ZeroHedge - On a long enough timeline, the survival rate for everyone drops to zero
www.zerohedge.com
Oil Price Could Hit "Stratospheric" $380 If Russia Retaliates To G7 Oil Price Cap
SUNDAY, JUL 03, 2022 - 11:15 AM
As discussed previously, one of the most notable events of the past week was the decision by G7 leaders "to work" on a price cap for Russian oil as part of efforts to cut Moscow’s revenues.
However, it didn't take long for the same G7 motley crew to realize that they have a major problem on their hands: as JPM's commodity desk notes, given Russia’s strong fiscal position,
the country can cut up to 5 mbd of production without excessively hurting its economic interest. Meanwhile, a 5mbd cut would spark a Europe-wide depression, confirming that once again Europe had not even done the simple math.
What about prices? According to JPM, given the high levels of stress in the oil market, a cut of 3.0 mbd could cause global Brent price to jump to $190/bbl,
while the most extreme scenario of a 5 mbd slash in production could drive oil price to a stratospheric $380/bbl.
Let's back up: as we noted last week, the stated goal set out by G7 leaders this week is two-pronged:
- to limit upward pressure on global oil prices
- to curb Russia’s revenues from oil sales.
To achieve those goals, the allies agreed to explore a new mechanism that aims to impose a ceiling on Russian oil prices. The idea behind this price cap is to permit countries that have not imposed import bans to buy Russian oil as long as it is priced at or below a predetermined price. The cap could be enforced via limits on availability of European insurance for Russian oil cargoes as well as shipping services and US finance. While G7 leaders have not indicated where the price cap would be set, it must be lower than the $80/bbl at which Russia’s Urals grade trades today (a $32/bbl discount to Brent) and higher than Russia’s marginal cost of maintaining production levels, estimated at around $40/bbl to ensure Russia’s earnings are reduced while production is maintained.
A $50-60 per barrel price cap would likely serve the G7 goals of reducing oil revenues for Russia while assuring barrels continue to flow. Of course, for the price cap to work, oil importers like India China and Turkey—which have significantly increased their purchases of heavily- discounted Russian grades—would need to agree to participate to access even cheaper oil.
That's the background. Here are the 3 scenarios as to what happens next. They are, as one would expect from any plan conceived by hapless politicians, bad, worse and much worse.
Scenario 1: Russia does not cooperate and retaliates — a 3 mbd cut would likely deliver a $190/bbl oil price
The most obvious and likely risk with a price cap is that Russia would not to participate (which, of course, it won't as why would Putin agree to produce oil at a lower price than clearing) and instead retaliates by reducing exports. In fact, as JPM head commodity strategist Natasha Kaneva notes, Russia had already showed its willingness to withhold supplies of natural gas to EU countries that refused to meet payment demands. Indeed,
emboldened by a surging current account surplus, after entirely cutting off the flow of piped gas to the Netherlands, Bulgaria, Finland and Denmark, since the start of June Gazprom has reduced the flow of gas to Italy by 50% and to Germany by 60%—though claiming the latter reductions in June were due to maintenance-related issues.
As a result, the EU as a whole is now receiving 53% less gas from Russia than it averaged before the start of the war. Withholding gas volumes from Europe comes at a personal cost to Russia—as a measure to manage the reduced export-related flows, Russia has had to allow for natural production declines. According to Gazprom, the company will reduce its production by 17 Bcm this year, or 3% of 2021 production. That said, history suggests that there is far more capability for production reductions in Russia. For example, in 2019 Gazprom production was ~500 Bcm, while in 2020 Gazprom production fell to ~453 Bcm.
So far in 2022, Gazprom production has been down 20 Bcm yoy, suggesting further declines are likely relative to Gazprom’s current forecast.
Unlike gas, which accounts for about one-fifth of Russia’s budget revenues, oil makes up over half. Russia’s policymakers will likely address the challenge of the oil price cap from the position of strength, and as JPM concedes, "Russia’s starting fiscal position is strong." Besides, the global oil market has tightened, while the strong balance of payments opens room to accommodate lower export volumes without inflicting too much financing pain. Which brings up the key question:
How much oil production can Russia realistically cut without hurting its economic interest?
In answering this question, JPM notes that Russia's fiscal position strong:
low deficit, low debt.
Russia’s sovereign balance sheet remains strong even as half of CBR’s reserves were frozen. Last year, Russia’s federal budget recorded a modest surplus of 0.4% of GDP or $7bn, while this year, as things stand, is tracking a modest deficit of less than 1% of GDP. Financing needs are equally low. The National Wellbeing Fund—effectively, a government deposit at the CBR—reached an equivalent of $198bn by May 2022, with $116bn in usable funds. Treasury cash balances exceed ~$85bn. Gross sovereign debt stood at 15.9% of GDP (~$279bn) as of end-2021.
Federal budget revenues, originally budgeted at RUB25tn ($347bn), are tracking about RUB26tn this year ($394bn) as higher oil & gas revenues more than offset the shortfall in non-energy fiscal revenues. If fiscal rule was still operational, Russia would accumulate around $80bn into the sovereign fund this year. Yet, as following the old fiscal rule has become challenging,
the authorities decided to use additional oil & gas revenues to increase spending and reduce issuance instead. A new fiscal rule is being debated in the government.
So let's assume the G7 plan is effectuated and a hypothetical $50/bbl price cap on Russian oil was imposed and effective, Russia could lose about $75bn per year in export revenues and about $42bn in budget revenues compared to JPM's base case of an average annual price of around $80/bbl. The impact on budget balance would be smaller, as exchange rate would offset part of the impact.
JPM concludes that
the Kremlin would not face big problem financing a deficit of ~$40bn given the large stock of savings and low initial level of debt. The local financial system should be able to absorb additional issuance, especially given the scarcity of available instruments for savings outside of Russia. For example, in 2020, the government raised an equivalent of 4.8% of GDP ($71bn) from the local market.
However, as JPM's commodity team also notes,
the Russian government will likely retaliate by cutting output as a way to inflict pain on the West, especially since the tightness of the global oil market is on Russia’s side, the continued appreciation pressure on the exchange rate would ease, and the strong public finances could absorb the revenue losses without too much difficulty.
As a hypothetical scenario,
a cut of 3 mbd from JPM's base case of 9.7mbd output assumed for this year could open up a deficit of $50bn at a $50/bbl price, which could be relatively easily funded by issuing local bonds without stressing the oil fund. Importantly, the imbalance in Russia’s external accounts, which generates excessive inflows of hard currency to the local market, might, ironically, even be considered as a relief.
Then there is the question of too much USDs and EURs to stomach. Russia’s key macro-economic challenge following the imposition of sanctions has been the unsustainable dynamics of the balance of payments, which has resulted in significant appreciation of the exchange rate. Main sanctions-induced developments were the following:
- First, sanctions against the central bank made it close-to-impossible for the CBR to accumulate reserves. Last year, the CBR accumulated $64bn in reserves, while this year, if the fiscal rule was still operational and domestic crude price averaged ~ $80/bbl (at a big discount to Brent), the CBR would have had to purchase more than $75bn. Today, the CBR is only able to buy gold from local producers (small scale). Policymakers study the feasibility of buying assets of friendly EM countries, but infrastructure constraints, closed capital accounts, and lack of depth of EM markets will likely make the rollout of EM-buying slow and lacking scale in the near term.
- Second, sanctions and, more importantly, risks of further financial sanctions (asset freezes) have made residents reluctant to accumulate foreign assets in ‘unfriendly’ countries. In the past, accumulation of foreign assets was traditionally the main channel of private capital outflows, averaging ~$80bn in the past 10 years. This has largely dried up now.
- Third, trade and logistical restrictions have dramatically affected imports, which, judging by indirect data, halved. Given the strong oil revenues, Russia's 2022 current account surplus to reach ~$170bn this year ($68bn in 1Q22).
The higher current account surplus and the lack of private and public sector capital outflows has meant that the RUB has been the main adjustment valve.
This has made Russia’s non-energy exports expensive and uncompetitive. Policymakers have focused their efforts on reviving imports, by stimulating domestic demand and addressing logistical challenges and the CBR has cut policy rate aggressively, while fiscal authorities are contemplating a stimulus of 2-3% of GDP. Obviously, given the nature of sanctions / trade restrictions, reviving imports, especially of investment-related goods, will be hard.
In addition, most of capital controls that were introduced at the height of the crisis have been removed. Also, a couple of quasi-sovereign institutions have had to accumulate foreign assets in recent months, but this is not seen as sustainable or desirable due to sanctions risk.
As Russian officials often put it, USDs and EURs have become “toxic”.
Although
authorities’ preference would be to increase imports and recycle petrorubles in friendly EMs, this does not look an easy task, especially in the near term. Hence, if the geopolitical situation requires, it now appears more likely that export cuts could be used as leverage / policy tool.
Putting it all together, JPM concludes that
"given the high level of stress in the oil market, a cut of 3.0 mbd could cause global Brent price to jump to $190/bbl, while the worst-case scenario, a 5 mbd cut, could drive oil price to a stratospheric $380/bbl."
Part 1 of 2
rumble.com
RadioGenova @RadioGenova
Kees71 @Kees71234
Maurice de Hond @mauricedehond
