Commentary by GZC Investment Management

In January, global energy demand was on the strong side of expectations, with oil storage in OECD drawing significantly. However, global crude oil balances suggest it is likely to ease for the coming months despite a strong backwardation in oil curves and limitation in US stocks building instrumented by Saudi Arabia. When analyzing non-OECD countries – the less visible part of oil storage, which accounts for approximately 50% of the total – it is noticeable that balances are not as tight, indicating that aggregated crude oil stocks remain relatively healthy. 

That said, since late January, the oil market priority has been to replace Russian oil with other sources of crude, not at risk of being sanctioned. In effect, for about a month, the oil market has traded as if a significant portion of Russian oil (possibly 3 to 4Mbd or around 1/3 of Russian production) was already lost to sanctions and/or embargoes. That resulted in a rare tightness with curves steepening to levels not seen during the Gulf wars. While nobody knows if Russian barrels will be lost, oil buyers from NATO countries especially have already prepared for the worst-case scenario. Demand for competing Ural benchmarks has increased incredibly sharply, and Russian Ural crude oil is now trading at a historical discount to Brent, leaving the market with two questions going forward: 

• Firstly, are Russia and NATO capable of compromising relatively fast or are we headed for the largest geopolitical conflict at the European border since the 1940s? 
• Secondly, in the event of escalation/invasion and sanctions, would Russian barrels stay outside of the scope of sanctions? Would they find their way East (to China and India typically) or would Putin use the 1973 play book and cut production voluntarily with the idea of being compensated by the price appreciation? 

Ex-Russian input, we think oil prices will struggle to maintain at their current level in the $90s – essentially because there is enough production coming back to match demand in 2022 and rebuild stocks during the year, especially in the event of an Iranian deal which seems more and more likely. If Putin obtains quick concessions, the last few weeks would have been a horrendous squeeze, and oil prices/curves could collapse back very quickly. Our base case is that a security arrangement, especially between Russia and Europe, will eventually be reached after multiple episodes of increased tensions and diplomatic failures followed by new negotiations until a compromise is found. It might also mean in this scenario that Russia will have invaded part or the entire Ukrainian territories. 

In our base-case scenario, oil keeps having ups and downs for a few weeks, with a trend for ups being sold more and more rapidly. As eluded above, we don’t think sanctions would trigger a large move up in prices as oil market participants have already largely prepared for it. What will keep us on our toes though, is the extreme scenario where Vladimir Putin uses the energy weapon with full force and possibly even slashes his natural gas and crude oil production. Until last winter, we have always treated Russia as an incredibly rational player in the context of global diplomacy. 

The manipulations of European natural gas this winter and the limited supply from Gazprom (contractual obligations were fulfilled, but the additional flexible supply was very tightly offered) have brought doubts that Putin remains the strategic player we have known for years. If Putin used the energy weapon this winter to possibly compensate for Nord Stream 2 interruption, he has made a strategic mistake by already losing his top customer for the coming decades. Indeed, Europe, via Ursula Von der Leyen’s voice, has already drawn its conclusion: ‘one of the main lessons we have already learned is that we must diversify our energy sources and that we must get rid of the dependency of Russian gas. This is what Russia achieved last winter in testing the powerful Energy weapon. This precedent has us concerned that Putin is on a new path, a less diplomatic one, maybe not to the point of cutting its production to strangle Europe à la 1973 embargo but possibly capable of cutting supply to non-cooperative countries while trying to sell excesses at a discount to Russian allies. 

Therefore, we remain open to numerous scenarios and intend to stay very flexible in the coming weeks. In January, SCF finished the month at -2.08% (Net) with directional exposure losing 0.7%, mitigated by relative value at +0.7%. Vol downside in crude was the main negative contributor at -1.2%, followed by our gold upside portfolio hedge ending at -0.6%. Keeping our fundamental view that oil balances should loosen in 2022, we will express it with more flexibility in the short run to also cover the scenario where the situation in Ukraine deteriorates significantly. We still think gold vol/upside skew is particularly attractive as a hedge versus oil. Overall, we will be running a portfolio that can perform in different scenarios with a long vol bias.

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