Illustration by Jon Krause
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About the author: Karim Fawaz is an oil market analyst and director of research and analysis at S&P Global Commodity Insights.
The history of oil markets is full of watershed moments. Some are brief moments, like the oil shocks of 1973 and 1979; others are long-term phenomena such as the American shale revolution. But what they all have in common is that they fundamentally changed market conditions and the framework that market participants used to form expectations for forward rates. The events of 2022, culminating in the December 5th implementation of European sanctions against Russian oil, mark the beginning of a new era for oil markets. They warrant a fundamental rethinking of the global oil map, how oil prices are set, and how political and economic motives of different stakeholders interact in a fragmented market.
The oil market has followed a path of consistent but managed globalization for nearly 50 years. This process can best be encompassed by the three “Fs”: free (virtually unlimited trade), fungible (oil of different qualities and origins are largely interchangeable), and financialized (with a deep, liquid financial commodity market that facilitates hedging and price discovery). The advent of shale was set to limit this process by ostensibly creating a just-in-time supply function that could stabilize prices closer to the marginal cost of production and help erode the influence of geopolitics on oil price formation (the “depoliticization” of oil). The more the oil crises of the 1970s faded from collective market memories and the more sophisticated the global oil market became, the less policy was seen to drive oil prices beyond a declining “risk premium.” However, it was an illusion. Oil remained too intertwined with geopolitics for depoliticization to last.
The shale sector has transformed and given up its price elasticity in the process. More importantly, it has become clear that the free, tradable and financialized global oil market was a construct supported on political and commercial pillars, several of which are now being eroded. Three are worth highlighting.
The first of these pillars was the notion of the Organization of the Petroleum Exporting Countries as a market-stabilizing and consumer-relevant construct that holds and manages the oil market’s reserve capacity buffer to avoid serious physical imbalances and price extremes. At the heart of this idea was the political alignment between the US and Saudi Arabia and the latter’s responsiveness to pressure from the former in the oil arena. In 2022, the stance of the wider OPEC+ group, an organization led by Russia that is in direct confrontation with the West, changed this dynamic. OPEC+ decision cutting production by two million barrels per day in October, despite US calls, is a manifestation of this trend. For oil markets, OPEC and its partners’ shift from a stated goal of market stabilization to direct resource monetization by targeting higher prices adds a more motivated and potent force dictating supply.
The second was the relatively minimal role played by oil consumers and major importers (mainly the West and Asia) in oil price formation. Consumers acted largely as price takers, and mandated strategic oil reserves (for members of the International Energy Agency) were used exclusively for acute emergencies and shortages. Today, out of necessity and desperation in the fight against inflation, consumer countries and especially the United States have discovered ways to influence price formation. The massive SPR pulls of 2022 was such a path; the price ceiling may be different. It also goes both ways, exemplified by the US intention to use the replenishment of the SPR to support domestic producers above a certain price ($67 to $72 per barrel) and establish a de facto target price range. The newfound interventionism of consuming countries – even if they are nascent and limited in capacity – suddenly gives them a seat at the table in oil price formation.
The third was a set of core, dedicated trade streams and commercial lineages that support price discovery and leave the spot oil markets fluid but not unmanageable. The largest was exports of crude oil from the Middle East to Asia, followed by exports of Russian crude oil and refined products to Europe and Canadian crude oil to the United States. from the EU represents a tectonic shift. The realignment of global oil flows that began to unfold in 2022 will be far-reaching. Russia’s efforts to circumvent sanctions against maritime insurance and services have led to the expansion of the global tanker “dark fleet”. The fragmentation of the physical oil market and the realignment of global oil trade currently unfolding are reshaping commercial relationships, adding opacity to price discovery, and increasing price differentials in profound ways.
What comes next? Creative destruction. Through this process, oil will flow less freely, be less fungible and potentially suffer from lower financial liquidity, all of which will blur price discovery and amplify price volatility. Discrepancies in producer and consumer price targets can translate into dueling interventions and widen the range of supply and demand outcomes. Eventually, new structures and a new equilibrium will emerge, but first the untangling of the current patchwork will continue to unfold. The oil market that emerges will hardly resemble the market at the start of 2022.
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