Global commodity markets have surged to multi-year highs, with oil prices topping $130 per barrel, while natural gas, aluminium and wheat have all hit fresh record highs since Russia’s invasion of Ukraine and the subsequent sanctions that have been imposed on Russia as a result. An extended period of geopolitical tension and elevated risk premiums across all underlying commodities is now expected, with far reaching implications across global commodity markets. The unfolding conflict has vast implications and J.P. Morgan Research has revised commodity price forecasts up 10-20% across the sector. Russia's impact on the global energy balance is meaningful, with even the U.S., a major gas and oil producer, importing Russian crude and Liquid Natural Gas (LNG) cargoes to meet its consumption needs. In this report, J.P. Morgan looks at how geopolitical tensions could impact oil and gas prices in the months ahead.

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Natural gas prices in Europe under pressure

Russia is the second largest producer of natural gas globally, accounting for 16.6% of total global natural gas supply in 2020. That same year, Russia exported 37% of its domestic natural gas production, with the majority of this going to Europe, meeting about 45% of the region's import demand. About 70% of Russian exports are sent to Europe by pipeline and the region relies heavily on Russian gas transiting through Ukraine. There are three major arteries to move Russian gas to Europe currently in operation: Nord Stream 1 with 55 billion cubic metres per annum (bcmpa) of capacity, the Yamal-Europe pipeline with 33 bcmpa of booked capacity and a trio of pipelines (Brotherhood, Soyuz, and Progress) that transport natural gas through Ukraine into Europe with 40 bcmpa of booked capacity.

Russia natural gas exports

Line chart depicting that since 2009, the majority of Russian natural gas exports has been sent to Europe by pipeline.

J.P. Morgan has maintained its base case assumption that Russia would continue to honor long-term natural gas supply commitments to Europe. Within this assumption, it is expected that Russia will deliver nearly as much natural gas to Northwest Europe as it did during 2021, specifically around 94% of 2021 Russian imports. J.P. Morgan Research has officially removed the prospect of Nord Stream 2 from its 2022 and 2023 forecast and expects Northwest European storage to exit the year 60% full with key Dutch gas benchmark, TTF prices averaging 81.25 euros per megawatt hour (euro/MWh).

“We assume the current geopolitical risk premium now embedded in our 2022 annual price forecast of 81.25 euro/MWh (a result of the potential risk of supply disruptions) would lend to Northwest Europe importing around 18% more LNG year-over-year, as TTF prices are likely to attract more spot cargoes relative to last year,” said Shikha Chaturvedi, Head of Global Natural Gas and Natural Gas Liquids Strategy at J.P. Morgan.

However, market participants have been contemplating the potential for supply disruptions and undoubtedly, the probability of a supply disruption is increasing. J.P. Morgan has identified two other scenarios in which a Russian natural gas supply disruption to Europe could manifest, either through infrastructure damage or from sanctions impacting energy flow:

1. Infrastructure damage: 110+ euro/MWh

With the current potential for infrastructure damage most likely to occur in Ukraine, J.P. Morgan Research estimates there is likely up to 33.5 billion cubic meters of natural gas (bcm) of Russian natural gas exports at risk over the remainder of this year. While it is difficult to surmise the extent of the damage to infrastructure or the duration of the supply disruption, J.P. Morgan Research imagines with combat the likeliest cause of the infrastructure damage, the market would assume this reduction in supply will likely be for a longer duration than witnessed with “normal” infrastructure-related issues.

“A reduction of 33.5 bcm into Europe over the remainder of the year is quite substantial, accounting for nearly 30% of 2021 Russian natural gas flows into Europe. While this is a substantial disruption, through price, we believe that Europe could attract enough spot LNG to fill the supply gap. It is also important to note that amid the initial disruption of supply, revisiting a price level above 180 euro/MWh is highly likely—a level reached in late-December of last year amid Russian supply uncertainty and the potential for storage to run out in Northwest Europe,” said Chaturvedi.

2. A total reduction of Russian natural gas exports to Europe: 200+ euro/MWh

At the moment, the west has taken careful steps to ensure that current SWIFT (Society for Worldwide Interbank Financial Telecommunication) and Russian bank sanctions do not prove to be an obstacle for Russian natural gas exports to Europe.

At risk in this scenario is as much as 120 bcm of natural gas expected to flow into Europe over the remainder of the year. This includes flows on Nord Stream 1, Yamal-Europe, through a trio of pipelines in Ukraine, and the second string of Turk Stream which was built to meet European demand.

Given that the west has seemingly chosen to carve out natural gas exports from the latest round of sanctions, particularly given the already precarious state of the European natural gas balance, J.P. Morgan Research finds it unlikely that the west initiates a supply disruption of this magnitude. But the low probability currently assigned to this scenario could increase very quickly. Similarly, given that energy exports are such an important aspect of its economy, Russia reducing gas flows as a punitive measure to the west, is not the base case.

We assume the current geopolitical risk premium now embedded in our 2022 annual price forecast of 81.25 euro/MWh (a result of the potential risk of supply disruptions) would lend to Northwest Europe importing around 18% more LNG year-over-year.

“With the lack of connectivity between Russian gas fields feeding Europe and the Power of Siberia pipeline exporting gas to China, China is unable to take these specific molecules. Therefore, Russia only really has two options to deal with a significant reduction of natural gas to Europe: to store it or to curtail natural gas production at the wellhead,” said Chaturvedi.

Price impacts from a combination of both sanction-related and Russian-induced supply disruptions would be the most severe and could mean there is no real barrier to how high prices can initially go. Given the potential scale of supply reduction, with the only means to soothe what will be an exceptionally sharp move higher in price—a move beyond what has already been seen in the global gas market over the past 6 months—likely to be from government-mandated energy rationing. The reason that demand destruction will be the only mechanism to slow price’s upward momentum is because there are simply not enough molecules in the global LNG market to make up the shortfall of Russian supply into Europe.

“Therefore, at a bare minimum we believe that TTF price will have to average at an egregiously high level to force natural gas demand destruction around the world. That price level could be an average price of 200 euro/MWh for 2022 or even significantly higher. This would be a structural problem for Europe with market participants grappling with the longevity of this type of supply disruption and as such, these types of higher prices are not likely to only be concentrated in 2022 but also even as far back as 2024,” added Chaturvedi.

What is the outlook for oil prices?

With a 12% market share, Russia is also one of largest global oil producers. Almost half of Russia’s oil and condensate exports are directed to Europe. China is the single-largest importing country of Russia’s crude oil, accounting for almost a third of the country’s oil exports. Russia's oil exports are transported via Transneft's pipeline system that connects Russian oil fields to Europe and Asia. With its 1.5 mbd (million barrels per day) Druzhba pipeline supplies Russian oil to European refineries in Poland, Germany, the Czech Republic, Hungary and Slovakia via Belarus and Ukraine.

U.S. imports about 600-800 kbd (thousand barrels per day) of Russian oil, which mainly consists of fuel oil feedstocks and some crude. Russian oil imports, as a share of U.S. total oil imports, hit a record high of 10% in May 2021, according to data from U.S. Energy Information Administration, up from 4% in 2008. The rise in Russian imports coincided with the imposition of U.S. sanctions on Venezuela in 2019, as U.S. refiners looked to replace some of their heavy oil supplies that were lost by other sources.

So large is the immediate supply shock that we believe prices need to increase to $120/bbl and stay there for months to incentivize demand destruction, assuming no immediate Iranian volumes.”

While the U.S. and its allies have so far stopped short of imposing penalties directly on Russian oil and gas, it has become increasingly clear that Russian oil is being ostracized. The preliminary Russian crude oil loadings for March revealed a 1 mbd drop in the loadings from the Black Sea ports, 1 mbd drop from the Baltics and 0.5 mbd drop in the Far East. In addition, there is an estimated 2.5 mbd loss in oil products loadings from the Black Sea, for a total loss of 4.5 mbd.

Up until recerntly, Russia was exporting about 6.5 mbd of oil and oil products, with two-thirds clearing through the now-frozen seaborne market. Out of that, Europe and the U.S. accounted for 4.3 mbd, with Asia and Belarus rounding to 2.2 mbd. As the invasion persists, almost 70% of Russian oil is struggling to find buyers. So far, Russia is not withholding volumes. However, Russian producers are facing difficulties selling their oil, with Russian benchmark Urals oil being offered at a record $20 discount to international benchmark, with no bids.

“So large is the immediate supply shock that we believe prices need to increase to $120/bbl and stay there for months to incentivize demand destruction, assuming no immediate Iranian volumes,” said Natasha Kaneva, Head of Global Commodities Strategy at J.P. Morgan.

This could result in a 1.2 mbd hit to this year’s demand, bringing 2022 oil consumption 550 kbd below 2019 levels. If disruption to Russian volumes were to last throughout the year, the Brent oil price could exit the year at $185/bbl, likely leading to a massive 3 mbd drop in the global oil demand. Key to this significant upside is the assumption that even if shale production responds to the price signal, it cannot grow by more than 1.4 mbd this year, given labor and infrastructure constraints.

The Iranian deal could immediately increase supply by 1 mbd over the next two months through the release of floating storage. As Iran ramps up production from the current 2.5 mbd, another 0.8 mbd could be added throughout the second half of the year. Another potential supply response could come from the Organization of the Petroleum Exporting Countries and their allies (OPEC+). The alliance has the capacity to quickly release 1.5 mbd of supply but so far, there is no indication that the group will alter its current plan to increase output in 400 kbd increments. Finally, the third option is the Strategic Petroleum Reserve (SPR) release. The International Energy Agency (IEA) agreed to release 60 million barrels from its members’ strategic reserves, worth barely two weeks of lost Russian supply.

Reflecting the higher risk premium across the oil market and wider commodities complex, the J.P. Morgan baseline view calls for the Brent oil price to average $110 /bbl in the second quarter of 2022, $100/bbl in 3Q22 and $90/bbl in 4Q22, with the possibility that prices rise as high as $120/bbl in the interim, depending on the state of geopolitics. This represents an 11% increase on J.P. Morgan’s November forecast.

If the market begins to price a probability that Russia may take retaliatory measures by reducing its energy exports, a four-month disruption of 2.9 million barrels per day (mbd) of Russian export volumes to Europe and the U.S., will likely see the Brent oil price averaging $115/bbl in 2Q22, $105/bbl in 3Q22 and $95/bbl by 4Q22.

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