After a lacklustre finish to last week oil bulls received a fresh dose of medication yesterday, which helped crude oil prices rally about $2/bbl whilst the CME RBOB contract jumped $6.70/bbl equivalent. The treatment has certainly revived the ailing patient, it is even stronger this morning, but the long-term impact of the new therapy is not entirely clear. The recovery actually started when the ECB rate rise helped the euro (and other currencies) recover some of the lost ground against the dollar and the greenback’s weakness continued yesterday. The real bullish impetus, however, came from Russia. Gazprom announced yesterday that it would reduce supply via the Nord Stream 1 pipeline to a mere 20% of capacity, which amounts to 33 million cubic meters per day. The announcement revived fears that Russia, despite its cynical denial, will not shy away from using its energy as a weapon in order to gain concessions in its war against Ukraine and, as discussed below, could probably expect short-term success.

Whether these antics would ultimately work remains to be seen as supply issues could easily be swept aside by demand considerations as it has been laid bare in the past. Recession fears could re-surface this week. The Federal Reserve will most probably hike its benchmark interest rate by another 0.75% in its fight against inflation. Today’s US consumer confidence data, Wednesday’s durable goods orders estimate and Thursday’s 2Q GDP growth rates will also provide indications of the state of the US economy. On Wednesday focus will also be on the US gasoline demand figure when the EIA releases its latest findings and investors’ sentiment could once again make a quick U-turn. The clash between supply considerations and recession worries continues ensuring volatile trading conditions.

What could hurt Russia?

Ukraine’s allies are desperate to find and launch effective retaliatory measures that would deprive Russia from much needed revenues and could force the invader to the negotiating table. The gut reaction in the immediate aftermath of the invasion seemed logical and was understandable. Given that Russia is a significant exporter of energy products a boycott of its sales seemed the way forward. Traditional buyers of Russian oil and gas gradually reduced their purchases and agreed to find ways to replace Russian supply in the medium term. On June 3 the European Union adopted its sixth sanction package against Russia, which included a ban on seaborne imports of Russian crude oil by December 5 this year and a ban on product imports two months later. The EU has also pledged to replace Russian gas imports by two-thirds by the end of this year. The net result of these measures has been higher energy prices that greatly contributed to the global inflationary pressure and economic malaise whilst Russian revenue has actually risen despite falling export volumes.  The re-alignment of Russian oil flows to “friendly nations” has also gotten under way helping fill up Russia’s coffer.

In the short-term plans to reduce dependence on Russian energy has been a rather spectacular own goal; the western world and within that the EU has suffered more significant economic damage than its adversary. Consequently, the idea of introducing a price cap on Russian oil has been floated. The plan, as detailed in last Thursday’s note, faces several, possibly insurmountable, obstacles. The aim of the proposal is to meaningfully reduce the Kremlin’s oil revenue and create extra supply, thereby mitigate the negative economic impact of the war. From day one there has been a healthy dose of scepticism surrounding the proposition. A price cap would likely create extra demand for Russian oil pushing prices higher, could lead to Russian refusal to supply oil, would require an implausible global co-operation that should include China and India and finally could not possibly be enforced and would be prone to cheating.

Prices can be brought under control by rising supply and/or falling demand. The last five months has clearly demonstrated that supply sanctions do not work, at least not for now and their economic impact is nearing the unbearable. Reducing demand, therefore, is the only remaining option. Natural gas is the viable tool to do it. European stockpiles are nowhere near to the required 90% level as winter approaches and fears are growing that Russia can use natural gas as a weapon to gain concessions from the West. The EU has urged member countries to be prepared to cut their gas consumption by 15% below the 2017-2021 seasonal average from August 2022 to March 2023. Given that Russia supplied 40% of Europe’s natural gas last year it is imperative that demand is reduced before cold weather arrives on the northern hemisphere otherwise rationing will have to be introduced.

The price we pay for living in democracies is painfully slow decision making with no guaranteed result. There are several issues that need to be sorted before any kind of deal is implemented. Hardly a week after the original idea was proposed member states are attempting to tweak the proposal to make it work. The original plan recommends voluntary cuts that could be made binding in case of an emergency, much to the dissatisfaction of several member states. The revised plan that was being discussed yesterday and will be the subject of talks between energy ministers today would offer exemptions to mandatory reductions to those that are cut off the EU’s gas network or have already built up their national stockpiles to secure levels. Some says the revised proposition forms a solid basis for a possible agreement whilst others argue that the number of exemptions would make the plan ineffective.

Whilst ideas are being thrown around it is becoming disturbingly clear that Russia has not been cornered, far from it. The dilemma western leaders are facing is whether to prioritize national and economic interest or to present a united front and refuse any kind of concession towards Russia. Until alternative oil and gas supply is secured, and it will take years to achieve that, domestic political and economic concerns will likely dominate. At this early stage of the war the EU is more dependent on Russia than the other way round. And if this line of reasoning proves accurate no significant demand reduction should be forthcoming apart from recession-induced fall in consumption and at the same time Russian oil and gas will keep flowing effectively discouraging oil bulls from betting on considerably higher prices – unless, of course, Russian energy is weaponized further.