This week's special analysis focusses on the Asian crude market, and what impact the Russia-Ukraine conflict is having on flows.
Impact of Russia-Ukraine conflict on Asian crude flows
By Eesha Muneeb and Chen Ee Woon
Oil traders in Singapore were heading out to lunch on 24 February when the news that Russian tanks had crossed over into Ukraine started trickling in. In the days leading up to the invasion, now in its second month, most had dismissed the likelihood of an attack, and certainly no one East of Suez had fathomed the scale of escalation, both in the warzone and in the financial markets, over the weeks to come.
The current chain of events has far-reaching effects across global oil flows and energy policy. One such externality is OPEC policy, both on supply and pricing. OPEC refused to buckle under international pressure to ease sky-high oil prices by releasing more crude supply in the wake of the invasion. Since February, it has downplayed the conflict’s impact on oil balances and prioritised the Covid demand destruction that has unfolded in the last two years instead. At the moment, OPEC continues to hold to a monthly schedule of easing oil supplies by 400,000 b/d each month, as per its Covid-influenced agreement prior to the invasion.
Its decision may be more circumstantial than the producer group is willing to let on. Market data shows that the group is at the higher limit of its production capacity, with not much to spare even if it decided in favour of a supply increase. It is already struggling to eke out the extra 400,000 b/d increases as per its own policy.
Added to that is the internal incentive for many Middle Eastern nations in the form of higher oil prices. In a tightly wound-up and jittery global market, Covid demand destruction has been long forgotten and replaced by $100/b-plus crude. Earlier this month, Saudi Arabia issued all-time record high official selling price differentials for its Asian customers, ranging from US$9-10/b premiums for its Arab crude grades on top of the $100/b benchmarks that underpin Saudi pricing.
Asian refiners are heavily dependent on Middle Eastern crude, more so than Russian barrels. This is a particularly biting time to be hit with some of the most expensive crude oil prices as countries begin to unfurl two years' worth of Covid restrictions, lockdowns on mobility and consumer spending. Instead of incentivising economic activity via monetary policy, upward inflationary pressure driven by high oil prices is forcing many central banks to accelerate tightening to rein in inflation.
As the conflict drags on so do sanctions on Russian economic activities and an unforeseen exodus of international companies from the producer nation. The collective impact of Russian actions, Western policymaking and corporate PR is multilayered and multifaceted, and much of it is still unclear while it unfolds.
Question marks over ESPO benchmark role
For Asia, there are several key issues to wade through. As one of the largest crude oil producers in the world, Russia’s impact as a supplier to Asia is immense. Its Eastern Siberia Pacific Ocean (ESPO) blend crude flows almost entirely into Asia from the Far Eastern port of Kozmino, and via pipelines into China at a rate of around 3 million MT each month. The grade is considered a de facto crude ‘benchmark of North East Asia’ due to its liquidity and plentiful spot trading activity each month, allowing a clear visual into crude pricing for China, Japan and South Korea.
Monthly spot market trading for ESPO dictates price differentials for millions of barrels of crude grades flowing into North East Asia from all over the world – grades like Johan Sverdrup from Europe’s North Sea, Tupi from Brazil, and many other crudes from West Africa, Brazil, the Middle East and elsewhere.
Other smaller productions of grades like Sokol and Sakhalin crude are also key Asian exports, flowing into nearby countries like South Korea, or as far away as India.
In the weeks following the invasion, Asian pricing mechanisms for ESPO, Sokol and Sakhalin were heavily impacted in two key ways. First came the wave of self-sanctioning by buyers in the region, following initial geopolitical rhetoric led by the US, UK and the EU.
Although energy was quickly pushed to the bottom of the list among other types of punitive measures, oil companies are well-versed in modern-day sanctions strategy that targets banking and trade finance, even if physical oil barrels are foregone.
As the trading community has experienced with similar circumstances in Venezuela and then Iran, moving commodities without the support of the banking system is nearly impossible, and the consequences harsh.
The timing of the invasion came at the natural end of the February trading cycle in Asia, with initial self-sanctioning slow to pick up, but the pricing impact seen immediately. The last February spot cargo for ESPO that was heard traded on 24 Feb saw its price drop sharply from a peak of US$7.25/b mid-month to US$6.20/b. After that, there was pin-drop silence: General Index did not record a single ESPO cargo traded during March, and indicative prices nosedived to minus US$5/b by the first week of March.
By comparison, General Index had recorded a total of sixteen spot market trades of ESPO, Sakhalin and Sokol combined in February, quite representative of market activity in a typical month.
Initial evidence suggests that spot ESPO is still being bought by Chinese refiners through intermediaries. Since the Russia-Ukraine conflict began, regular open tenders for ESPO crude have completely evaporated, with buyers electing to buy through private negotiations instead.
A preliminary program for May loading ESPO indicated that 3.3mn MT of crude is scheduled for loading next month, around 10% more than the average loading seen in a month.
Sokol flows are expected to be heavily affected as well. South Korea is a major buyer of Sokol, taking around 2-5 cargoes per month. Japan and US are also occasional buyers of the crude. The US has already banned the import of Sokol and while Japan and Korea did not expressly ban the import of Sokol, refiners have expressed their reservations in continuing to lift the crude.
This means some Sokol must be rerouted in the near term. Trade data supports this. ONGC of India’s regular Sokol sell tender saw no bids in March. The cargo was heard eventually taken into India’s own refinery system.
It is hard to quantify how much Sokol will be rerouted because Japan and Korea have yet to announce a concrete stance on the continued procurement of Russian crude.
Sokol and Sakhalin pricing are closely linked to ESPO, as is pricing for nearly all grades that flow into China, Japan and Korea from all around the world. Pricing an untradeable grade is a complex exercise. The North East Asian benchmark, which had previously led pricing for other crudes amidst well-held correlations and spreads, now stands disconnected in the vast mesh of grades that flow into Asia. Indicatively, price differentials for ESPO are now languishing below negative US$-15/b against Dubai as of early April conversations with traders.
ESPO’s status as regional benchmark has been heavily thwarted in a short period of time. Until just weeks ago, it was considered one of the most stable and reliable pricing indicators in Asia. It remains to be seen whether another grade fills the gap for the North East Asian crude market.
Dirt-cheap Urals crude finds its way to Asia
Russia’s other big crude export, Urals, saw an even worse crash in pricing across Europe, with differentials plummeting to minus $20/b by early March, from minus $4/b in mid-February.
Financiers like banks refused to issue letters of credits which are key to managing liquidity for commodity traders due to increased risks of non-payment. Shippers refused to operate their ships in troubled waters like the Black Sea. Insurance premiums soared as well due to the increased risk of wartime miscalculations.
A longer April loading program also added salt to injury. A document seen by General Index indicated that April volumes amounted to 9.575mn MT which was well above the average volume by around 12%. Observers attributed the increase to Russian refinery maintenance which frees up more crude for export. Some also guessed that domestic export-oriented refineries could no longer process as much crude due to difficulty in exporting its products.
Unsurprisingly then, many of these dirt cheap Urals barrels found their way to Asia, almost exclusively being picked up by India through February, March and April as a suitable alternative to India’s usual Middle East sour crude diet.
Urals is a key sour grade favoured by European refiners. Around 1.7mn b/d of Urals is exported on seaborne vessels through the three main ports of Novorossiysk, Ust-Luga and Primorsk.
Seaborne Urals forms a limited portion of Asian imports. Kpler data indicates that between 50,000-200,000 b/d of Urals was imported into the region monthly. China and India are the main buyers of this crude grade.
Mass procurement of this grade is usually not economically feasible due to freight costs required to transport Urals into Asia. Geographically, the three exports ports are not easily accessed from the East. Alternative grades from the Mideast all load from ports in the Arab Gulf which are relatively closer.
Furthermore, the use of VLCCs is limited because these vessels are generally too large to pass through the Suez Canal. VLCCs are generally preferred to exploit arbitrage opportunities because they provide the cheapest form of transport on a per barrel basis. However, the size of these ships prohibits a direct journey through the Suez Canal. Typical voyages need to loop around the south of Africa which greatly increases the time and costs of transport.
But in March, General Index saw around 10-15 million barrels of Urals crude flow into India by way of spot market trading. Early April trading depicts a similar buying spree on account of state-owned Indian refiners, with sellers keen to clear their tanks of Russian barrels at record discounts ahead of a mid-May deadline for European financial sanctions.
It is worth noting that India procured very limited amounts of Russian crude before the war. About 10mn bl was bought in the whole of 2021.
Spot purchases in March suggest that the lower bound is around 300,000 b/d or 7% of India’s imports.
Additionally, Russian crude bought this way displaces spot crude from the Mideast which is where India usually procures its crude.
General Index assessed Dubai M1M3 fell sharply throughout March as headlines from India emerged, with the spread eventually stabilizing near US$5.00/b by early April.
India’s bargain hunt may come to an end soon in light of European sanctions, even if there is no willingness from the country itself to participate in the exercise. The crude purchases made by India are a subset of private spot market trading conducted by trading companies who procure these cargoes directly, by having a stake in the oilfields, or indirectly, by buying from someone who does.
Most of these companies are European based, and are therefore impacted by and subject to sanctions under EU law. The European sanctions will have a knock-on effect in spite of India’s willingness to purchase Russian crude. Reports indicate that the current spate of deals for April and May Urals cargoes are likely the last few such purchases in Asia, and June arrival cargoes of Urals, ESPO, Sokol and Sakhalin are unlikely to see any private trade at all, unless buyers are willing to talk directly to the source: Russia.
Zooming out of private spot market trading, India and China are already in conversation with Russia at the state level to hash out oil flows in a way that can sidestep the European and US sanctions regime.
Russia was heard offering crude to India at deep discounts of US$35.00/b under pre-war prices during an official visit by Sergei Lavrov to India towards the end of March. India confirmed that it intends to continue procuring crude from Russia, using a system that would allow it to bypass SWIFT sanctions.
However, it is unclear how much India intends to procure from Russia going forward.
China is the other major buyer of Urals crude in Asia, mainly via state owned refiner Unipec. China has taken a neutral stance towards the Ukraine war thus far and is expected to continue normal procurement activities, although sparse private buying activity has been heard by Chinese players in the spot market since late February, suggesting that China has not procured extra spot Urals despite the cheap price tag.