Oil and War: Analyzing the Oil Markets in the Wake of Geopolitical Conflict Marcel Peplow, Analyst, Szymon Zephan Capital
mpeplow@crm.szc-group.com November 15, 2023

SafeRack, 2016

Introduction
Wondering about the different factors, variables, and opportunities at play in the current oil markets? Curious about what effect the ongoing conflicts in Eastern Europe and the Middle East will have at the pump? Oil prices have seen a lot of volatility in response to recent geopolitical events. The pandemic, rising interest rates, and recent global events have all contributed to price fluctuations in the past 3 years, from lows of -$36.73 per barrel during pandemic shutdowns in April 2020 to highs of $120.82 per barrel after sanctions on Russia intensified in June 2022.

From a consumer standpoint, oil price increases are passed along by producers and other firms throughout the supply chain, resulting in a measurable cost of living increase for everything from groceries to tires. For manufacturing firms, market uncertainty can reduce investor confidence and make production planning a challenge. At the same time, market instability presents a lot of opportunities for domestic and intraregional production in the Americas to ease potentially vulnerable dependencies on foreign oil imports.

In this article, we will explain how oil moves in the overall commodities market, explore the determinants of oil prices and assess the impact of recent geopolitical events.

To begin, let’s examine how oil is traded on a typical commodities market, like the Chicago Mercantile Exchange.

Types of Oil
There are two types of oil most commonly traded: WTI (West Texas Intermediate) and Brent crude.

Brent crude oil is a blended mix sourced from the North Sea and is typically used as a benchmark for oil in international markets, such as EMEA (Europe, the Middle East, and Africa). WTI, on the other hand, is a US-based crude oil both drilled and processed in the United States and is typically used as a benchmark for oil in the US market. Overall, the Brent Crude market is larger, comprising two-thirds of all oil pricing. This is due to factors such as greater locational accessibility and cheaper transportation through waterborne means, allowing for more global shipping capacity, port capacity, and storage capacity.

These types of oil have a few differences in uses and composition: sulfur content, sweetness, and lightness differ between WTI and Brent. Additionally, WTI trades at a lower price than Brent Crude for several reasons, including aforementioned transportation difficulties, US advancements in oil drilling and fracking increasing production quantities, and a history of US crude oil export prohibitions, which were only recently lifted in 2015.

While the prices and content may differ, we see an extremely high degree of correlation in market movements due to their overall similarity- trends that affect oil supply or demand usually affect both benchmarks. With that being said, geopolitical conflicts are widening the spread between WTI and Brent- global uncertainty, as we’re currently experiencing, has a much wider effect on Brent Crude prices than WTI, which is produced in landlocked areas in the US like Texas and New Mexico and is less subject to supply chain disruptions.

Flickr, 2010

What Does the Oil Market Look Like?
WTI and Brent are traded on both a spot price and a futures price. A spot price refers to the price paid for oil “on the spot”- i.e, if you were somehow able to contact a producer and purchase a single gallon of crude oil at the current moment (mind you, not that you could- as Bloomberg’s Tracy Alloway once attempted to). Futures, on the other hand, are a type of derivative used to purchase these gallons of oil “in the future”. They are used to hedge against price movements by forming a contract that obligates both parties, the buyer and the seller, to transact a given amount of a commodity at a given time.

The Chicago Mercantile Exchange (CME), the world’s largest options and futures exchange, tracks oil futures under codes such as CLZ3, using the Globex coding system. Here, the first 2 characters, CL, refer to the type of commodity (Crude Oil, specifically WTI in this case). The next character, Z, refers to the month of December using Globex month indicators, and lastly, 3 refers to the year of 2023. So, a CLZ3 futures contract refers to Crude Oil futures physically delivered in December 2023.

It’s important to note that futures contracts generally trade at a premium to the spot price due to carrying costs including insurance, storage, and other handling fees related to the physical commodities themselves.

Who Might Purchase or Sell Oil Futures?
Both hedgers and speculators participate in the oil futures market.

Firms that require oil for business activities (i.e manufacturing companies) or produce oil (i.e oil fracking companies) are both concerned about oil pricing trends. These firms experience what is known as commodity price risk- where price movements and volatility in the oil market can greatly disrupt their flow of operations.

For example, if the price of oil were to spike in the future, a synthetic leather producer who uses oil as a production input may be unable to maintain production levels, or may experience lower profit margins and higher operating expenses. To hedge (mitigate) against this price risk, they purchase future contracts dated for the month they will begin production in order to secure the price of oil and guarantee their ability to use oil in the future. Similarly, oil producers may be concerned about the possibility of oil prices dropping, and can hedge against this by locking in a selling price for future oil production. This provides surety for both the buyer (who guarantees that they will have the barrels they need) and the seller (who guarantees a buyer).

Speculators, on the other hand, have no interest in taking physical possession of oil but rather seek to profit from fluctuations in its market price. As active traders, they bet on the price of oil futures to rise or fall- leveraging futures and other derivatives to gain exposure to assets without owning them outright. To avoid physical delivery, they close positions before expiration by taking an opposite position (buying if they sold initially, or selling if they bought initially). This way, they settle the contract in cash, without ever owning the physical commodity. Additionally, speculators often sell existing contracts before maturity, repurchasing new contracts with later expiration dates (known as “rolling over”). Speculators are an important source of market liquidity and price discovery, and help oil markets function- but may also be a contributing factor to volatility.

Now that we understand how the oil markets operate, we can assess the causes of price movements made in the past and future, and the effect of global events.

Determinants Behind Oil Price Movements
The main determinants behind oil price movements are, as with all commodities, supply and demand. On the supply side, we have North American producers, OPEC (the Organization of the Petroleum Exporting Countries) an oil-producing cartel led by Saudi Arabia, as well as Russia. On the demand side, we have the countries, firms, and others who require oil.

Macroeconomic events have predictable effects on the prices of oil based on their influence on either supply and demand. As seen in the following example, a lack of demand (due to pandemic restrictions) meant oil trended downwards, and there was a surplus. In current times, political instability and warfare leads to price movements based on predicted effect.

U.S. EIA, 2021

April 2020 Oil Market Plunge
One of the most interesting movements in the oil markets happened very recently- April 2020. In April, oil prices did the unthinkable, going negative and closing at a low of -$37.63 on the 20th. For a commodity so often labeled as “black gold” or “the lifeblood of civilization”, such a move would seem impossible under ordinary circumstances. If, however, we refer back to our knowledge of the futures market, we can examine how such a movement occurred.

Recall that a futures contract, unless cash-settled or rolled over, obligates both the buyer and seller to physically transact oil. In this case, buyers of expiring May 2020 WTI futures would be required to take delivery of 1,000 oil barrels per future upon expiry, as oil futures represent a thousand barrels each. At 42 gallons per barrel, this amounted to 42,000 gallons of oil per contract- not exactly something you can hide in the garage.

Oil usage was at record lows due to the pandemic- less cars on the road, no demand for flights, and slowed international trade. At the same time, storage capacity and onshore space became increasingly limited, making it harder to manage potential transfers from Cushing, Oklahoma, where futures are delivered. Speculators, who had no interest in actually accepting delivery, began to panic as they realized their imminent obligation, and as a result, the price went negative as they attempted to offload their futures before expiry.

NBC News, 2022

How Has the Russia-Ukraine Conflict Affected Prices So Far, and What Does the Future Hold?
Ongoing tensions between Russia and Ukraine have far-reaching consequences that extend beyond the borders of these two nations. Eastern Europe comprises a globally significant area in the production, transport, and export of oil, and any disturbance in the region sends ripples throughout the world’s markets. Let’s examine the significance of Russian oil to understand the scope of its influence.

Russia is one of the world’s leading oil producers, comprising a 10% share in the overall market and producing over 10 million barrels a day- almost as much as Saudi Arabia. Europe has long been dependent on Russian oil and gas, importing an average of 15.2 million tonnes of crude oil per month pre-conflict as Europe lacks the production capacity to produce its own. At the same time, Russia relies on Europe for much of its export revenue, as more than half of Russian oil exports go to Europe.

When Russia attacked Ukraine, prices jumped from $76 per barrel at the start of January 2022, to $110 per barrel at the start of March 2022, a week after the invasion. Supply-side concerns were the primary motivator behind this, including the risk that production capacity and infrastructure in Russia could be negatively affected. Additionally, there were questions about Russia’s continuing participation in global trade due to increasing sanctions, a key area of interest.

By reducing the supply of oil available to sanctioning countries, sanctions created price increases. Canada, for example, banned imports of Russian crude oil in February 2022, as did the U.S in early March, leading the previously mentioned jump to $110 per barrel. Sanctions were followed with price caps to Russian oil in September 2022, when the G7 group of nations agreed to cap Russian oil prices in order to reduce Russian revenue while stabilizing oil supply. While opinions on the efficacy of the price caps are mixed, they had the desired effect in allowing Russian supply to hold down rising oil prices.

If we zoom back out, we realize that Russia is not the only country of note- Ukraine has a large impact of its own.

Ukraine, while not a noteworthy producer of oil, is a key player in the global energy markets. Situated at the crossroads of European energy transit routes, Ukraine serves as a key transit country for Russian natural gas destined for Europe, and has control over the intricate network of pipelines that crisscross the region. In fact, the Nord Stream and TurkStream pipelines were designed specifically to bypass Ukraine’s influence, and have been a source of contention so far. The conflict has heightened concerns about the reliability of energy transit routes, leading to increased uncertainty among market participants.

All in all, markets are still determining how the long-term effects of transit disruptions and Russian sanctions will play out. It’s worth noting that the market seems to have already recovered from the highs of the early invasion- partially due to a European move towards energy independence and renewables, and a shift towards US crude oil suppliers. Of course, new developments in Russia and further sanctions or price cap developments will continue to drive changes in the oil markets.

How Will the Israeli-Palestinian Conflict Affect Prices?

While the full impact on oil prices remains to be seen as the conflict in the Middle East continues to unfold, it’s important to understand how the market views possible outcomes on oil supply.

Firstly, note the historical precedence regarding similar conflicts in the past. The 1973 Yom Kippur War ultimately led to an Israeli counteroffensive funded by President Nixon and thus OPEC oil embargoes. At the time, due to a global dependence on oil and the sheer price-fixing power of OPEC, the price of crude experienced a fourfold increase, and an era of “stagflation” began. Current macroeconomic conditions look a lot different, however- due to an emergence in renewables, an increase in North American production capacities, and a shift away from oil dependency altogether, such an embargo would not be nearly as destructive.

However, the intricate web of relationships and interests in the region, coupled with its significant role in oil production, makes any disturbance in the area a cause for concern among energy markets worldwide.

The Middle East has long been a “geopolitical chessboard” where major powers vie for influence and control. Israel, as a key player in the region, has historically been backed by the United States, while Palestine is supported by various Arab nations. The region holds the majority of proven oil reserves and is home to some of the world’s largest oil-producing nations, including Saudi Arabia, Iran, and Iraq. Any conflict has the potential to disrupt oil production and transportation infrastructure. The fear of these supply disruptions, even if not immediately realized, can lead to speculative trading and a subsequent increase in oil prices.

Furthermore, the conflict has the potential to impact key strategic areas such as the Strait of Hormuz. The Strait of Hormuz is a critical passage for oil tankers transporting crude oil from the Middle East to global markets, overseeing an average of 20.5 million barrels per day, a fifth of the world’s total oil consumption. Any escalation in the Israeli-Palestinian conflict that raises the risk of disrupting these maritime routes can contribute to market uncertainty, prompting oil price volatility.

Lastly, note that there have been no actual material changes thus far to the supply side of oil, as Dr. Neil Quilliam of Chatham House stated. Oil and gas flows from the Middle East have remained stable even throughout the Israeli-Palestinian conflict, simply due to the distance between Gaza and crucial trade routes. The market rise in prices, then, is due more to speculation around future concerns, including the possibility of an intervention by the Iranian-backed Hezbollah, which at the moment seems unlikely though things can change.

This is reflected in the price of WTI- while WTI initially rose 4.3% to $86.38, a lack of tangible impact on oil supply has caused prices to stabilize, dropping back to $79.39, at a similar level to August’s floors. Such a drop reflects the outlook of the market: a general belief that material impacts will be limited to a ground battle in the Gaza Strip. However, investors should remain conscious of the potential for escalation and the omnipresent risk of oil-rich countries joining the conflict.

Conclusion
The oil markets represent a complex web of hedgers and speculators who respond in real-time to geopolitical developments. By understanding the differences and similarities between the types of oil traded, Brent and WTI, we gain a better view of the specific impacts global events can have on oil benchmarks. And by understanding how the futures market works, we see how these impacts are reflected in pricing outlooks.

We hope that you’ve enjoyed this article, and that you now have a better understanding of both the considerations and opportunities in the global oil markets.

As an investment bank, we offer professional services for firms and private placement opportunities for investors. This video shows our 6-Step Process for assisting you in your business needs- from debt or equity financing to mergers and acquisitions.

To speak with us about any of our services, please feel free to contact me at mpeplow@crm.szc-group.com or our managing partner, please email sjparsan@szc-group.com – we’d be delighted to assist you.

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