil trade in the world.

Market Fragmentation

The COVID-19 pandemic in 2020 initially caused oil market actors to focus on supply disruptions in the global oil supply chain rather than focusing on the price and cost of purchase, but with the recent geopolitical events and especially the tension in Ukraine, the dimensions of this issue have expanded. Managers of large oil trading companies such as Trafigura have announced that buyers are now asking oil trading companies more questions, which are more related to the source of oil supply.

Buyers want to know who produces the oil, or through which route and supply chain the crude oil is shipped to them, prior to paying for the cargo, how much carbon emissions it causes and how and when it would reach them. After they get clear answers to these questions, they ask about prices.

The extreme divergence of the price of sanctioned crude oil compared to the other crude oil prices following the recent developments indicates a decrease in the efficiency of the global oil market system and the weakening of its integrity, which is known as the partitioning of the oil market.

In the current situation, commercial transactions with crude oil trading companies are also affected by this issue, and these companies require that the leased tankers have not transported crude oil cargoes originating in Russia for a certain period of time in order to trade crude oil. Even exchanges such as ICE London have banned the trading of Russian diesel.

Senior managers and experts of commodity trading companies believe that the efficient global system and the integrated and global supply chain of oil will not return to the previous situation even if the war in Ukraine ends in the near future. On the other hand, regionalization of oil trade and development of non-integrated parallel supply chains are expected to increase in different regions of the world. In fact, we are moving towards a new oil business model in the oil market, where buyers of crude oil prefer security of supply sources and route over efficiency and cost of crude commodities.

Pricing Discovery Disruption

The removal of Russian Ural crude oil from the European market has disrupted the sour crude oil pricing discovery process in the world and reduced the efficiency of interregional arbitrages. The pivotal role of the Ural as the main benchmark of the pricing of sour crude oil exported to Europe has ended. For decades, the Ural has been the most important baseload crude oil feedstock for European refineries and has been freely traded on European cash markets. In addition, many producers in the Middle East used Ural crude oil in the methodology of announcing official selling prices (OSP) for their crude oil exports to Europe. Now, in the situation that the Ural crude oil does not reflect the European refining economy, the crude oil price discovery process in the world has been disrupted, especially for medium and sour crude oils.

Low Transparency

The transparent trading of Russian crude oil and petroleum products has become extremely gloomy in the aftermath of the tension in Ukraine. Russian oil sellers are trying to circumvent EU and US sanctions for financing, insurance and shipping. Evidence of Russia's opaque dealings abounds. The price of Ural oil is no longer officially announced. In addition, Russia relies on a fleet of so-called shadow or dark tankers, whose mobility is very challenging to track using conventional means, to divert shipments of crude oil and petroleum products and avoid insurance and shipping restrictions.

In addition, most Western oil trading companies such as Vitol, Trafigura and Gunvor are not willing to trade Russian oil and oil products due to the imposed sanctions. Therefore, new companies such as Bellatrix, Sunrise and Coral Energy have replaced them in the market, whose activities are outside Group-7 countries and whose task is to sell Russian oil. These institutions, which have no credit history or experience in oil business, and there is no information about the details of their performance, even their personnel and employees are changed regularly so that there is no information leakage. It seems that these companies will play an important role in the oil business in 2023. They create new supply chains and infrastructure and open up new trade routes for Russian oil, while there is no information about them.

Non-Dollar Transactions

Due to the increase in Chinese and Indian crude oil imports from Russia, the share of oil trade with non-dollar currencies is increasing, and there is a great demand from these countries to buy oil based on national currencies such as the yuan and the rupee. In a recent meeting in Saudi Arabia, the president of China called for yuan-denominated oil and gas trade. The Reserve Bank of India has also implemented a trading mechanism for the Russian crude oil trading in rupees.

Of course, it should be noted that this process of replacing the US dollar in the trade of crude oil and petroleum products does not have a good momentum, and so far none of the Persian Gulf countries have committed to selling crude oil based on the yuan. The mechanism of the Indians to buy Russian crude oil in rupees is not operational yet and the cost of buying Russian crude oil is settled in dollars.

Market Monopsony

Even though Russia has succeeded in changing the route of its oil shipments, the country's customer base has greatly decreased and it has become highly dependent on a few countries such as China, India and Turkey. Except for Turkey and several European countries that have been exempted from crude oil sanctions against Russia, most of Russia's customers are located east of Suez, and in this region, about 90% of Russia's exports to China and India take place. Therefore, these two countries have a lot of market and bargaining power against Russia. In addition, shipments of Russian crude oil and petroleum products will have to travel longer distances than in the past, so the Russians will be forced to offer more discounts despite higher shipping and insurance costs, which will further limit their profits or rents and negatively impact their oil income.

Russian Weak Position in OPEC+

Russia is unlikely to be able to maintain its current production capacity under the current sanctions and without access to Western companies and quality equipment. Therefore, it is very likely that Russian oil production will decrease over time.

According  to Energy Intelligence, Russian oil companies were able to boost their output by supplying 10.9 mb/d of crude oil and gas condensate in December 2022, 150 tb/d higher than the 2022 average output. However, due to the reduction of Russian crude oil exports in December to 4.1 mb/d and the slight increase of 100 tb/d in refining capacity, a significant part of the production has been transferred to storage sites.

But Russia does not have extensive infrastructure to store this amount of crude oil, so the country's oil production is forecast to decrease in 2023. In this regard, Alexander Novak announced last month that the country's crude oil production will decline between 500 tb/d and 700 tb/d, most of which hitting the refining and feedstock sectors.

Russia's crude oil production in December 2022 was lower than the quota set for this country and even lower than the base production level. However, one of the consequences of this event could be the weakening of this country's position within OPEC+, especially when other members of this alliance, such as Saudi Arabia and the United Arab Emirates, have ambitious plans to increase production capacity and potential exports.

Government Intervention

One of the key features of the oil market in 2022 is the reaction of the consumer countries ‘ governments to the war in Ukraine. These interventions were in various forms, such as bailout packages for consumers, price and income caps, windfall taxes, and finally imposing sanctions on energy imports from Russia. But in the oil market, the most important government interventions are the release of strategic reserves and the imposition of a price cap on the import of Russian crude oil and oil products.

The US’s use of strategic storage as a tool to manage the oil market cap has been one of the most important government measures to control the market in 2022. Last year, the United States supplied about 221 million barrels of crude oil on the market, although Russia's oil production has also had a very limited downward trend compared to 2021.

But the issue is beyond these, in fact, by releasing SPR, the Energy Information Administration (EIA) sent the signal to the market that intends to set the maximum and minimum limits of oil prices in the market and manage expectations in the oil market through this channel. It seems that the United States intends to continue this policy in 2023 and the interesting thing is that the American government has plans to repurchase crude oil and fill its strategic reserves so that while guaranteeing the demand for its oil industry, it will keep US oil prices within the range of $67-72 per barrel. Therefore, this key component should be also considered in the analysis of the oil market in 2023.

Another government intervention of the consuming countries in the oil market is the application of a price cap by G7 on the import of Russian crude oil and oil products to non-European destinations. This measure has been adopted with the aim of avoiding the formation of an oil supply shock and at the same time controlling the oil revenues of the Russian government. Although the operational dimensions of this policy are very vague and have confused oil market participants, it seems to be one of the most important factors influencing the status of the oil market in 2023.

The Russian government's policy towards oil trade is different from gas; because the retaliatory action to reduce oil production will harm Russia's important commercial oil partners, namely India and China, which are the world's largest oil importers, and will cause these countries to favor Russia's competitors in the oil market, namely the countries of the Middle East. Therefore, in response to these interventionist policies of Western countries, Russia is trying to continue its oil trade through financial and physical channels independent of the West. This can be costly for the oil market during the transition to the new order, but ultimately it will create a new and more decentralized model of the oil market.

In conclusion, it should be mentioned that the oil market is a global and mature market with financial and physical layers intertwined and numerous players in the supply and demand sector, which has faced various impulses during the past decades. But the year 2022 could be considered a turning point in this market because the shocks which hit oil market have been completely different in nature and the oil market has not displayed enough resilience to government interventions, and this issue could be added to the layers of uncertainty in this market.

The effort to develop solutions to bypass the banking and international payment system and crack the hegemony of the dollar in the financial markets, along with the development of insurance systems and parallel and independent supply chains from Western countries, shows the unity and firmer determination of non-Western countries to reduce dependence on Western energy infrastructure.

It is noteworthy that the interventionist actions of Western countries could be also a warning for OPEC countries because by applying these policies, Western countries have warned oil exporting countries that, contrary to their apparent support for international free trade, they are ready to jeopardize the oil trade of oil and gas exporting countries by following protectionist and interventionist measures justified in the context of escalating geopolitical tensions. In any case, logic dictates that major OPEC member countries take this warning of western countries seriously and invest and cooperate more for the development of parallel energy supply chains and a decentralized financial system.

Courtesy of Iran Petroleum

Negar Sadeghi