Fuel for Thought: Market must count all costs in Russian oil flow upheaval

The West's boycott of Russian barrels will be the oil market's ultimate test. While it has an impressive record of adapting to unthinkable shifts in trade patterns, from self-imposed embargoes on US exports to sanctions on Iranian and Venezuelan crude, the stakes, and costs, have never been higher.

The market is already doing what it does best in bringing new buyers and sellers together and boosting existing relationships, but at a magnitude rarely seen before.

Russian oil supply makes up some 13% of total oil exports. The EU alone was importing about 2.3 million b/d of Russian crude before the war in Ukraine, which started on Feb. 24.

Europe is now weaning itself off Russian Urals and buying more crude from across the Atlantic and via the Middle East.

Light sweet US grades had already become a mainstay of European refiners' diets since being freed from their shackles some seven years ago, and is a trend that has seen Platts deciding to bring the WTI Midland export variety into the Dated Brent benchmark from mid-2023.

Russia is now looking to Asia, with India emerging out of nowhere as a new top buyer of its heavily discounted crude, and lockdown-hit China is returning as a pivotal customer. The two Asian oil importers have now grown their share of Russian shipped crude to almost 30% and 20%, respectively, a combined growth of more than 1 million b/d from pre-war levels.

But the accounting ledger points to the extra ton-mile shipping costs and time involved bringing in barrels from further afield as even Brazil grades start to move up in popularity in Europe.

These costs may be easily swallowed amid bumper refining margins, but European buyers are still at a competitive disadvantage to Asian refiners taking Urals, which could be at around a $40/b discount to Dated Brent, according to S&P Global Commodity Insights assessments.

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Finding replacements

The challenge of swapping in a medium sour replacement for Urals is doable but far from straightforward, given the Russian grade is one of the largest of that quality.

"When the Russian flagship grade was expensive in summer 2020, European refiners looked for alternative grades, so, some European refiners have done Urals substitution exercise in the past," said Rasool Barouni of Platts Analytics.

"They have considered other medium sour grades including North Sea and Middle Eastern grades as substitutes for Urals … Refiners have also blended light and heavy grades to make Urals-like grades."

Norway's Johan Sverdrup, Iraq's Basrah Medium, Egypt's Suez Blend and several key Saudi grades have all been high in the substitute list and make good replacements.

It's a similar story for India and China, with many of the refiners built to take cheap heavy and sulfurous grades often from the Middle East, but they also can generally take diesel-rich Urals without hesitation, especially at today's prices. China was the biggest buyer of Russia crude before the latest COVID-19 round hit the country anyhow.

Product of its own making

But this reshuffle has a knock-on effect on oil product flows. With European refiners taking more naphtha-rich crudes from the US, they are making more gasoline and often selling it back to US road users in one large round trip that again is a boon for shippers.

Asia by the same token may have to send more fuel oil to Europe, given a shortage in fuel oil-rich crude, again adding to extra distances and marine fuel costs that have to be passed on somewhere in the supply chain.

The EU alone was importing 1.2 million b/d of Russia's oil products before the war and may still end up snapping up Russian molecules that have found their way into various blending pools given the fact that once crude has been cracked it is much harder to track.

That's despite origin restrictions becoming a feature of the market, with the Platts Market on Close assessment process witness to buyers putting stringent terms on purchases to ensure Russian product is avoided.

Weaponizing oil

The lessons of the past are also indicative.

The US' ability to throttle Iranian crude production by excluding it from the international financial system wiped out around 1.5 million b/d in output, but even then Iran has managed to find ways to sell its crude.

It's much easier to weaponize oil when prices are low than when Dated Brent remains well into triple digits and shows little sign of falling.

The more supply is cut from the market, the more consumers get twitchy and pump prices become politicized, so should Russian supply eventually plummet, buyers may start to scramble.

OPEC+ spare capacity is already down at dangerously low levels at a time when Libya output is volatile and US hurricane season is just around the corner. Russian seaborne exports are at three-year highs, but the difficulty comes in finding fungible grades should the market tighten further. Analysts point to the door opening to an Iran oil deal, hanging in the balance for more than a year, should the pressure get too much.

The oil market may already be paying the extra costs of epochal changes in oil flows, but the eventual price could be much higher.