EXPERT PERSPECTIVE — The new year is bringing new concerns for the energy market and what that might mean for broader national security moving forward. Last year saw the world’s first global energy crisis. This year, there is unprecedented transformation in the global distribution infrastructure as the Biden Administration seems to set a new normal for drawing on the U.S. Strategic Petroleum Reserve. What does it mean?
The Cipher Brief tapped Energy Expert and former National Intelligence Manager for Iran at ODNI, Norm Roule to help us better understand the ‘new normal’ in a world rife with volatility.
The Cipher Brief: Many analysts referred to 2022 as the first global energy crisis. How will they describe 2023?
Roule: The world’s leaders, market managers, and businesses have had time to develop strategies to respond to energy, economic, and political conditions that have become the new normal. However, the coming year will probably see much of the uncertainty, volatility, turbulence, and sensitivity to geopolitical events and severe weather we saw in 2022.
We may not yet appreciate how much the world has changed. Some changes, such as the expanded use of fossil fuels, likely represent a temporary trend. Let me name three that will likely be long-lasting.
First, the energy sector has only begun to witness an unprecedented transformation in the international sources and distribution infrastructure associated with energy use. The physical arteries that carried energy from Russia to the world are being replaced by new sources in the Middle East, Latin America, Central Asia, and Africa. Europe will continue to flesh out a multi-year program that will consume billions of dollars in investment, considerable intra-EU debate, and will require new political relationships between energy producers and consumers.
Next, the unprecedented U.S. draw on its strategic petroleum reserve established a new paradigm for its use as a tool to manipulate markets for what some would call political purposes, instead of a reserve to be drawn upon only in the most extreme of situations. The Biden administration speaks of replacing the oil, but that will depend heavily on price and geopolitical developments.
Last, we witnessed a transformation involving traditional producers. Once written off as dead, OPEC reasserted its influence on the global economy. OPEC will continue to aim for price stability and manage threats to the oil price floor. The unnecessary spat between Washington and Riyadh before the midterms was only one consequence of this shift. At the same time, the United Arab Emirates, Saudi Arabia, and other Gulf states accelerated programs to move their economies – and economic influence – into green energy.
The Cipher Brief: What will be the main drivers of energy developments in the new year?
Roule: Market bears and bulls will each find a home this year. Energy prices will likely face downward or neutral pressure in the first half of 2023, but there is good reason to expect upward pressure in the second half of the year. With the midterms behind us, the political rhetoric on oil has vanished, which is good news for everyone.
We will likely see a market broadly defined by a handful of issues: the nature and pace of China’s reopening while dealing with COVID, the tightening of sanctions on Russia’s energy sector and how Moscow responds, OPEC efforts to maintain market stability - at least at current price levels, U.S. gas and oil production and policy, global recession pressures, and whether Iran’s aggressive behavior produces the conflict we all hope to avoid.
This summer will be interesting. China’s reopening should be underway, peak driving season will be upon us, and political rhetoric associated with the presidential primaries will increase. If, as some analysts predict, the China reopening pushes prices above $100/barrel, we could well see a return to OPEC-bashing and releases from our strategic reserve.
The Cipher Brief: The reopening of China would be good news for the world economy but would inevitably bring higher energy prices. What are some issues we should anticipate as China works through its ongoing COVID crisis and how will this impact Europe as it deals with energy shortages?
Roule: China’s reopening may be gradual or something that takes place in fits and starts impacting different industries at different levels, depending on the location within China of intense COVID outbreaks. This said, we shouldn’t be surprised if China’s energy demands increase towards the end of the second quarter of this year. China’s depressed economy has generally been a positive for Europe in reducing competition for finite gas and oil on the market. The lack of domestic demand even allowed China to export some of its LNG to Europe. European leaders are probably thinking now about how to lock in oil and gas supplies that might be more expensive and less available later in the Spring.
The Chinese impact on Europe’s energy problem will have several facets, including how China manages its strategic reserve. For example, China’s market is centrally managed, allowing Beijing to control LNG exports as the economy grows. The picture gets complicated when we look at China’s export of refined products. Oil prices will initially face upward price pressures as China increases purchases for its domestic market. But how China decides to handle exports shouldn’t be overlooked.
For example, suppose Beijing decides to shift a portion of its crude oil imports to refineries to enable increased exports of refined products. In that case, these exports will contribute to lower distillate prices in the global market as the law of supply and demand plays out. Pulling this thread a bit further, if China’s refineries face lower profit margins, they might call for oil, reducing China’s import requirements.
The Cipher Brief: The Biden administration and Europe succeeded in developing a price cap, and new and unprecedented sanctions will come online in February that will focus on Russian fuel exports, including diesel. Unpack this for us.
Roule: You’re correct that the upcoming February sanctions will be significant and will reshape a major element of the global energy distribution network. On 5 February, new sanctions will put a price cap on Russia’s fuel exports. The impact on diesel prices is getting the most attention.
Once these sanctions come into play, Europe will need alternative sources, which will likely drive up prices in the near term. The energy market is more accustomed to dealing without Russia, so this should be less impactful than had such an array of sanctions been introduced immediately after Russia invaded Ukraine.
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The Biden administration and Europe have structured sanctions in a way that tries to keep the energy flowing, while denying Russia much of its revenue. Thus far, Moscow’s response has been primarily rhetorical in its claims that it won’t sell energy products to countries that follow the sanctions. Russia, China, India, and even Turkey have become Russia’s primary consumers and have benefitted from the low prices that market pressures have produced. Europe has generally been the primary consumer of Russian diesel. The latest sanctions mean that Russia will need to offer its fuel at significantly reduced prices to its dwindling (but not insignificant) list of energy clients, some of whom are diesel exporters themselves.
There is the possibility of storing fuel, but the number of available land facilities and ships is finite. Absent a solution, Moscow will have no choice but to reduce or mothball production at its refineries.
The Cipher Brief: Let’s head back to Europe, which has borne the brunt of Russia’s weaponization of energy and the impact of sanctions. Europe seems to be fairing the winter pretty well. How is that having an impact on priorities?
Roule: European leaders scrambled last year to deal with a blizzard of economic and political consequences that followed Russia’s invasion of Ukraine. The good news is that Europe is well-positioned to respond to this winter’s requirements and – if warm weather persists – will be in a good position to build its 2023 stockpile.
Their priorities in 2023 will seem familiar. First and foremost, they must address the issue of Winter 2023’s natural gas stockpile requirements. I believe the new mandate is that each EU country must store at least 90 percent of its winter gas needs by 1 November.
Beyond gas stockpiles, their “must-do” list will include steps to protect their economies and industries from energy inflation and the ensuing social impact on their poor. Even before Russia’s war against Ukraine, European aluminum smelters closed due to high natural gas prices. Europeans must also lock in new energy sources and long-term supply deals, and integrate a growing web of pipelines, gas hubs, and refineries to end supply distortions. I don’t think we have seen the end of energy disagreements between EU members: their supply and demand priorities often differ and, in some cases, compete.
Weather remains one of Europe’s unpredictable variables. If warmer weather was welcomed this winter, last summer’s heat and drought inflicted thousands of deaths, damaged crops, distorted river shipping, and constrained hydropower and nuclear energy.
The Cipher Brief: How will U.S. oil and gas producers react in the coming year? They have had record profits but seem reluctant to expand production. Also, where do things stand with the U.S. strategic petroleum reserve?
Roule: U.S. shale producers and their investors get little sympathy from consumers, but theirs is a tough industry in which profits are thin and significant debt is routine. During the past few years, we have watched the industry consolidate, pay more attention to investor returns and pay down more than $20 billion in debt. This approach required discipline but came at the cost of growth. Production has also been hampered by higher interest rates, difficulties obtaining equipment and personnel, and an unwillingness to assume significant debt in the current political environment.
I sense that U.S. shale production will see only a relatively modest expansion in 2022. The Energy Information Administration predicts a rise in U.S. oil production to 12.4 million barrels this year, a rise of about 550,000 barrels over 2021. We also hear more observers express concerns that U.S. shale production may have peaked. At a recent conference, a prominent U.S. oil executive stated that he believes U.S. daily shale production will peak around 13 million barrels per day in 2026.
We may face a new normal regarding the U.S. Strategic Petroleum Reserve (SPR). It is possible that we have yet to understand the consequences of the Biden administration’s decision to turn to the SPR to draw upon 180 million barrels of oil to maintain lower gas and inflation instead of utilizing it as an emergency reserve - for which it was intended. The current SPR level is the lowest in almost 40 years, and the administration has only begun to take steps to restore the spent oil. The administration is trying to lock in a price of $70 a barrel, but producers will likely anticipate higher prices later this year and will be unwilling to risk the lost revenue.
Congress also must fund the DoE’s purchasing strategy, which could currently manage only a small portion of the planned repurchase. We shouldn’t be surprised if the current lower reserve becomes a new base for the foreseeable future and if the Biden administration draws on it.
The Cipher Brief: As ever, we end with a request for wildcards. Could you give us a few issues that could dramatically impact the energy picture this year?
Roule: Many things are floating in my crystal ball, but I will name three that deserve attention.
First, we’re closer to a conflict with Iran than we’ve ever been. Tehran’s nuclear program has expanded dramatically in the past two years, beyond levels once thought sufficient to require military action. This, as Tehran launched terror operations against Americans in the U.S. and British journalists in the United Kingdom. Iran is enabling Russia’s horrific drone attacks on Ukraine by sending technology to the front lines. Iran also continues to send weapons to the Houthis, complicating a fragile Yemen ceasefire. Any of these challenges could spiral into a conventional, cyber, or drone conflict involving the U.S., Israel, Saudi Arabia, or even Ukraine.
Next, Russia could turn off energy supplies to increase pressure on Western countries supporting Ukraine or press OPEC to respond to Western sanctions. We spend much time discussing our sanctions but we have to remember that the adversary always gets a vote.
Lastly, COVID may not be done with us, and winter 2023-2024 could see a fresh outbreak. All things worth keeping in mind.
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