War in Ukraine Helps Fuel Global Battles Over Oil and Gas
COVID-19. Russian aggression in Ukraine. Surging oil prices and increasing demand. Inflation. Crises appear to have piled up over the last couple of years, and it is difficult to know where to lay blame or find solutions. A seemingly unending cycle of disasters has left investors, consumers, manufacturers, and farmers with similar financial stressors and worries.
A spike in oil prices to more than $130 per barrel and renewed supply chain disruptions leave consumers and politicians around the world wondering whom to blame. The answer is… it’s complicated.
All Roads Lead to Oil and Gas
In 2020, worldwide oil demand fell rapidly as governments closed businesses and restricted travel due to the COVID-19 pandemic. As nations emerged from lockdowns and news spread about multiple vaccines, a global economic recovery was in sight. Unfortunately, the pandemic has been a roller coaster, where an economic relapse closely followed any moments of recovery.
Although 2021’s economic growth was the strongest it had been in decades, it fell short of what economists hoped for. Variants of the virus sparked an increase in illness and hospitalizations, keeping people indoors longer than anticipated. A return to normalcy was delayed, and repeatedly. global recovery seemed less attainable as individuals and industries struggled to cope with the new normal.
The global pandemic has affected economies on a global scale, and the Oil and Gas industry is no exception.
Oil accounts for nearly 3% of Gross domestic product (GDP) on average globally –andit is one of the most needed commodities in the world. Petroleum products can be found in everything from personal protective equipment toplastics, chemicals, fertilizers, aspirin, clothing, and fuel for transportation. Libya’s revenue from oil equaled 43.89% of its GDP in 2019. Oil represented 9.16% of Russia’s GDP. And in the United States (U.S.), oil revenue was just 0.36% of its GDP.
Oil and Gas Industry Basics
Petroleum (oil) and natural gas are limited commodities formed from tiny plants and algae that settled in seas or lakes millions of years ago. The oil and gas industry is broken down into three segments: upstream, midstream, and downstream.
- Upstream, or exploration and production (E&P) companies, find reservoirs and drill oil and gas wells.
- Midstream companies are responsible for transportation from the wells to refineries.
- Downstream companies are responsible for refining and the sale of finished products.
- Drilling companies contract their services to E&P companies to extract oil and gas.
- Well-servicing companies conduct related construction and maintenance activities on well sites.
- West Texas Intermediate, commonly known as WTI, is the benchmark crude for North America. Brent crude oil futures trade on the Intercontinental Exchange (ICE).
- E&P companies measure oil production in barrels. One barrel, usually abbreviated as bbl, is equal to 42 U.S. gallons.
- Natural gas production is described in terms of cubic feet.
More about the industry: U.S. Library of Congress
Why Are Oil Prices Rising?
Inflation had already been rising before the war in Ukraine began with the Russian invasion in February 2022, pushing up prices for food, gasoline, shelter, automobiles, and a wide range of basic consumer goods and imports. The outbreak of the war reduced the global supply of crude oil, wheat, minerals, and other key exports from both Russia and Ukraine. Severe sanctions have imposed enormous costs on Russia’s economy in response to Putin’s decision to invade Ukraine.
“Prior to Russia’s aggression, oil prices were headed lower and overall inflation was peaking as pandemic-scrambled supply chains were slowly, but steadily, sorting themselves out,” said Mark Zandi, chief economist at Moody’s Analytics. But, with oil prices up and other commodity prices increasing, inflation is accelerating at an alarming pace.
U.S. President Joe Biden banned Russian oil imports on March 8, 2022, in response to Russia’s invasion. The move pushed gasoline prices to new highs, but according to polls, 71% of Americans said they were willing to support a ban on Russian oil even if it resulted in higher gas prices.
Every time Americans stop to fill up their gas tanks, it becomes clear that rising costs create more problems than solutions. With the most expensive cost of living in recent history, consumers must decide how much they can afford to spend on necessities like oil. Recently, consumers have been interviewed at gas stations and have shared that their financial concerns at the pumps would be a temporary hardship compared to violence against civilians in Ukraine. Paying the price for oil consumption may pale by comparison.
Any products dependent on transportation and the global supply chain cost more to produce and introduce to market. U.S. gas price hikes received significant publicity on the way up. By mid-April, the national average price for a gallon of gas was down to $4.10. According to Consumer Reports, that means that a Toyota Tundra, with a 32.2-gallon tank, would still cost more than $132 to fill up from empty.
Gas prices are one thing, but most Americans are feeling a pinch almost everywhere they spend money. Food prices rose 8.8% in the 12 months leading to March 2022.
Data released by the U.S. Labor Department in mid-April 2022 found that consumer prices climbed 1.2% in March and 8.5%annually. The yearly increase marks the highest seen in roughly four decades, as the Russian-Ukraine war exacerbates the nation’s inflation problem.
Energy prices increased by 11%last month, with gasoline prices seeing a sharp 18.3%increase in March, after seeing a 6.6%increase the month before – a jump economists have also credited largely to Russia’s invasion of Ukraine in February 2022 and sanctions imposed on Moscow.
“We’ve definitely been talking about gasoline inflation over the last year. But what happened as a result of the invasion, it just took it to a new level of awful,” said Wendy Edelberg, director of The Hamilton Project and a senior economic studies fellow at the Brookings Institution.
In its consumer price index (CPI), the Labor Department said gasoline prices made up more than half of all monthly increases.
The Global Oil and Gas Chess Board
President Biden’s ban on importing Russian oil and other petroleum products represents about 8% of U.S.-bound crude shipments. In the wake of Biden’s decision, global energy giants also announced cutting ties with Russia.
Divestiture by major international oil companies will potentially forge significant changes in the West’s energy relationship with Russia. Shell, BP, and Exxon all pulled out of Russian energy deals in March 2022. Within just a few weeks, Shell announced that its decision to pull out of Russia had already cost the company roughly $5 billion in reduced value of Russian assets and credit losses.
“The Russia-Ukraine crisis significantly changed global oil supply forecasts, a key input into how oil is priced globally,” said David Bahnsen, chief investment officer at The Bahnsen Group, a wealth management firm based in Newport Beach, Calif.
Ties between China and the West have long been strained over trade and human rights issues. Moreover, those tensions have grown following Russia’s invasion of Ukraine, which China has refused to condemn.
In mid-April, China's top offshore oil and gas producer CNOOC Ltd. prepared to exit operations in Britain, Canada, and the United States. CNOOC is the largest producer of offshore crude oil and natural gas in China and one of the largest independent oil and gas exploration and production companies in the world. Leaving Britain, Canada, and the United States was reportedly a result of concerns that their assets could become subject to Western sanctions.
This CNOOC announcement came one week after the United States said that China could face consequences if it helped Russia to evade Western sanctions.
Yet, as many Western buyers shun Russian oil, gas, and coal, Russian President Vladimir Putin said Moscow will find new customers for its energy products both domestically and overseas.
European Dependency on Russian Energy
According to the European Union’s statistics office Eurostat, the EU relied on Russia for 26% of its crude oil imports, which met 37% of the EU energy needs in 2020.
Since the Russian war in Ukraine started at the end of February 2022, Europe has been hesitant to slap embargoes on Russian energy. Following scenes of atrocities in Ukraine, the European Union adopted a ban on importing Russian coal. But its high dependency on Russian oil and gas has kept the EU members from agreeing on imposing embargoes on oil or gas.
In a speech to the European Commission, President Ursula von der Leyen explained the importance of using oil and gas as a tool to energize peace in Ukraine.
“We have to look into oil, and we will have to look into the revenues that Russia gets from fossil fuels. And we really have to make an effort, for example, to take a share to an escrow account, so that we will really limit the source of revenues of Russia from fossil fuels. This has to end, and this is the next step we will have to take together.”
What Determines Global Oil Prices?
But what about not in times of war?
Like most commodities, crude oil prices are determined by global supply and demand. The price of oil as we know it is actually set in the oil futures market by hedgers or speculators. Speculators bet on price moves. Hedgers limit risk in the production or consumption of oil.
An example of a hedger in the oil industry would be an airline buying oil futures to guard against potential rising prices. The largest operating cost for airlines is typically fuel expenses. In its early days, Southwest Airlines famously expanded routes and raked in profits after setting up a state-of-the-art jet-fuel-hedging program. The move saved Southwest $43.1 million in the third quarter of 2000 alone.
Economic Growth Drives Demand
The world may be less dependent on oil than it was during the energy crisis of the 1970s, but the Ukraine conflict shows us that the world economies still run on fossil fuel consumption and it can still disrupt economies.
The Organization of the Petroleum Exporting Countries (OPEC) can significantly influence oil prices by setting production targets for its members. OPEC includes countries with some of the world's largest oil reserves. At the beginning of 2020, OPEC members controlled about 71% of total world-proved crude oil reserves (plus lease condensate), and they accounted for 36% of total world crude oil production in 2020, according to the U.S. Energy Information Administration.
OPEC attempts to manage oil production of its member countries by setting crude oil production targets, or quotas. Compliance of OPEC members with OPEC quotas is mixed because production decisions are ultimately in the hands of the individual members. Demand is not always met with increased supply.
In general, the main factors determining OPEC's effectiveness in influencing oil prices include:
- The extent to which OPEC members actually comply with production quotas
- The ability or willingness of consumers to reduce petroleum consumption
- The competitiveness of non-OPEC producers when oil prices change
- The efficiency of OPEC producers to supply oil compared with non-OPEC producers
Outlook From U.S. CEOs
The Business Roundtable, an association of U.S. CEOs, concluded that continued risk from COVID-19 and rising inflation will create a period of uncertainty as they look toward the final months of 2022.
A few months ago, optimism among American CEOs hit the highest level in 20 years. But given stubbornly high inflation, Russia's invasion of Ukraine and a COVID wave in Europe, that sunny outlook dimmed quickly. The overall CEO Economic Outlook Index declined 9 points from the previous quarter but remained well above its long-run average.
Joshua Bolten, Business Roundtable CEO, commended efforts by the Biden Administration’s support of a ban on Russian oil imports while stressing the importance of U.S. efforts to increase its energy independence.
Russia's war tactics seem positioned to enter a potentially more brutal and focused phase in the Eastern Ukraine as fighting shifts away from Ukraine's capital of Kyiv and into its industrial heartland, into what's being called the Battle of Donbas. The Kremlin and Putin are expected to shift fighting toward Ukraine's industrial hub in the Donbas and Donetsk regions that touch the Russian border. And Putin is angered by discussions about Sweden and Finland joining NATO.
It will be interesting to see what America’s CEOs are thinking toward the end of the year.
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