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Ukraine crisis as likely to result in lower as higher oil prices

London, 19 March 2014

Concerns about potential disruption to Russian energy exports initially caused oil and natural gas prices to rise as the crisis in Ukraine unfolded, and they may yet do so again. But global energy prices could eventually end up lower than otherwise if tensions escalate, according to Julian Jessop Chief Global Economist at Capital Economics. Indeed, the balance of power increasingly favours the West over Russia in the energy sector, just as it long has in finance.

In short, Russia is of course a major producer and exporter of both oil and natural gas. Russia exports more than 7 million barrels per day (bpd) of oil and oil products (fuel oil and diesel), representing around 8% of global consumption. The vast majority is sold to the EU, mainly Germany, the Netherlands and Poland, making Russia the dominant supplier to these countries.

"What’s more," confirms Jessop, "according to the US Energy Information Administration (EIA), Russia supplied around 30% of Europe’s natural gas in 2013, with a little over half of this (around 16% of Europe’s total consumption) passing though Ukraine. The major customers here are Germany, Turkey and Italy. Note also that Russia has already threatened to cut supply to Ukrainian customers, which might force Ukraine to siphon off gas that would otherwise have been shipped on to Europe.

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"Nonetheless, there are several factors that should limit the upside for energy prices in the near term, and might even increase the downside risks on a longer horizon. For a start, despite threats from some officials in Moscow, Russia seems unlikely to take the first steps in restricting the flow of energy to the West. This could simply backfire by further damaging the country’s reputation as a business partner and prompting EU customers to seek more secure supplies elsewhere. What’s more, Russia badly needs the revenues and may actually have to cut prices to increase sales to other markets (notably China)."

The West is reluctant to impose economic sanctions that would target Russia’s energy exports, given the understandable nervousness of EU customers, notably Germany. "But if the West did go down this route, the US and EU would presumably announce additional measures at the same time to limit the impact on aggregate supply and prices, including releases from strategic reserves," Jessop concludes.

"Indeed, some commentators have already argued that the US should pre-emptively sell a large amount of its Strategic Petroleum Reserve (SPR) to reduce global oil prices and undermine Russia’s economy. To be clear, we think this is unlikely to happen, partly because of the collateral damage to other (more friendly) oil producers. The market impact would also be too uncertain. Oil prices were actually higher a month after the release of 60m barrels coordinated by the International Energy Agency in June 2011, including 30m from the SPR, to offset the loss of Libyan supply. Nonetheless, prices would probably have been even higher if that release had not taken place. The revolution in US energy production also means that the SPR could now be reduced further without compromising the security of supply."

Even if the US is unwilling to launch an all-out pre-emptive strike, this month’s test sale of 5m barrels from the SPR (out of a total of 696m) can clearly be seen as a warning shot against any attempt by Russia to restrict supply. Russia would almost certainly come off worse in any exchange of tit-for-tat measures in the oil market, just as she would in the financial sphere.

"This still leaves the possibility of mischief or accidental/conflict damage to Ukraine’s gas pipeline infrastructure. However, the risks here are smaller than in the past. As much as 80% of Russian natural gas exports to Europe used to transit Ukraine. But this figure has now fallen to 50-60% since the Nord Stream pipeline (direct to Germany) became operational in 2011. Seasonal demand is also set to decline as the warmer summer months approach. The unusually mild winter means that European reserves of natural gas are already relatively high: the EIA estimates that natural gas storage levels were 46% full in Europe earlier this month, compared to 23% in the US.

"Overall, despite the possibility of further volatility in the coming weeks, we continue to expect the price of a barrel of Brent crude to end the year below $100. Indeed, the Ukraine crisis may add to the downward pressures by accelerating the permanent drawdown of strategic reserves and by hastening the development of alternative sources of energy for Europe, including increased imports from the US, confirms Jessop.

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Julian Jessop is Chief Global Economist at Capital Economics.