Update: The Latest on the EU and Russian Oil

The EU and Russia’s ongoing economic battle over fossil fuels continues—this time with Germany signalling it is willing to support an EU ban of Russian oil imports.^[i] Or at least, that was the most common summary of the situation from commentators we follow, but we think that is a touch oversimplified. Whilst we don’t dismiss the risk of sanctions—whether an EU embargo or Russian halt—likely causing a severe energy crunch and European recession, we think the chance of Europe implementing a sudden, recession-inducing ban still appears quite low.

Importantly, Germany did not suddenly bless an instant embargo. Rather, it said it would support a gradual, phased-in ban.^[ii] It also argued against some of the other measures EU officials have posed, including tariffs, unilateral price cuts and forcing energy companies to place their payments to Russian suppliers in escrow, on the grounds that these measures could prompt Russia to ban all EU oil exports instantly.^[iii] The debate amongst EU leaders is ongoing, and we think it remains to be seen what—if anything—they will agree on, especially after Hungarian officials reiterated their opposition at the weekend.^[iv]

We think one big reason Germany is lobbying for a gradual ban with a long runway is largely the same reason an immediate cessation of Russian purchases risks causing economic harm: refining capacity. Not all oil is created equally. Different strains of crude have different densities (ranging from light to heavy) and sulfur content (ranging from sweet to sour). Russia’s Urals oil blend is a cocktail of light sweet and heavy sour crude. Russian imports fuel (pun intended) about one-fourth of daily EU oil consumption, which means somewhere around one-fourth of EU oil refining capacity—give or take—is likely geared to this rather unique blend.^[v] At a high level, we see two ways to substitute this. Either the EU finds alternate sources of oil that have similar density and sulfur count as Urals oil, or Energy firms reconfigure their refineries to process either heavy sour or light sweet crude, depending on which producers they buy from (or, of course, some combination of the two).

Choosing new suppliers could be a tad tricky, in our view. The EU imports 3 – 3.5 million barrels per day, on average, of Russian crude—that is what they will need to figure out how to replace eventually.^[vi] Option A—a like-for-like import swap for the entirety—seems rather limited, in our view. According to the US Energy Information Administration, the closest cousins to Urals are blends from Saudi Arabia and Iran.^[vii] Saudi Arabia has plenty of spare capacity but, thus far, has agreed to only modest OPEC production increases.^[viii] Iran has upped output recently, but US sanctions prevent European purchases.^[ix] Without commenting on the sociology or geopolitics here, it wouldn’t shock us if chatter about resurrecting the Iran nuclear deal heated up. Geopolitics often make for very strange bedfellows, in our experience.

Option B, which we think might be more feasible, would be to buy more light sweet crude from the US and heavier sour crude from Canada, Mexico or (currently sanctioned) Venezuela and blend them together to approximate Urals.^[x] US refiners experimented with a similar blending approach during the height of the shale boom, when they had a refinery/oil blend mismatch.^[xi] This isn’t the simplest solution, in our view, but at the very least we think it buys time—or abates the need—for reconfiguring refineries to process heavy sour or light crude, which is a long and expensive endeavour. Depending on the complexity of the required retrofit, industry estimates show costs can run over a billion dollars, as they did for US refiners during the aforementioned shale boom.^[xii] To undertake this, we think European refiners will need strong reason to believe the long-term benefits will justify the high up-front cost. In our view, that isn’t a given, especially with EU officials continuing to stress the long-term shift away from fossil fuels.^[xiii]

We also think there are several infrastructure roadblocks in the way of an immediate shift, including the number of European ports equipped to receive the so-called “supertankers” that ship crude oil by sea. Germany solved one of those stumbling blocks last week, when Poland agreed to let it use the Baltic Sea Port of Gdansk, which is quite close to a major German refinery to which it has a direct pipeline connection.^[xiv] But port access doesn’t help landlocked countries like Hungary, considering rail shipments of oil are on the wane and most pipelines are mapped out to deliver oil from Russia, not the sea.^[xv] (Hence, Hungary’s hesitations about an outright ban, in our view.) It will likely take time to get these supply lines worked out.

At any rate, we think there are some indications that the oil market is already gearing up to replace Russian supply. Production in the US’s Bakken shale formation, which has similar density to Urals oil, is up.^[xvi] That might not seem noteworthy, but the Bakken isn’t the easiest place to export oil from. It is located in the north central US, far away from the export terminals on the Gulf Coast, and pipeline capacity to transport oil from that region to the coast is limited. Oil producers there generally have higher breakeven costs than those in Texas’ Permian Basin, meaning oil prices must be relatively higher for new wells to be profitable.^[xvii] We think producers there would have to be pretty confident about securing longer-term pricing contracts in order to take on that level of risk. The new Iranian output is going mostly to China for now, but that theoretically reduces Chinese demand for Saudi oil blends as a replacement for Urals—potentially freeing up more supply for Europe to buy.^[xviii]

We think the market will probably sort itself out, eventually. But it will likely take time. In our view, phasing in a Russian oil ban slowly—if indeed the EU pursues this—would be a way to signal support for Ukraine whilst buying time to make the necessary supply and infrastructure adjustments. We think it would give time for producers in the US, Canada, Saudi Arabia and elsewhere to continue ramping up or give refineries time to retrofit, to the extent any deem that a viable long-term move. Or time to determine how best to combine their options and come up with a viable solution.

So if the EU decides to pursue a gradual ban, we think it is probably manageable for most member states and the region overall from an economic standpoint. It likely creates winners and losers, and some countries will adjust more than others, but we think there is also some potential for related construction activity to be additive to gross domestic product (GDP, a government-produced measure of economic output). That is a silver lining we haven’t seen mentioned much by commentators we follow. If Russia retaliated with an instant snubbing of Europe—unlikely, in our view, given its need for hard currency, but possible—then we think an energy crunch and recession in the EU becomes much likelier. It might accelerate the readjustment process, but we think it would probably be costly and not seamless. Markets shift fast, but not that fast, in our experience.

We think that makes this a watch and wait situation, but not reason to suddenly shift a long-term portfolio out of stocks, in our view. As we showed last week, even a lengthy European recession like the mid-2010s’ sovereign debt crisis isn’t automatically enough to tip the globe into an economic contraction.^[xix] According to our analysis, for stocks, it isn’t about whether a certain bad thing happens—but rather, whether the balance of everything that happens, good and bad, works out net positive or negative for the economy and corporate earnings over the next 3 – 30 months. At times like this, we think looking at the totality of the economic landscape, not merely one potential negative, is vital to keeping perspective. Right now, we think there are sufficient positives—like the economic tailwinds from the easing of COVID restrictions and signs of strength in America’s big private sector—to tip the balance in favour of stocks.^[xx]