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Price cap Proposal Pushes Brent Towards Contango

By: Harry Altham, Energy Analyst, Market Analysis EMEA & Asia

Price cap Proposal Pushes Brent Towards Contango
 
Harry Altham
Energy Analyst, EMEA & Asia

Oil markets have experienced significant volatility over the last 24 hours, largely beginning with a major sell-off after reports emerged that the E.U. was proposing to set a price cap for Russian oil between $65-$70. This morning, the Brent prompt spread briefly entered a contango for the second time this week, as markets forecast reduced supply-side pressure in early 2023. That said, LOW temperatures have finally arrived in Europe, which is placing greater pressure on European energy infrastructure as national power grids across the continent warn of the risk of blackouts; Dutch TTF prices have overcome such concerns to trade €5/MWh lower (€124/MWh) despite the increasing rate of inventory depletion (0.22% drawdown in European stocks d/d yesterday). 

image 56331
Brent's Contango. Source: Bloomberg
could price cap prop-up global oil supply
Given that Mediterranean Urals is currently trading around the $62/bbl mark (the discount to dated Brent has oscillated close to the $21/bbl mark since mid-August), the proposed price Russian cap is at a level which is likely to encourage continued trade of Russian oil, potentially reducing some of the balance sheet pressure that has crippled oil markets this year (Russia produces around 10% of the world’s crude supply). The restrictions are primarily targeted at the shipping and insurance of Russian oil, which would not be legally available for crude traded above the price cap (by Western providers); markets are pricing in an increased availability of oil due to the prediction that both Russia and counterparties will be encouraged to trade within such conditions.
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Source: Bloomberg, StoneX

However, we envisage potential obstacles on the horizon. Though the unexpectedly high price cap is bearish for oil, we hold concerns that OPEC+ will react, possibly complicating the situation. The group has said the technicals are running ahead of the fundamentals, that they are pessimistic about the demand outlook, and some members have stated a fair price as being $90-$100/bbl in the short run. With Arab Light currently trading around the $86/bbl mark, there is a possibility that OPEC+ could respond by cutting supply further in order to boost prices – a particularly significant risk given the worsening COVID-19 situation in China. If Brent were to stretch north of $95/bbl, would Russia still be willing to sell, knowing that China, India and Turkey would still be willing buyers otherwise (provided that alternative ships and insurance contracts are available)? 

This makes OPEC+’s next quota announcement in early December particularly critical in evaluating our outlook for 2023; a production increase (as has been rumoured in some quarters) is likely to maintain the commercial appeal of the price cap to Russia as an exporter and thereby prop-up production. Due to the insistence by the European Union that they will halt Russian purchases regardless of the price cap, plus the current uncertainty of the timing and mechanisms of the price cap (in legal terms) we continue to believe that Russian production will fall by between 2.0M – 2.5M bbd y/y in Q1 2023. However, a neutral or bearish OPEC+ policy could herald a quicker and more profound production recovery (a rise of at least 1.5M bbd by Q4, which we believe will weaken the backwardation strength seen across crude securities (particularly since Q1 2021). 
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