EU members finally agreed on a watered-down ban on Russian imports of oil and refined products. This decision is still relatively favorable to the market, given that the ban covers the bulk of Russian oil flows to the EU.
What the EU accepted
The EU has spent a month trying to reach an agreement on a ban on Russian oil. The initial proposal was to ban all Russian imports into the EU.
However, this has led to some opposition from Hungary and other Central and Eastern European countries (CEECs), which are heavily dependent on the Russian pipeline.
Therefore, the EU has agreed to exempt pipeline flows for the time being and only ban maritime imports for the next six months. Imports of refined products will be reduced over the next eight months.
Although pipeline throughputs are exempt from the ban, it is likely that we will still see these reduced throughputs. Germany and Poland have signaled that they will work to reduce Russian flows to zero.
This is important, given that they are the largest recipients of Russian oil from the Druzhba pipeline.
The exemption for pipeline streams will also likely be temporary. The EU will always strive to get Hungary and other Central and Eastern European countries to reduce their dependence on Russian oil over a longer period.
Full details of the EU ban have yet to be released.
How easily can the EU replace Russian supply?
The EU imports about 2.3 million barrels/d of crude oil from Russia, or about 26% of total crude oil imports. About two-thirds of these imports are by sea, while the rest goes through the Druzhba pipeline.
However, if Germany and Poland stick to their plan to zero Russian oil imports, rather than seeing flows cut by two-thirds by the end of the year, we could see more 90% of Russian imports into the EU affected.
Source: Eurostat, IHS Markit, ING Research
The EU also imports a significant quantity of refined products from Russia, in particular gasoil, naphtha and fuel oil. Eurostat figures show that the EU imported more than 800 Mbl/d of these three products from Russia in 2020, of which more than 55% was diesel. Russia accounts for more than 40% of total EU imports for these three products.
The more lenient ban on Russian oil will make it easier for EU member countries to endure the latest round of sanctions, especially those heavily dependent on Russian oil flows.
We will have to see how Germany and Poland logistically manage a reduction in flows from Russia, if they really want to end their dependence on Russian oil.
Refiners in these countries that depend on the Druzhba pipeline can use other pipeline routes from Gdansk and Rostock. Although it is difficult for some German refiners to fully offset flows from the Druzhba pipeline.
Along with some potential logistical issues, refiners will also want to replace the Ural with crude of similar quality. Urals are generally a moderately sour crude, and so this is what refiners will want to target as a replacement.
If a refiner changes its raw inputs, it could impact refinery yields. Given the tightness of the middle distillate market, refiners will want to ensure that they take grades that will produce more middle distillates. US shale alone will simply be too light to replace many of these refiners.
The other key question is whether there is enough spare capacity within the oil industry, which would allow EU buyers to simply turn to other suppliers. According to the International Energy Agency (IEA), OPEC members have 4.12 million barrels/d of spare capacity, and if Iran is included, that rises to 5.4 million barrels/d.
So, theoretically, members could tap into that spare capacity, which would help offset Russian supply. However, there are questions about OPEC’s capacity, given that members have consistently fallen short of production targets in recent months.
Furthermore, if US crude oil production increases by around 840 mb/d by year end, as expected, this would only provide an additional buffer.
However, the problem is that OPEC members have been reluctant to dip into their spare capacity. So far, OPEC has said market volatility reflected geopolitical risks rather than a supply/demand imbalance.
However, it is important to remember that Russia is part of the OPEC+ pact and therefore would have an influence on the group’s production policy in the broad sense. Moreover, OPEC does not have significant spare capacity.
The bulk is in the hands of Saudi Arabia and the United Arab Emirates. If they were to tap into this spare capacity, it probably wouldn’t take the market too long to go from a rhetoric about the need for additional OPEC supply to a narrative that the market is more vulnerable given decrease in unused capacity.
Source: IEA, ING Research
We assume that OPEC+ will not deviate from its current production policy of modest increases in supply each month. Therefore, the EU will have to rely in part on crude oil trade flows to change.
Non-European buyers who could significantly increase their purchases of Russian oil would be India and China. As demand from EU buyers will drop significantly over the next six months, there is potential for even deeper discounts for Russian crude, which will provide a strong incentive for other buyers to grab Russian oil.
China is already a big buyer of Russian oil, with imports averaging 1.6 million barrels/d in 2021, or 16% of total imports. In the short term, Chinese demand will be affected by the COVID-related lockdowns, but in the medium to long term, we could see an increased buying appetite for Russian crude.
China’s latest trade data for April shows imports during the month averaged 1.6 MMb/d, so no signs of an increase yet.
India is historically a very small buyer of Russian oil, accounting for around 1% of imports. India imported around 4.2 MMb/d of crude oil in 2021.
However, the steep discounts we have seen have already attracted interest from Indian buyers, and this is a trend that is likely to continue, particularly if we see even deeper discounts on the Urals.
According to reports, India increased its share of Russian oil imports to 5% of total maritime imports in April.
What this means for oil prices
The challenge in forecasting the evolution of the global oil balance over the next few months is to determine what additional demand we might see from other non-European buyers of Russian oil.
Significant discounts should guarantee alternative buyers. However, there is the risk that we will see the United States impose secondary sanctions on Russian oil. This would make it difficult for any buyer to buy Russian oil, and thus tighten the global market even more than we currently expect.
Although, since the EU ban is a partial ban, the US administration may refrain from imposing secondary sanctions for the time being.
Through a combination of already announced government sanctions and self-sanctions, we see Russian supply falling into the region of 3.5 million bbl/d by the end of this year.
The US, UK, Japan, Korea and Canada have already imposed bans or at least avoided Russian oil. The market will struggle to fully compensate for this loss of supply, so we expect the oil market to be in deficit in 2H22.
However, weaker demand growth estimates (due to China’s lockdowns and weaker economic growth expectations) mean the deficit is more manageable than initially expected.
Growing US supply, continued production growth from OPEC+ (minus Russia) and the assumption of a lifting of Iranian sanctions should mean the market is relatively more balanced in 2023.
This should see prices move away from the higher levels we have seen this year. However, the market will remain vulnerable, particularly if Russian supply losses exceed our expectations and Iranian supply does not make a strong comeback during 2023.
A phased ban on Russian oil means market strength should not be as brutal as it might have been had we seen an immediate ban. Instead, we expect prices to rise over the course of the year.
We have revised our ICE forecast for 2H22 upwards from 109 USD/bbl to 122 USD/bbl. Additionally, we have raised our full-year 2023 forecast from US$93/bbl to US$99/bbl.
However, as mentioned, obvious upside risks to our 2023 forecast include potential secondary sanctions on Russian oil and US sanctions on Iran that will remain in place in 2023.
Source: ING Research
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