Oil Market Update

Ukraine crisis can trigger oil spike and tip EU back into recession
Nordea Global Research, 02 May 2014
Russia as important oil as gas supplier to Europe Tight European oil market sensitive to oil supply disturbances Disruptions to Russian oil flows will have huge impact on oil prices Embittered political climate, oil prices at USD 150/barrel and high financial market uncertainty can tip EU back into recession Oil price spike and flight to safety a recipe for broad-based USD strengthening and lower global rates: three risk scenarios US shale oil or SPR release will not prevent oil price spike

Thina M. Saltvedt Chief Analyst Macro/Oil (Ph.D.) Global Research, Norway +47 22 78 79 93 @ThinaSaltvedt thina.margrethe.saltvedt@nordea.com

The oil story: Russian conflict could trigger a sharp oil price spike and push the European economy back into recession Recent events in Ukraine have raised concerns about the risks of disruption in Russian energy exports. Memories have been awakened of episodes in 2006 and 2009 when Gazprom halted all Russian gas flows through Ukraine, amid pricing disputes, completely cutting off supplies to Southern Europe and partially other European countries. Not nearly as much attention has been paid to the risk of a disruption to the oil flows. Russia is as important an oil exporter to Europe (of both crude and refined products) as it is a gas exporter, but unlike for gas, only a relatively small portion of its overall oil exports to Europe transit through Ukraine. Oil, in contrast to gas, is easy to store, ship and trade, which means that the markets more flexible and a single customer has less immediate scope for action. Nevertheless, the consequences of a cut in Russian oil supplies could be as rave since the oil global oil market has little back-up capacity to lean on, European commercial oil stocks are low and there is no real substitute for oil in the transportation sector (which accounts for more than 60% of total oil consumption worldwide). As a result a halt in the oil deliveries from Russia to Europe will spark a sharp spike in oil prices and in a worst case scenario an oil crisis. A longerlasting disruption to oil supplies and an extended period with high oil prices will curb the potential for Euro-zone economic growth and slow down growth in the global economy. If the oil price spike is accompanied by a sharp fall in confidence and financial players recede to safe havens, the impact on global growth and financial markets will be even more severe. The questions are therefore how vulnerable the European oil market is to a halt in oil deliveries from Russia and whether the European economy can withstand a protracted period of high oil prices?

Contents
The Oil story p1

Europe is highly dependent on Russia p2 Europe vital for Russian energy export p3 Russia has excess pipeline capacity Ukraine as a transit country Ukraine dependency on Russia Big impact on oil prices Three risk scenarios p4 p5 p5 p5 p6

US shale and SPRs will not prevent oil price spike p8 Political turbulence and high oil prices can push the EU back in recession p8

research.nordeamarkets.com

Oil Market Update

Brent oil price and NBP natural gas prices

175 GBp per Therm and USD/barrel

150 Brent Crude 125

100

75

50 Natural Gas, National Balancing Point, green

25

0 02 03

04

05

06

07

08

09

10

11

12

13

14

Source: Reuters EcoWin

Europe is highly dependent on Russian oil and oil product deliveries Europes net oil import from Russia at 32% The oil production in the EU peaked in 1999 and has since fallen by almost 60% and thus the region imports a large chunk of its oil from Russia. Last year the EU imported around 3.05m b/d of Russian crude (36% of total net crude imports) and 1.02m b/d of oil products (23% of net total imports). Import dependence on Russia for crude oil is higher on an absolute basis than for products, although Russias share of net product imports is higher.
Russian Oil Exports in 2013
OECD Europe % of total 71% 36% 57%

In mb/d Crude Oil Products Total

World 4.30 2.80 7.10

OECD Europe 3.05 1.02 4.07

Source: International Energy Agency and Nordea Markets

EU heavily dependent on Russian gasoil

Overall the EU is only a relatively small net importer of products as the region exports a substantial amount of petrol. Nevertheless the EU is heavily dependent on import of gasoil from Russia accounting for about 620k b/d, or 69% on a net basis. The main gasoil consumers can typically be split into two main categories: heating oil and fuels such as marine diesel and diesel for road transportation. Heating oil consumers can to a large extent switch to other energy sources such as natural gas and coal if Russian exports are halted, but for the transportation sector there are not many other alternatives.
2

research.nordeamarkets.com

Oil Market Update

Therefore, a stop in the supply of oil products from Russia would have a relatively strong effect on the European fuel market, particularly diesel car owners, trucks, buses, small to medium-sized ships and ferries.
EU crude oil import in % by country of origin
Rest Algeria Azerbaijan Iraq Kazakhstan Nigeria LibyanArabJamahiriya SaudiArabia Norway RussianFederation 5.00% 5.00% 15.00%

%ofTotalImports

25.00%

35.00%

Source: EU, 2010 figures

but Europe is vital market for Russian energy export Although the EU receives a large share of its energy imports from Russia, the importance of the European market to Russia is also very high. Commodities exports are an important driver of the Russian economy. In 2013 energy resources accounted for around 70% of total exports (USD 515bn annual) from Russia, and the revenues generated from the production and sales of energy represented almost 52% of the countrys federal budget revenues.
Russian exports split on products in % of total

Energy resources 70% of total Russian exports

research.nordeamarkets.com

Oil Market Update

Russian oil and shale oil reserves among the biggest in the world

Russia will be a producer and exporter of energy for many years to come as the countrys reserves of oil account for 5.2% of total world reserves or 11.9bn tonnes (British Petroleum). With these reserves and oil production remaining unchanged at the 2012 level, Russias production of oil can continue for the next 22.4 years. In addition, Russia has the worlds largest technically recoverable shale oil reserves at around 75bn barrels, almost 30% higher than the reserves in the US. The EU remains the most important export market for Russian energy commodities. As much as 71% of Russias crude oil and 36% of petroleum product exports were destined for Europe in 2013 (IEA). A cut in exports of crude oil and products to Europe will have major implications for the Russian economy and the rouble. To become less dependent on a European oil market in stagnation, Russia has diversified its export markets and increased its exports to the East. In 2012, oil exports to Europe fell by 7% as more oil is directed to China after Rosnef, the Russian state oil company, signed a delivery deal with Chinas CNPC. Going forward, an increasing number of Russian barrels are expected to be heading east rather than west. Nevertheless Russias share of total European oil demand (including crude, products, NGLs and feedstock) remains unchanged. Recent changes in the Russian tax policy incentivise product exports at the expense of crude. Net refined product exports to Europe increased by around 15% (130k b/d) in 2013 and this trend is expected to continue.
Russias crude oil and condensate main export destinations, 2012

Russia is diversifying more of its export to Asia

In contrast to rival the US, Russia has excess pipeline capacity In contrast to Russias biggest rival on the other side of the Atlantic Ocean the US, the state-run pipeline monopoly Transnefs aggressive expansion plans have outpaced the rise in crude production. According to IEA, Russia has about 1.4 mb/d unused crude export capacity, which makes the country much more flexible as it can shift its export according to changes in the market conditions for example to maximise profits (maximise netbacks) or
4

Transnefs pipeline expansion outpaced crude production

research.nordeamarkets.com

Oil Market Update

minimise disruptions to flows in case of unplanned maintenance or unfavourable weather conditions at the terminals. The only outlet running at full capacity at the moment is the ESPO pipeline to Daqing, China. The better and more flexible the pipeline system is, the less dependent Russia will be on exporting its oil to European buyers if the quality of the crude meets the markets demand. How important is Ukraine as a transit country for Russian oil exports to Europe? For the oil market, a potential cut in Russian deliveries via Ukraine will have less impact than for gas. Most Russian oil exports go by tankers from Russian ports in the Baltic and the Black Sea. Pipeline oil movements to the West are mostly via the Druzhba pipeline system which exits Russia into Belarus, then the southern branch cuts across the northwest corner of Ukraine. The other major oil pipeline, the Odessa-Brody line, has been largely unused since 2010, but was set to begin shipping Russian oil to the Odessa refinery recently acquired by Vetek, a Ukrainian company, under agreements reportedly arranged with President Yanukovich but those agreements and in fact the ownership of the refinery are currently uncertain (PIRA). Ukraine highly dependent on Russian oil Ukraine itself is very dependent on Russian oil. In 2013, Ukraine produced around 65k b/d of oil, and consumed 280k b/d. Most of the countrys consumption was met by petroleum products from Russia, but petroleum products also came in from Poland, Greece, Italy and Hungary. Overall, only about 25% of Ukraines consumption was met by domestically refined products, as only a fraction of the countrys refining capacity was operational in 2013 (IEA). Crude exports through Ukraine loom large, however, in the energy supply of three European countries: the Slovak Republic, Hungary and the Czech Republic. The Slovak Republic imports 100% of its crude requirements via the Druzhba pipeline, while Russian crudes account for 94% and 65% of imports to Hungary and the Czech Republic, respectively (IEA). A disruption to the oil flows from Russia via Ukraine would obviously have a devastating effect on these three countries. Disruptions to Russian oil flows will have big impact on prices The sabre-rattling and threats will no doubt continue for a while, but so far tensions between Russia and the West over Ukraine have had minimal impact on physical oil balances. What if an escalation of the crisis in Ukraine, in a worst case scenario, leads to disruptions in the oil supplies from Russia to the EU as a consequence of for example a halt in oil deliveries via Ukraine, a halt in deliveries of oil and gas from Russia to EU as a retaliation of stricter sanction imposed by EU/US on Russia and attacks on infrastructure following increasing political turbulence what would then
research.nordeamarkets.com 5

Oil Market Update

be the effect on Brent oil prices and economic growth in the current tight oil market environment? Any disruptions to the oil flows going from Russia to the European market will presumably have a big impact on oil prices, as commercial inventories are low (three major OCED 2013 year-end stock levels lowest in 10 years), the current European supply/demand balance remains tight and the worlds spare production capacity is fairly low. Supply outages remain severe in aggregate at roughly 3.5 mb/d in the MENA region alone, mostly in Iran, Iraq, Libya, Syria and Sudan (PIRA). Commercial stocks are not ample enough to weather significant ongoing physical supply disruptions and definitely not to withstand a curtailment of supply arising from a growing political dispute between Russia and the West. A sharp rise in oil prices if prices remain elevated for a period of time will have a negative effect on economic growth and in a worst-case scenario push the EU back into recession. Clearly, higher oil prices and weaker growth in the EU will also have an impact on the growth potential of the global economy. How long a price spike will last, and thus the impact on the EU and the global economy, depends on the volumes held back from the market and the reason for the halt whether the production/transportation infrastructure is damaged or the taps are turned off.

Low European oil stocks and high MENA supply disruptions

Oil prices spike will clearly have a negative impact on the global economy

Three risk scenarios: a halt in oil deliveries from Russia impact on oil prices and EU GDP growth We have looked at three different scenarios and the potential effects on oil prices, economic growth, the EUR/USD cross and rates depending on the period and severity of the disruptions.
Oil Price Scenarios: Russian oil export is cut by one-half
170 USD per barrel USD per barrel 170

150 Two weeks 130

150

130

110 Baseline 90 Two quarters

110

90

70

Two quarters + risk appetite

70

50 May

50 Jul Sep 13 Nov Jan Mar May Jul 14 Sep Nov Jan

Source: Nordea Markets and Reuters Ecowin

research.nordeamarkets.com

Oil Market Update

In all three scenarios we assume that Russian crude oil exports to Europe are cut by 50% or around 1.5mb/d. The GDP calculations are based on the International Monetary Fund GEM simulations. Scenario 1: A short-term halt to oil deliveries lasting only two weeks, pushing oil prices up by 10-20% (from Q1 average at USD 108/barrel). Scenario 2: one-half of Russian oil supplies to Europe is locked in, but this time for two quarters. Global spare capacity will fall to lows last seen in 2008 to 2.2% of global demand from the current 3.9%. We expect that Saudi Arabias spare capacity will compensate for some of the losses, but with a lag. Notably the ECB will not act against EUR/USD in this scenario, since it will see the advantages of a weaker EUR towards the USD for energy imports and increasing competitiveness for Euro-zone products and services abroad. Scenario 3: oil supply disruptions are expected to lead to a cut in oil flows to Europe by 1.5m b/d and push oil prices up to USD 150/barrel. Saudi Arabia will increase production (the spare capacity buffer will fall), and the market situation will call for an IEA Strategic Petroleum Reserve (SPR) release (see box), but with a lag. As the market is concerned that the disruptions will be more severe than in scenario 2, the price spike is followed by a huge spike in risk aversion triggering a flight to safety by financial players away from risky assets, a widening of credit spreads recipe for broad USD strengthening and we will likely see global rates go much lower. In this case the impact on the global economy would be much larger and the EU will most likely tip back into recession.
Potential impact of the 3 scenarios
Brent USD per EU GDP barrel Period growth Scenario 1 Scenario 2 Scenario 3 122 150 150 2W 2Q 2Q No 1%> 0% World GDP growth No 3% 3%> High Vol "Flight to Safety" No No Yes

EURUSD 1.37-1.40 1.33-1.35 1.30>

Global Core Yields -5-10bp -10-30 bp min -80-100bp

The oil market is global and a sharp spike in Brent oil prices would of course raise prices of other crudes and oil products as well. Since Russia is one of the largest oil producers and exporters in the world with total exports of 7.1m b/d crude and products, it would be close to impossible to compensate for the full amount in the short to medium term if these barrels do not reach the market. Even a smaller volume, say 50% of the crude exported to Europe (the amount used in the scenarios above), would be very difficult to replace as the quality of the replacement needs to match.

research.nordeamarkets.com

Oil Market Update

Oil price spike 3 scenarios: Impact on EURUSD

1.42 1.4 1.38 1.36 1.34 1.32 1.3 1.28 1.26 1.24 EURUSD spot Forward 2W 2Q 2Q+Vol

01/05/2013

01/06/2013 01/07/2013

01/08/2013

01/09/2013 01/10/2013

01/11/2013 01/12/2013

01/01/2014

01/02/2014 01/03/2014

01/04/2014 01/05/2014

01/06/2014 01/07/2014

01/08/2014

01/09/2014 01/10/2014

Source: Nordea Markets

US shale oil or SPR release will not prevent an oil price spike Some have argued that the shale oil revolution in North America will solve the problem while others have proposed to dump oil from the large US strategic reserves to lower prices and thereby hit the backbone of the Russian economy the oil industry. First, not even a sharp upswing in shale oil production in the US or a sizeable SPR release would be adequate to replace or offset lost Russian barrels. The US is still a net crude importer and dependent on shipments from Canada and the Middle East to meet its domestic demand. Second, Europe and the US co-ordinated a strategic inventory release after the Libyan production was locked in following the civil war from the Arab spring uprising in 2011. The crude oil price fell by USD 10/barrel when the release was announced 23 June, but the effect did not last for more than two weeks before prices were back to the pre-release level. The market did probably not see a stock release as a satisfactory long-term solution as per se inventories will only last for a given period of time, and thus the risk of further supply disruptions pushed the risk premium and oil prices back up. Therefore, we expect a stock release to have only a short-term effect on prices. Embittering political climate and higher oil prices can push the EU back into recession Consequently, in the absence of Russian barrels, world oil prices would undoubtedly spike causing economic pain for the large oil importdependent countries such as the EU and reducing the growth potential of the world economy. An embittering political climate and an oil price spike would most likely be followed by a huge drop in market confidence,
research.nordeamarkets.com 8

Effect on oil prices expected to be short lived

01/11/2014 01/12/2014

Oil Market Update

triggering a flight to safety in financial markets which in turn would magnify the impact on economic growth and push the EU back into recession. Do not expect an oil crisis as Russia and the Europe remain closely linked As Russia and Europe remain closely linked as oil and economic trading partners, we do not see this as the outcome of the crisis. But the recent escalation of the conflict in Ukraine clearly increases the risk of a supply disruption materialising. The shock of the Crimean annexation should speed up the sluggish European decision-making process on energy storage, interconnection in the gas market, diversification of suppliers, liberalisation, shale gas production and efficiency measures especially on the transportation side. Sources: International Energy Agency (IEA), PIRA, US Energy Information Administration (EIA), British Petroleum (BP), The Economist, Financial Times (FT), The Guardian, Al Jazeera, International Monetary Fund (IMF), Godzimirski, J. M. (2013), Russian Energy in a Changing World, Ashgate. IEA SPRs requirements for member countries At the end of 2011, oil stocks in IEA member countries totalled some 4.1bn barrels. Each IEA member country is required to maintain total oil stock levels equivalent to at least 90 days of net imports, but there is flexibility in meeting this requirement using both crude and refined products. Countries may guarantee this minimum obligation by holding stocks as government emergency reserves, through specialised stockholding agencies, or by placing minimum stockholding obligations on industry . /d to a 4-month low at 1.95 mb/d in March after a resurgence of oil theft-related damages to the Nembe Creek pipeline and renewed threats to the countrys oil infrastructure by the militant group Movement for the Emancipation of the Niger Delta (MEND). Royal Dutch Shell declared force majeure on Bonny Light export after the pipeline closure cutting shipments of the crude to zero in June.

Nordea Markets is the name of the Markets departments of Nordea Bank Norge ASA, Nordea Bank AB (publ), Nordea Bank Finland Plc and Nordea Bank Danmark A/S. The information provided herein is intended for background information only and for the sole use of the intended recipient. The views and other information provided herein are the current views of Nordea Markets as of the date of this document and are subject to change without notice. This notice is not an exhaustive description of the described product or the risks related to it, and it should not be relied on as such, nor is it a substitute for the judgement of the recipient. The information provided herein is not intended to constitute and does not constitute investment advice nor is the information intended as an offer or solicitation for the purchase or sale of any financial instrument. The information contained herein has no regard to the specific investment objectives, the financial situation or particular needs of any particular recipient. Relevant and specific professional advice should always be obtained before making any investment or credit decision. It is important to note that past performance is not indicative of future results. Nordea Markets is not and does not purport to be an adviser as to legal, taxation, accounting or regulatory matters in any jurisdiction. This document may not be reproduced, distributed or published for any purpose without the prior written consent from Nordea Markets.

research.nordeamarkets.com