By Putnam Investments | May 10, 2022
Izzet Yildiz, Analyst | Originally published April 1, 2022

As the investment manager for the Canada Life U.S. All Cap Growth and Canada Life Pathways U.S. Equity funds, Putnam Investments keeps a watchful eye on developments in energy markets and how they link to the outlook for the broader economy. Despite immense volatility and geopolitical challenges, Putnam’s bearish outlook for oil leads them to believe lower oil prices could mitigate growth risks and support riskier assets.

We still have a bearish view on oil prices at the end of March. Physical markets for oil should be better than expected in coming months. We expect oil prices to enter a correction stage and for Russia’s war in Ukraine to play less of a role in oil markets.

March was a wild month, even by the standards of the volatile oil market. We’ve seen oil price at US$35 swings, $130 peaks, and a $93 bottom.¹ More recently, it is trading in the $110s after a rally.

We view these price moves not as a reflection of physical markets, but as a sign of shifts in expectations and related financial positioning. The causes of the price swings are the Russia-Ukraine War, a possible EU ban on Russian oil, and big supply disruptions, with Caspian Pipeline Consortium (CPC) pipeline deliveries expected to be down about 0.6 million barrels per day (mbpd) over the next six weeks. At some point, spot prices will likely converge to the realities of the physical markets. This means the key question is the outlook for physical markets.

We still have a bearish view at current levels, on the belief physical markets will be better than expected in coming months, and oil prices will enter a correction stage. The major risk and biggest uncertainty in this view is Russian exports. In our estimation, buyers will show up and the final impact will be limited.

Price expectations based on current tanker tracking numbers are misleading, we believe, since they reflect pre-war orders. We’ll have better information in the second half of April.

Demand for Russian oil is strong in Asia

So far in March, Russia crude oil exports are the highest since 2019, at close to 5 mbpd. (Kpler and TankerTrackers.com). They export an additional 2 mbpd to 2.5 mbpd products, with half of this being gasoil (also known as heavy oil, marine fuel, bunker, etc.). However, these contracts were made before the Ukraine invasion. We will start to see the effects of the war in the second half of April. The International Energy Agency (IEA) is estimating a 3 mbpd loss (–28%) in Russia’s production, but we expect it will be a smaller drop. We also believe an EU ban, which is the market’s biggest concern, is unlikely so long as Germans oppose it. Germany should be brave enough to accept recession risks.

The current discount on Urals oil would translate into $17 million in profit per 1 million barrels (an average tanker), even including current super-expensive shipping costs. (Urals oil is a reference oil blend of heavy sour oil from the Urals mountains and Volga river region and light oil from Western Siberian fields used as a basis for pricing of the Russian export oil mixture.²) We believe this is a lifetime opportunity, and we don’t underestimate the profit incentive of traders, especially ones in Asia where reputational risks from profiting on the war are not that high. In particular, the Indians and Chinese are having some difficulties finding shippers, but they are coming back to market. We’re already seeing buyers from India and China:³

• Hindustan Petroleum Corp. recently bought 2 million barrels of the Urals grade for delivery in June, and other Indian refiners are also seeking cargoes.
• Indian Oil Corp. (IOC) bought 3 million barrels of Urals oil for May loading.
• Several Chinese state-owned refiners also have returned to the spot market to buy Urals oil for May loading.
• Sinopec and PetroChina are looking for barrels for June loadings.
• Independent, or teapot, refiners also have started taking Urals oil, but quietly, to avoid public attention.
• Teapots are also reemerging in the far eastern spot market for Russian ESPO (Eastern Siberia Pacific Ocean) oil.

Many forces could weaken oil demand and increase supply

Now, in our view, the key risk is the duration of the war. Considering Russia’s current losses, it can’t continue the same offensive for a long time. One way or another, we’ll see an end to the war. The worst path would be nuclear war. It’s a tail risk, but it’s rising, unfortunately, and remains difficult to price into the market scenarios.

Below are additional supply and demand considerations.

• Iran: According to sources, Russia received the guarantees it was seeking that sanctions wouldn’t block its trade with Iran. However, the leaks from the teams sound increasingly pessimistic about chances of a new Joint Comprehensive Plan of Action (JCPOA). Chances are lower than last month, down to 50-50 (Sources: Axios news, Energy Intelligence Group).
• China lockdowns: Cities across China with a combined population of close to 200 million are now under some form of Covid-related lockdown, which will have negative impacts on crude oil demand. (Argus).
• U.S.: The Dallas Fed Energy Survey shows oil production increased at a faster pace, according to executives at exploration and production firms. The oil production index jumped from 19.1 in the fourth quarter of 2021 to 45.0 in the first quarter of 2022. U.S. oil product demand is slowing after a temporary spike due to colder than normal winter months.
• Trading views: Our unchanged view is that one way or another, the Ukraine situation will reach an equilibrium. Nuclear conflict remains a small but growing tail risk. However, shipping problems are likely short term. At current levels, the risk premium in oil is excessive in the medium to long term. Corrections to under/overshooting could be very sharp and quick in the oil market.

Lower oil prices could ease inflation pressure

If oil enters a correction stage in line with our bearish views, it’ll be positive for inflation risks and risky assets. Oil above $90 is usually seen as demand destructive and stagflationary. Lower oil prices could remove the upside risks in headline inflation, and we could see peak inflation soon. The reaction of households and firms to oil prices is nonlinear. They typically respond to extremely high oil prices via lower consumption and production. Therefore, lower oil prices could mitigate these growth risks and could support risky assets.