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The oil saga continues

The swings in oil prices – despite pulling back from recent highs not seen since 2008 – speak to some of the fallout from the Russia-Ukraine war. But without a peace treaty in sight, the story of what’s happening with oil (and other commodities) is far from over, as James Robertson explains.
Published 23 March
9½ mins

New sanctions continue to be drawn up by governments on almost a daily basis against Russian entities, Kremlin-favoured firms and oligarchs. Other firms are choosing to pull out of the Russian market of their own accord, fearful of the reputational fallout if they are seen to be funding the continued conflict.

It’s a tally that, according to the Yale School of Management’s list, now totals over 400 firms. More still (such as Burger King and Subway) would like to pull out, but are unable to do so because their franchise owners have refused to cease operations.

One industry, however, that remains relatively untouched is that of fossil fuels. Aside from Australia, Canada, the UK and US – with Canada and the UK setting the end of the year as their deadline – the rest of the world’s politicians have so far balked at sanctioning Russia’s oil exports – even if it is under debate, as with the EU. India, by contrast, has used the crisis to buy extra oil from Russia.

The decisions to keep the sales of ‘black gold’ flowing are being made in the full knowledge of the atrocities in Ukraine and that Russia’s aggressive actions will be funded – albeit partially – by the US$1.1 billion the Brussels-based think tank Bruegel believes is received on a daily basis by Russia in oil and gas receipts from the EU alone.

In total, it’s thought that oil and gas revenues can provide over 40% of the Russian government’s budget – income that’s increasingly needed given the cessation of other trade.

But even though many think we should terminate all of the oil trade, the complexities following a decision go far beyond leaving voters’ homes unheated, pump prices spiralling and rolling blackouts impacting industry.

Why is oil so important?

Oil is integral to economies – many of which were only just beginning to climb out of the financial pits caused by COVID-19 – given it’s needed to power factories and is a key ingredient in swathes of products. A 2015 EU study showed that if oil prices decreased by 50%, up to three million additional jobs would be generated in the economic region. At the time that was 1.3% of the total labour force.

High oil prices are bad for consumers too. Whether filling up our cars, cooking with gas, decorating our homes or buying household goods, the price of oil can have a dramatic effect on the day-to-day cost of living. Without central heating, cold weather could lead to deaths due to the risk of increased blood pressure it causes. Many UK homes may turn to using their wood-burning stoves more, despite knowing they are the biggest source of fine particulate pollution (38%) for the country.

Perhaps more worryingly still for those in charge is that high oil prices could lead to civil unrest, as we saw in 2018 when the French gilets jaunes cited the cost of petrol as the initial reason for their protests.

But even though Russia delivers an estimated 10% of the world’s oil production, why can’t we switch to other supplies? To do so would require some significant challenges to be overcome.

Processing needs

One such hurdle was highlighted by the US announcement to switch off its Russian oil supplies. While many may have deemed this to be a relatively easy decision given it ‘only’ makes up 8% of its imports and the country produces the most oil of any nation, the complexities here lie in the makeup of Russian oil, which is one that suits US refineries.

It transpires there is no one type of oil despite it all being derived from dead ocean bugs. Oil can be sour or sweet depending on how much sulphur is in the crude. It can also be heavy or light in density. While we talk about oil and gas markets, they are technically the same stuff, albeit with different densities of hydrocarbons. At the lightest end of the range, for example, is gas methane, which has just four hydrogen atoms bound to each carbon atom.

Processed by refineries, which ‘hit’ its chains of hydrocarbons with chemicals and heat over and over again – particularly for heavy oil – until the fuel becomes more usable, a country’s oil usage isn’t just down to what is drilled locally or imported, but also how its refineries work.

And America’s 129 refineries excel at converting heavy, sulphur-filled fuel into usable mid-grade products. With a long history of processing Canada’s western tar sands, Russian oil proved useful as it is similarly dirty and sour. The need to continue to find suppliers for sludgy oil to process may also explain the alacrity to restart talks with Venezuela, which is similar again.

Political compromises

Another challenge is that although it would be difficult to make up all of a future shortfall from Russia, it is not impossible to bring currently unused sources back online. If Iran and Venezuela were both able to sell oil on the global market again, they could make up as much as half of Russia’s production. But neither of these nations are naturally seen as solid trading partners.

In Venezuela, sanctions were first put in place in 2011 in response to the actions of an administration led first by Hugo Chaváz and then by his successor Nicolás Maduro. Measures have been widened over the years as the list of crimes against humanity grew, until, in 2019, oil sanctions were imposed. Maduro is widely blamed for the destruction of Venezuela’s democracy and economy, which has led to a fifth of the country’s population fleeing abroad.

Iran is also a problematic partner due to (among other issues) its insistence on continuing its uranium-enrichment activities. And although Iran recently started to convert up to a third of its weapons-grade uranium into material for medical purposes – which was seen as a “significant show of faith” – and Britain finally paid its multimillion pound tank bill, dating back to 1979, in “parallel” to the release of two dual nationality hostages, the nuclear negotiations (which would also result in oil sanctions being lifted) may hinge on Iran’s desire to see the US remove its terrorism designation of the Islamic Revolutionary Guard Corps – a powerful force also accused of a long list of human rights violations.

OPEC+ supply

Although OPEC+ had already started to grow output month by month from August 2021, the group’s production remains around 2.6 million barrels per day lower now than it would be by the end of September 2022 – its deadline for unwinding the supply cuts put in place as the pandemic depressed demand.

But the bloc faces other difficulties in raising production, not least as most of the OPEC+ countries don’t actually have the capacity to increase output meaningfully.

Among the nations that do is Saudi Arabia. And while the Saudis could help, they are reluctant to do so. The country needs the higher oil prices to support its economic programme and is likely to want to maintain a relationship with Russia, despite the war, in a bid to keep the broader OPEC+ alliance together. Meanwhile, the attacks on Sunday 20 March by Yemen’s Iran-backed Houthi rebels could spell a different set of issues for the country. If more attacks take place, and see the same level of damage that the 2019 strikes caused, half of Saudi Arabia’s total oil production could again be knocked out for a period.

Fluctuating demand

Last but not least, there is the complexity thrown up by a debate about whether as much ‘new’ oil really is needed. China’s “zero-covid” strategy and linked lockdowns suggest we may not need as much in the next few months. Demand could also be hit by rising interest rates which impact consumer spending. Meanwhile, others are questioning the focus on replacing fossil fuels with fossil fuels. Shouldn’t this spur us to invest in greener options – a sector already established with investors (as we know from the assets held in client portfolios) and also potentially less susceptible to the political challenges associated with the other options?

So what does all this mean?

Unlike the relatively clear set of stocks that benefitted from life under lockdown, an investor’s ability to understand the impact of the current conflict is hampered here. The concerns and consequences are not based on companies’ operations within Russia per se, or their cessation, but instead on the supply chains that extend beyond, as well as other knock-on effects.

In addition to oil, Russia and Ukraine are important suppliers of other commodities. Together they account for 26% of the world’s wheat exports, 16% of corn, 30% of barley and circa 80% of sunflower oil. Russia is also the world’s largest exporter of nickel, used in car batteries, and palladium, used in car exhaust systems, while Ukraine is home to half the world’s supply of neon, used in the production of semiconductor chips.

And although we really haven’t seen any consequences of the economic embargoes to date, rocketing electricity costs have already forced the hand of some businesses to cut output, such as several Spanish steelmakers. The loss of bundled electric wires led BMW and Volkswagen to cut European car production.

Tesla may be the ‘exception that proves the rule’ as it was able to pass on higher prices to consumers. Others may not. US food firms, for example, had already been pushing up prices to offset rising energy, ingredients and transport costs. Consumers will ultimately balk at yet more hikes given inflation has already hit a 40-year high.

Meanwhile, if the EU does impose sanctions on oil and Russia has to start to turn off its well taps, the future for oil could be even more uncertain given the move could limit the country’s long-term production levels. Closing off oil supplies is not a simple process and the specific skills needed to restart flows may not be available. The EU move could even permanently hurt Russia as the country might never be able to return to full capacity.

And while the true economic implications of these issues may take months to unfold, recessions could be triggered in the EU, UK and US sooner.

But, as we flagged almost a month ago in our first update on Ukraine, while it remains a cold comfort, we wanted to reiterate that you should remain invested.

As before, it is important to note that while many plans may falter due to the conflict, your wealth plans need not be among them.

Aside from the decades of time many of these plans will still benefit from, wealth plans are not just forged by investments alone. They are also driven by wealth planning decisions – which seek to structure your assets and support tax efficiency – and are supported by the expertise of individuals who are there to guide you through the many periods of uncertainty that will occur in the short term, but also in the medium and long term too.

Our investment team continues to fulfil its double mandate: reduce volatility and seek out emerging investment opportunities. Those most shielded from volatility are diversified investors, with portfolios spread across companies, industries and sectors, geographies, types of investment and currencies.

And if you are concerned, please get in touch. We are here to help and support you, and ensure you remain reassured of the robustness of your wealth plan.

Clients of Nedbank Private Wealth can get in touch with their private banker directly to understand how we manage money, or call +44 (0)1624 645000 to speak to our client services team.

If you would like to find out more about how we can help clients manage their investments, please contact us on the same number as above, or complete a form using the links towards the end of the page.

Sources: The Atlantic; Bloomberg; The Conversation; The Economist and Reuters.

Investments can go down, as well as up, to the extent that you might get back less than the total you originally invested. Exchange rates also impact the value of your investments. Past performance is no guide to future returns. Any individual investment or security mentioned may be included in clients’
portfolios. They are referred to for information only and are not intended as a recommendation, not least as they may not be suitable. You should always seek professional advice before making any investment decisions.

about the author

James Robertson

James Robertson

Based in our Isle of Man office, James is responsible for delivering the end-to-end investment management process, overseeing the implementation of the Nedbank Private Wealth house view within our discretionary managed portfolios, and for developing our investment proposition.

 

He has over 18 years’ investment experience and has been responsible for the Nedbank Private Wealth managed discretionary portfolios since 2007. James holds the Certificate in Investment Performance Measurement from the CFA Institute.

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