War in Ukraine: The Second Wave of Russia's Oil Shock Is Starting

Cliff Edge | Russian oil production has fallen sharply so far in April, with the monthly average heading to 10 million barrels a day, its lowest since September 2020

More production losses are likely as Western refiners and traders walk away from Russia upon the expiry of supply contracts in coming weeks. The European Union is also considering baby steps to reduce its purchases of Russian oil, trying to find ways to sidestep German opposition to the measures. “We are currently developing smart mechanisms so that oil can also be included in the next sanctions package," EU Commission President Ursula von der Leyen told the Bild am Sonntag.

For consumers – and central banks in inflation-fighting mode – declining Russian production signals the beginning of a second, and likely longer lasting, wave of oil price increases. For Vladimir Putin, the stakes are even higher: revenue from oil and gas sales has so far helped cushion the blow of international sanctions, stabilizing the ruble and financing his military machine. A lasting decline in production that outweighs any price increase would be a longer-term headwind for Russia’s economy on top of the direct costs of the war.

The first phase of the oil-price shock from Putin’s invasion was as intense as it was brief. Russian output proved more resilient than expected; China’s Covid lockdowns reduced demand, and the U.S. and its allies released millions of barrels from their strategic petroleum reserves. Brent, the global oil benchmark, initially surged to $139.13 a barrel on March 7 in the first days of the Russian military campaign but retreated nearly 30% to a low of $97.57 a barrel by April 11.

The second phase is likely play out in slow motion over a longer period, risking more economic havoc. Brent crude has already climbed back to near $110 a barrel, and prices will probably rise gradually as the market absorbs the supply losses. Seasonal peak demand is still two-and-a-half months away, with the summer holiday period of the northern hemisphere, and retail gasoline prices are sure to climb.

Brent has averaged $99.20 a barrel so far this year. In 2008, when prices hit an all-time high, the average price year-to-date at this time of year was $98.40 a barrel. The only potential relief is bad economic news: a recession in the U.S. and Europe is the clearest obstacle to $100-plus oil.

Russian oil production is likely to drop further in coming months, judging by statistics from OilX, a consultancy that uses imaging data from NASA satellites to measure flaring. It estimates that output fell earlier this month to a low of 9.76 million barrels a day. On average, Russia pumped about 10.2 million barrels a day in the first two weeks of April. While the losses appear to have stabilized in recent days, April represents a big drop from the 11.1 million of February, before the impact of the invasion of Ukraine, and the 11 million of March.

The behavior of the Russian oil companies themselves highlights the declining international demand for their product. State-controlled Rosneft PJSC is trying to sell millions of barrels of crude in Europe and Asia via tenders that close on Thursday. Typically, Rosneft sells via long-term deals with commodity traders like Vitol Group, Trafigura Group and Glencore Plc. But Western traders face a deadline of May 15 from the EU that restricts their dealings with Rosneft and several other Russian companies to “essential” activity needed to supply the EU. What essential means is open to interpretation, and for now many traders are simply reducing their dealings.

If the production losses so far in April continue and deepen in May, as many in the industry expect, the laws of supply and demand will take over. Oil markets are like the proverbial tanker: they take time to turn. But turning they are. And that means prices are heading higher, again.