Oil prices and the war

Without a loss of supply, oil can only go so high

Many are worried about recession-causing rises in oil prices resulting from the Russian military operation in the Ukraine.

A possible, but at this point blessedly unlikely scenario. Commodity spot markets, unlike financial instrument markets, are constrained by storage costs and physical settlement. Pets.com stock can be elevated for months or years while markets try to process new information, oil has to be stored, processed, and then sold to people in a quickly turning supply/demand cycle.

It almost doesn’t matter how temporarily irrational futures traders become, as traders in the spot market have to settle physically with the commodity in question. The buyer has to take possession of X-thousand barrels of oil. He needs a place to put that commodity, before he sells it on or uses it in some value-adding industrial process.

Let’s just walk through it quickly to clear up any potential confusion. Assume the world’s oil production goes along as it would have had some deal been worked out and there’d been no war. Oil futures traders go mad, heck even the spot market goes mad with fear and start buying all the oil they can, regardless of price. Oil rises to $400 a barrel, about 4x what it is now.

Retail gasoline prices move up in near-real-time with oil prices. In the USA, $400 oil translates into $12 gasoline. At such a high gas price, economic actors immediately recalibrate their gasoline usage. Car pooling, remote work, fewer trips, walking, bicycles, buses, more freight transportation by train, less by truck. There’s a whole lot that can be done tomorrow if gasoline is $12 a gallon.

Remember, in this example we said that oil production would not change vs the baseline of no war, that traders simply bid up the price out of fear. So all the oil production that happened at $90 a barrel, goes on at $400 a barrel, however, less gasoline is sold at $12 a gallon than at $4 per gallon. The result is that oil inventories rise, and keep on rising until the oil price comes down to match the supply-demand clearing price, or inventories max out.

You can only store so much oil, it’s expensive, capacity can’t be quickly added. Refiners are not in the business of hoarding oil at $400 a barrel, but in refining that oil into fuel, and selling it to customers.

The only way the Former Soviet Civil War could meaningfully affect oil prices, and by that I mean more than $20 or $30 worth of short term precautionary risk premium, is if the fundamental supply demand dynamics are disrupted. If NATO attacks Russia’s oil production, or Russia embargoes oil to punish NATO for sanctions, then we’ll get our $300 or $400 oil. If the war somehow increases oil consumption drastically, that could also affect prices, but you have to drive your tanks pretty hard to move the needle on aggregate oil consumption.

Once wars start, God know’s what will happen. This is why it’s so important that all relevant powers work jointly, in good faith, to avoid war, by recognizing what a power’s resources entitle it to, in the event that the Law of the Jungle is invoked. That didn’t happen here, and now we have a war. As long as the oil keeps being pumped and put on ships however, oil price rises should be transient, “risk premium” events. We already see this with oil coming down following the initial tepid sanctions, rising following the new round of sanctions over the weekend, and now falling again after Russian officials mocked the sanctions, rather than spur on a new round of tit-for-tat escalations.