When Russia invaded Ukraine in late February, forecasters were quick to revise their projections of prices for energy considerably higher in anticipation of supply shortages for both crude oil and natural gas. Europe was widely perceived to be vulnerable to cutbacks in supplies of natural gas from Russia, which accounted for about 40 percent of its energy needs.
At the same time, some forecasts called for the price of West Texas Intermediate (WTI) to double to between $125 -$150 per barrel in response to sanctions that were imposed on Russia.
Developments since then suggest the European Union (EU) may experience the worst scenario that was envisioned. But the fallout for the U.S. has been better than expected, as the price of WTI has dipped below $90 a barrel. According to a Wall Street Journal report, prices of liquefied natural gas (LNG) in Europe have nearly quadrupled over a year ago, and they are eight times higher than their U.S. (Henry Hub) equivalent.
Although the long-term correlation between prices for crude oil and natural gas is fairly low at about 0.25, the magnitude of the price divergence today is unusually high. Consequently, many people are wondering why it is happening and what it spells for the respective economies and financial markets.
In a previous commentary, I examined the fallout from Russia’s squeeze on natural gas shipments to Europe and the European policy response. The problem is that while the EU agreed on plans in May to reduce its reliance on Russian fuel, they will take years to implement.
Meanwhile, European policymakers are scrambling to lessen the burden consumers will face if the squeeze is maintained through the winter. The most urgent need is to curb price increases for electricity and heating fuel. A New York Times article reports that manufacturers are furloughing workers and shutting down production and face spikes in energy bills when contracts expire in October.
Last week, the European Commission outlined a plan to redistribute $140 billion of windfall profits from energy companies to consumers and businesses to soften the blow. The plan calls for a cap of 180 euro per megawatt hour on revenue earned by lower-cost non-gas producers of electricity. It would also require coordination with EU member governments that are implementing their own plans. Consequently, it is unclear how effective these measures will be and whether they will lessen inflation that currently stands at 9 percent.
By comparison, the energy picture in the U.S. has improved considerably in the past three months: Gasoline prices at the pump have fallen for 13 weeks in a row, from more than $5 a gallon in June to about $3.70 recently. This, in turn, has contributed to declines in headline inflation and boosted consumer confidence.
So, what’s behind these price declines and are they likely to continue or be reversed?
A commonly held view is they are linked to the decision by the U.S. and 30 other IEA member countries in March to release 60 million barrels of oil strategic petroleum reserves (SPR) to address supply disruptions from Russia’s invasion of Ukraine.
While there has been an ongoing debate about the effectiveness of using the SPR in emergencies, a report published by the Federal Reserve Bank of Dallas in 2019 concluded that such measures could lower oil prices temporarily. The big unknown, however, is whether the price declines would have occurred if the action was not taken, because higher prices would have resulted in faster inventory accumulation. Furthermore, prices could rebound once the selling program has ended.
Beyond this, a recent report by Morgan Stanley (MS) analysts titled “Finding the Floor” helps to shed light on the structural and cyclical forces at play in the global oil market. The principal conclusion is that the decline in both Brent and WTI prices is mainly the result of a reduction in demand for oil linked to global economic weakness. “Spot prices have fallen, forward curves have flattened, physical differentials have come in, and refining margins have weakened,” the analysts write. The slowdown in demand has occurred among all the main economic blocs, and the report cites China as a particularly important contributor, with its crude oil imports down by about 2 mb/d from two years ago.
With respect to gasoline prices, the MS report notes that there has been an unprecedented decline in crack (refining) spreads from a peak of $45/bbl in early summer to zero recently, which is very unusual. Another oddity is that crude oil has fallen below the price of coal, which raises the issue of whether it can fall much further.
Morgan Stanley’s assessment is that the oil market’s structural outlook is one of tightness, but for the time being it is being offset by cyclical weakness. Its base case is that oil prices will stay around current levels into mid-2023. With WTI prices having fallen by about $40/bbl from its peak of $130, the downside risks are limited. But a price surge is unlikely until there is a global economic recovery.
Weighing these considerations, my take is that the direct impact of Russia’s invasion of Ukraine is not as bad for the U.S. as was originally believed. One reason is the fallout on Europe has been more severe than expected and will likely result in a European recession as the ECB feels compelled to tighten monetary policy to curb inflation. Another reason is China’s economy has also slowed more than expected due to weakness in the property sector and the government’s strict COVID-19 policy.
The main implication for financial markets is that the U.S. dollar is likely to remain strong. First, with core inflation still elevated, the Federal Reserve has signaled that it will continue to raise rates aggressively for a while longer. Second, the U.S. benefits from being energy independent, whereas the EU and China are heavily dependent on imported energy. Thus, the U.S. is likely to experience a favorable shift in the terms of trade (price of exports relative imports) compared to the EU and China. In this respect, the U.S. has been shielded from some of the negative impacts of Russia’s invasion.
Nicholas Sargen, Ph.D., is an economic consultant for Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business. He has written three books, including “Global Shocks: An Investment Guide for Turbulent Markets.”