Beware of Russian Shut-Ins: Why The Trajectory Of Global Oil Supply Remains Fragile

This is meant to be a quick "micropost" and may be light on linking & original charts

I was recently quoted saying that oil prices surging past $150 was "not implausible" in 2022. The reasons for my concern remains, but through delivering greater demand certainty and financing certainty, the White House can blunt that risk.

Less than two weeks ago, the White House announced the release of over a million barrels per day of crude oil from the Strategic Petroleum Reserve. Alongside aggressive lockdown policies in China, the announced release has helped deliver some short-run stability to oil prices and flatten an otherwise steep crude oil futures curve. The premium associated with acquiring oil in spot markets has diminished relative to forward prices. On that narrow barometer, the release has proven to be helpful and effective.

We conditionally applauded the action, both because of the short-term relief to spot prices and because the administration was signaling that it would to refill the SPR through accelerated domestic production. The administration may still announce steps to incentivize and accelerate investment in future production, but thus far, we have no indication of a forthcoming plan (see here for EA's suggested structure for a plan, which centers around delivering demand certainty and financing certainty for domestic E&Ps in exchange for accelerated investment).

The problem with not having a public plan to accelerate investment: Russia may have to start meaningfully shutting-in production soon. The risk of this occurring helped drive crude oil prices (Brent) above $130 in early March. While commodity prices are similar to other financial assets in that they are partially forward-looking, commodities are also unique in terms of how spot markets must clear. To abstract and simplify:

1. Current consumption must be sourced from current production or currently available inventory (if inventory is even available!)
2. Current production must be used for current consumption or fill up spare storage capacity (if spare storage capacity exists!)

For most other financial assets, inventory and storage considerations are trivial. For major commodities (like crude oil), these considerations can make or break spot prices. For Russia, finding spare storage capacity is now an ongoing challenge, especially as the set of willing buyers dwindles and their available storage is exhausted. There are already reports trickling in that Russia is running low on available domestic storage. And that constraint is also being reflected in the discount that Russian oil must take to find a home.

Russian "Urals" crude oil is not earning the standard benchmark prices for oil (West Texas Intermediate, Brent Forties). Urals is valued at a $25 discount relative to Brent, when the normal discount is less than $3. Russian crude is thus selling for about $80/barrel, not the more widely cited $95-$110 crude oil price range.

The White House is actively trying to make it harder for Russian crude to find a home, but should they succeed, Russian crude will be sufficiently discounted to make some production uneconomical. Shut-ins will be the inevitable outcome in that scenario. Lost Russian supply will translate into systematically higher crude oil prices in the absence of a countervailing increase in oil production elsewhere. Outside of OPEC—which has thus far proven to be less than cooperative—the US has the greatest potential to ramp up production in a reasonably short period of time.

While the SPR release helps in a counterfactual sense—current supplies would otherwise be more scarce and set off bigger oil price spikes—it is a short-term and incomplete solution. If the White House wants to tame rampant oil price volatility, accelerating US investment in short-cycle production has to be part of the solution. The White House has the discretionary authorities—through the SPR and the ESF—to deliver precisely that outcome. If domestic E&Ps continue their (understandably rational) reluctance to accelerate investment and production, the current supply fragilities will remain long after the SPR release exhausts itself. The clock is ticking.