Oil prices carry a risk premium for the first time since 2008. Why?

High oil prices from a large record inventory drawdown intensified last week following concerns that Russia’s flows of crude will be scaled back. 

Most national oil companies sell crude directly to end users, which are refiners. Some national oil firms use third-party trading companies to help sell smaller quantities of crude, a practice that has been in place for as long as we can remember.

The issue that surfaced over the past week involved those smaller parcels of oil. Indications were that some of these buyers walked away from planned purchases because of concerns about being sanctioned for taking Russian oil. Such punitive measures seem a remote possibility given Russia’s petroleum and natural gas exports are literally irreplaceable. Even so, fears about being sanctioned were not kept at bay.

It is unclear what volume of Russia’s total exports were impacted, nor how long this buyer hesitancy will persist. In the European cash market, though, Urals crude, the most common export grade of crude oil from Russia, last week traded $28 (SR105) under the dated Brent price. This all-time record discount compares with a discount that’s usually in the $1 to $3 per barrel range.

In constructing our supply and demand forecast, we do not model prospects for events such as weather-related supply outages, additional demand as the world normalizes from the economic downturn caused by the pandemic. Nor do we usually factor in production losses related to civil wars, be it in Iraq or Libya, disruptions from infrastructure deterioration in Venezuela, interruptions in output from Nigeria’s ongoing sectarian war, or disruptions to key exporter operations in countries like Russia. And yet, here we stand now having to discuss such a consideration.

We expect most customers of Russia will continue to purchase its oil because of insufficient spare production capacity elsewhere. Even so, based on where we estimate global oil inventories to be, the current fair value for Brent crude is close to $105 per barrel.

Any effective reduction in Russia’s oil exports would exacerbate the inventory drawdown that we have already been forecasting. This possibility now seems to be a worry in the oil market. Brent crude prices settled last week at just over $118 per barrel or $13 above fair value. It marked the first week since 2008 that saw oil prices display a risk premium.

Last week also saw a flurry of suggestions that a revived nuclear accord with Iran could be announced sometime soon. Perhaps it will, but like any such development, the devil is in the detail. Because of the nature of Iran’s oil reservoirs, resurrecting production after protracted supply disruption has proven to be problematic.

Indications suggest it will take six to nine months for Iran to raise its output by 700,000 barrels per day with the rest of pre-sanction output (about 600,000 barrels per day) needing a few additional months for restoration. Given our supply and demand forecast, the notion of a full or partial lifting of sanctions is still more of a headline risk to the oil market, as opposed to a fundamental risk to the oil balance.

Importantly, our sense is that the Organization of the Petroleum Exporting Countries, OPEC, would move to accommodate any boost of Iranian output to prevent oil inventories from swelling. The body does not want to see oil prices fall due to rising petroleum stocks. In point of fact, the discussion about a possible new nuclear deal appeared to be a contributing factor behind last week’s OPEC decision to unwind quotas by no more than what had already been agreed to.

As to last week’s 61.7 million barrel emergency oil inventory release agreed to by International Energy Agency member countries, we do not see those barrels preventing the global oil balance from tightening further. We know that our global supply and demand forecast is very different to that of the consensus (which projects the oil balance will loosen — by the way, that was also the case for 2021). This is especially true if we experience any unplanned supply losses over the course of this year.

• Michael Rothman is the president & founder of Cornerstone Analytics, a US-based consultancy focusing on macro-energy research. He has nearly 40 years of experience covering the global energy markets and has been attending OPEC meetings since 1986. He is also the author of “Cornerstones of Life” which is available on Amazon.