The soaring oil price has dominated headlines amid Russia’s invasion of Ukraine. Often less considered has been the conflict’s potential impact on oil in the medium term and if Western countries rethink energy policies as the international order is reshaped.
In March, Brent crude oil futures reached a 13-year high after momentarily topping $US130 a barrel in London. That’s almost double the price from a year before, and it’s expected to rise even further.
Some investment banks tipped oil prices above $US180 in a drawn-out conflict.
This came as the US and the UK banned imports of Russian oil, gas and coal. The energy supermajors – Shell, BP and ExxonMobil – exited their Russian operations as part of a broader exodus of Western companies from Russia.
On equity markets, the S&P Global 1200 Energy Sector Index, a barometer of 47 of the world’s largest energy companies, returned 42% in 2021. On a year-to-date basis, the index rose a staggering 22% to end-February 2022.
In Australia, Woodside Petroleum, the market’s largest oil stock, has a total return (including dividends) of 48% over 12 months, Morningstar data shows.
Investors who bet on oil equities in 2020 have benefited from the market’s best-performing sector. How long those gains will last is unclear. An escalating oil price is a huge tax on the global economy and a driver of higher inflation.
Inflation was a growing market concern before the Russia–Ukraine war. After decades of low inflation and falling government bond yields, markets became complacent about the risk of rising wage and input costs. Some economists argued that high inflation was a transitory response to supply-chain bottlenecks during the pandemic.
In January, US inflation was 7.5% – the highest in 40 years. Eurozone inflation that month was a record 5.8%.
In Australia, the average price for a litre of unleaded fuel in major cities has topped $2 in recent months. Higher fuel costs mean higher transport costs and rising prices for food and other products. Australian inflation will also climb.
Financial markets hate uncertainty, something Russian President Vladimir Putin has been providing in spades. By early March, Russia’s invasion had been less effective than the Kremlin anticipated because of effective Ukrainian resistance. Harsh economic sanctions and the promise of more to come inflamed Russia.
As pressure for a no-fly zone over Ukraine built, Russia warned of “terrible consequences” for its enemies. With talk of Poland supplying fighter jets to Ukraine, there was speculation that Russia could target Poland or other European countries.
As I write, it’s impossible to determine Putin’s endgame or how the invasion will play out. What seems clear is an elevated oil price for some time and possibly a higher oil price if the conflict is longer and more widespread than markets have priced in.
If that happens, energy-sector investors might take some profits. If the oil price rises too far, equity markets will react violently, fearful of an inflation crisis. A larger correction in global equity markets, including energy stocks, is possible.
In the short run, Australia’s economy will benefit from higher energy and commodity prices and the emergence of a commodities supercycle. But those gains may not last for long if high inflation forces some central banks to lift interest rates sooner and more aggressively than markets expect.
Energy-sector gyrations
Oil stocks have been a remarkable rollercoaster ride in recent years. The S&P 1200 Energy Index had drifted lower between 2014 and 2020, underperforming most sectors. Fossil-fuel producers lost favour as investors favoured clean-energy companies.
In March 2020, the index almost halved as markets feared the pandemic would spark global recession and sharply lower energy demand. At its 2020 low, the index traded below 200 points; it traded near 600 points in March 2022 as the oil price soared.
Key developments for oil occurred during this time. The first was the rise of institutional investors that use environmental, social and governance (ESG) factors in investment decisions. Pension funds and other institutions increasingly reduced their exposure to fossil-fuel sectors in response to climate-change risk.
The boom in shareholder activism accompanied this trend. In 2021, an activist hedge fund in the US successfully had three directors installed on ExxonMobil’s board. The tiny fund garnered the support of giant index funds that own more of Exxon’s stock.
Governments, too, have increased pressure on oil producers. The Hague District Court in the Netherlands last year ordered Shell to reduce its carbon dioxide emissions by 45% to 2030 (compared to 2019 levels).
Growing pressure from financial markets and governments will increase the cost of capital for supermajors and smaller energy companies, making it harder for them to maintain their exploration levels, reserve base and production.
Even without this pressure, oil production and reserves from the oil supermajors have declined over the past 20 years despite higher capital investment, notes Goehring & Rozencwajg, an investor in natural resources and an insightful energy commentator.
The long-term story could be one of constrained oil supply from non-OPEC (Organization of the Petroleum Exporting Countries) countries as global energy demand rises.
Put another way, a faster-than-expected transition from fossil fuels to renewables could increase the West’s reliance on OPEC energy producers, according to Goehring & Rozencwajg, at a time when global security risks are rising.
Crucial decision
Western countries have big decisions to make on energy security as Russia tries to reshape parts of Europe. Speculation is rife that China (Russia’s ally) could invade Taiwan in the next few years, prompting a military conflict that would draw in the US and its allies.
Clearly, as Russia and China attempt to create a new world order by reducing American power, the rise of autocracies is becoming a bigger risk.
Germany and other European countries that are aggressively decarbonising their economies have become more reliant on energy from OPEC-plus countries. Russia is the largest gas supplier to Germany, delivering about a third of its needs. It’s remarkable that Germany – Europe’s largest economy – relies on a rogue nation for so much of its energy supply.
As the gap between oil supply from OPEC and non-OPEC countries widens in coming years, the world will rely more on a small group of low-cost producers. The International Energy Agency predicts OPEC’s share of global oil supply will grow from about 37 per cent to 52 per cent by 2050 – the highest point in oil-market history.
OPEC-plus countries include Azerbaijan, Bahrain, Brunei, Kazakhstan, Malaysia, Mexico, Oman, Russia, South Sudan and Sudan. These likely aren’t countries the West would want to rely on for energy security.
Russia’s invasion of Ukraine could prompt Western countries to rethink the supply of fossil fuels. Few doubt that the world needs to transition to renewable to mitigate climate-change risks. But moving too quickly from fossil fuels to clean energy means countries like Germany are relying more on unpredictable actors like Russia.
Longer-term, energy security has implications for how Europe confronts the growing security threat of Russia – and China’s intentions with Taiwan. Energy security, which will rely on fossil fuels for many years to come, is vital to any reshaping of the international order.
So as markets focus on soaring short-term gains in the oil price, it’s worth considering how the Russia–Ukraine war could affect long-term trends in oil supply in non-OPEC countries.
Countries eager to move faster from oil, gas and coal might balance that against the risks of placing more of their energy security in the hands of autocracies.
The feature appeared in the April issue of Australian Resources & Investment.
Words by Tony Featherstone.