Russian invasion sends shockwaves through energy markets

Energy benchmarks have recently experienced sharp moves higher as Russian advances into Ukraine threaten to add supply disruptions to an already tight supply/demand backdrop for oil and gas markets. European natural gas prices have jumped, while the oil price has surged north of US$100 per barrel with international benchmark Brent crude hitting a high of US$139 on March 7th - levels not seen since before the global financial crisis in 2008.

The rapid escalation of Russian troops’ actions, from aggressive posturing under the guise of military exercises to a full-blown conflict in just a matter of weeks, has sharply heightened geopolitical tensions.

The oil market has experienced extraordinary volatility and displayed a sharply heightened sensitivity to news headlines. For instance, reports earlier this week that the United States was pushing for a ban on Russian crude sent the market to new highs, though an expression of resistance to these measures from Germany saw the gains pared.

BP and Shell have announced they will cut ties with their Russian partners, with Vladimir Putin’s decision to invade Ukraine forcing the biggest reappraisal of corporate relations with Russia for a generation.

BP were first to act, declaring its intention to exit a 20% stake in Russian state-owned oil company Rosneft, which, at the time of the announcement, was worth around US$11bn.  Both BP directors have resigned from the board with immediate effect and the firm will no longer report reserves, production or profit for Rosneft. Uncertainty regarding if or how BP would receive any proceeds for its share in Rosneft implies the market will likely ascribe zero value to it or the dividend stream.

Due to the use of equity accounting, headline cuts to earnings, production and reserves will be substantial, though for the fiscal year 2022 it was only expected to receive a prospective US$2bn dividend stream – approximately 10% of the group’s operating cash flow, which forms the basis for dividends and buybacks.  

Most importantly, BP’s shareholder return objectives remain unchanged, though dividend cover will weaken alongside an increase in leverage, which, all else equal, implies a higher target dividend yield. Furthermore, the soaring oil price will provide an automatic stabilizer, dampening the effects of the expected loss. 

Shortly after the BP announcement Shell followed suit, and while it has interest in several Russian assets, they represent a much smaller part of the business than BP’s Russia exposure. Shell’s assets are predominantly Gazprom jointly owned, the most important a circa 28% stake in Sakhalin 2 LNG project that represents around 1% of group operating cash flow. In total, Shell’s Russia exposure is around 3% of adjusted earnings, less than 2% of group operating cash flow.

While other firms such as Norway’s Equinor have also acted to cut ties with their Russian partners, several companies have not, so far. Total, the French oil and gas major, condemned Russia’s military aggression but unlike its peers did not pledge to divest. 

The impact of soaring oil prices is far-reaching, providing a headwind to economic growth and adding more fuel to the fire of persistently elevated levels of inflation. In other words, it adds further credence to calls for a period of stagflation. 

Higher oil prices can weigh on the rate of economic activity and simultaneously raise the cost of business. This is not good news for the economic recovery from the Covid-19 pandemic which was already under threat of being hindered by tighter central bank policy – caused by existing above-target rates of inflation. Panic buying by UK motorists has threatened to cause another round of fuel outages as customers rush to fill up their tanks, fearful of an impending increase in price at the pump.

However, in the near term the conflict may offer some reprieve from higher interest rates. As recently as mid-February, market implied Eurozone policy rates indicated the European Central Bank deposit rate would be back close to 0% by year-end – they now show it remaining near its current record low of -0.5%.  A more cautious approach to tightening would soften the economic blow in the near-term but if energy prices remain elevated, or go even higher, additional upward pressure would be applied to broader prices.

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