How the Energy Market Is Distorted by the Russia-Ukraine War?

How the Energy Market is distorted1 by the Russia-Ukraine War
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Since Russia launched the war against Ukraine in late February, the tension between the two countries has drawn worldwide attention, which makes the already broken global supply chains even weaker. In return for Russia’s actions, many countries and civil organizations have imposed various political or economic sanctions on Russia including kicking a majority of Russian banks out of the Society for Worldwide Interbank Financial Telecommunication (SWIFT) and setting up payment restrictions on rubles to limit Russia’s capability of using its foreign exchange reserves comprising $630 billion.

Many international companies also terminated their operations in Russia out of their own interests and concerns. These situations have resulted in a series of effects that caused violent turmoil in the global economy, especially in the energy sector.

Russia and Ukraine are the world’s important exporters of agricultural products and energy. Russia’s natural gas accounts for 21% of global exports while most European countries rely on Russia for 36% of its natural gas exports. At the same time, Russia and Ukraine account for 25% of global wheat and barley sales, 20% of global corn sales, and 80% of global sunflower oil exports. At present, prices of wheat, soybeans and palm oil all hit 10-year highs.

How the Energy Market Is Distorted by the Russia-Ukraine War

In addition to being a major supplier of crude oil and grains, Russia is also the world’s largest exporter of fertilizers, and one of the top producers of palladium, nickel, coal and steel. Excluding Russia from the global trading system would damage a slew of global industries and worsen the problem of global food security.

According to the data recently released by the U.S. Bureau of Labor, the adjusted CPI in February 2022 increased by 7.9% year-on-year and 0.2% month-on-month, mainly driven by the food and oil price surge. This number was in line with the general market expectations, making many researchers consolidated their opinions that Federal Open Market Committee would announce the implementation of a 25 basis point hike for federal fund rate in its open market committee meeting this month, and this would also indicate the first step for Fed to initiate a series of economic tightening measures since the outbreak of Covid-19.

Such prediction has now come true. The problem is that the United States was already caught in an inflationary spiral before the Russia-Ukraine Conflicts, and the recent events have further escalated this situation. Even though the U.S. inflation has already hit 40-year high, it’s very likely that the Fed’s upcoming policy making will be less aggressive as the rising oil prices will jeopardize the corporate profit margins and consumers’ willingness to purchase. More aggressive policies could only further exacerbate market volatility.

As federal discount rate hike is imminent, the decline in the value of the global bond market has intensified. The yield on the U.S. 10 Year Treasury bond has exceeded 2.18%, surpassing the highest level since 2019.

The relationship between crude oil price and CPI is not hard to understand. As crude oil prices increase, all costs related to petrochemical products, metal and plastic-related products, as well as transportation and telecommunications will rise simultaneously. As a result, if the costs of production, labor and capital increase, these costs will ultimately passed on to the consumer side through the final product prices.

CPI has a significant negative correlation with fixed asset investments and personal consumption expenditures. In the past 50 years, there have been three crude oil crises in the world, all of which ended up with the easing of geopolitical conflicts and supply recovery. From the perspective of energy structure, the proportion of crude oil in global energy consumption and production has gradually reduced from about 50% during the first crude oil crisis in 1973 to 31.2% in 2020; in contrast, the proportion of natural gas, coal, and nuclear energy has gradually increased.

During the first crude oil crisis from 1973 to 1974, the U.S. CPI increased from 6.2% to 11.0%, the growth rate of US personal consumption expenditures decreased from 4.95% to -0.84%, and fixed asset investment decreased from 13.39% to 6.38%. The same trends were shown during the second and third crude oil crises.

The talks between Russia and Ukraine’s foreign ministers in Turkey last Thursday didn’t end well as the two countries failed to reach an agreement on the issue of ceasefire. On March 9, 2022, The U.S. President Biden announced a ban on energy imports from Russia and new U.S. investments in the Russian energy sector, which caused the global oil prices to climb to a near 14-year high during the day.

The European Commission also made an announcement that they will gradually wean off their dependence on Russia’s energy, with plans to cut their demand for Russian natural gas by two-thirds by the end of 2022. On the same day, WTI closed at its highest settlement price since August 1, 2008 and CFD closed at its highest settlement price since July 22, 2008. On March 10, 2022, Crude oil futures fell sharply around more than 13%.

Based on the Energy Information Administration’s statistics, the U.S. crude inventories fell by 1.9 million barrels in the week ended March 4, the U.S. crude inventories fell by 1.9 million barrels in the week ended March 4, and the U.S. crude oil inventories fell by 1.9 million barrels in the week ended March 4.

Political risks brought more sensitivity to oil prices, which put more pressure on the U.S. economic recovery. As of March 14, 2022, the average price of regular gasoline per gallon in the U.S. has soared by $0.79, or 22%, to a record $4.43per gallon in two weeks. In the San Francisco Bay Area, the highest average price for regular gasoline even reached $5.79 per gallon. On March 1, 2022, the Secretary of Energy Jennifer Granholm announced that the United States along with other 30 countries will release 60 million barrels of crude oil from their strategic petroleum reserve.

On the other hand, the United States recently sent three senior officials to meet with Venezuelan President Nicolas seeking for the possibility of oil imports as part of deals to ease oil trade sanctions imposed on this country from 2019. The U.S. was the largest buyer of Venezuelan oil until 2019.

European countries such as Germany are highly dependent on Russia’s crude oil and natural gas while the United States has its own production capacity and has maintained long-term cooperation with other crude oil-producing countries, so there is a divergence of resolution upon the energy sanctions against Russia between the United States and European countries.

The United States has not imported liquefied natural gas from Russia for many years, and it imported less than 300,000 tons of coal from Russia in the last year, so the damage to people’s livelihood brought by the ban on Russian energy could be relatively smaller in the USA. Nevertheless, about 8% of total U.S. crude imports were from Russia last year, of which the refined products are closely related to the U.S. gasoline industry. The embargo on Russia will generate considerable inflationary pressure on the United States. Bloomberg expects U.S. inflation to rise to 9% by April if international oil prices remain above $120 per barrel.

Currently, there is no substitute for Russia’s production capacity of approximately 7 million barrels of crude oil per day, which accounts for 7% of global supply, and the rising shipping costs will further increase the crude oil prices. In 2020, China had the largest share in terms of the trade value of Russia’s crude oil, reaching 23.77%. In comparison, The United States had a share of mere 0.95%, ranking 13th among importing countries. A new AAA survey shows that almost 60% of Americans would change their driving habits and lifestyles once the gasoline reached $4.

While the average gasoline price was $3.5 per gallon during the time they conducted the survey, two-thirds of them felt that the gasoline prices had reached a very high level already. Therefore, high gas prices may force people to switch to cheaper commutes or drive electric vehicles instead.

S&P 500 energy sector index (SPNY) has risen by 24% so far in 2022. In a normal economic environment, higher oil prices would boost overall stock index earnings, but the recent boost in energy sector earnings is more likely to be outweighed by severe inflation concerns.

The recent events fully reflect the impact of geopolitics on the global economy, which has already extended to our daily lives. Investment allocation needs to be laid out in advance, and a series of actions need to be implemented to rebalance the portfolio in order to diversify risks and optimize the return mix. It all requires our own insights as well as the help of professional guidance.

Erli Wang