Pauls Miklasevics

Chief Investment Officer at BluOr Bank

February 24th, 2022, 5:36 am

I woke up in the dark and checked to see what time it was on my phone. 5:36. Too early. Best to try to catch another hour of sleep. By force of habit I checked to see what market futures we doing on my investing app. Both Brent Crude and West Texas Intermediate Crude were up 6%. Now I was wide awake. I knew that there was only one reason that the prices would have increased this violently overnight: Putin had invaded Ukraine. I quietly made my way to my living room careful not to wake my sleeping wife and child and turned on the TV news. My fears were confirmed. I sat glued to the news coverage for the rest of the morning. The rising sun began to fill the room, but the world had become a much darker place.

A former colleague of mine used to be the chief economist at a large Latvian bank. He prepared regular economic overviews of Latvia and global markets that we would present to the clients. Every so often I would ask him if there was any interesting audience feedback from his latest presentation. Regardless of what he presented or talked about the first question that we would invariably be “what is happening with the price of oil?”

It comes as little surprise that the spike in gasoline and diesel prices that has occurred since Putin’s invasion of Ukraine has our country’s drivers in a state of fury and disbelief.

We love our cars, but few things set us off like having to pay more at the pump.

Last year around this time Euro 95 gasoline prices were around 1.25 euro per liter. Now they are pushing 2 euro per liter. How is this possible? What are we paying for? How can our government allow normal people to suffer like this?

Let us first look at what constitutes the price we pay at the pump.

Neste’s website claims that the price they pay suppliers of actual fuel makes up 40% of the price paid by consumers. 7% goes towards their retail operations. The remaining 53% are taxes.

Virši-A’s website indicates that 45% of the price at the pump comes are fuel costs. Their retail operations constitute 10%, while 45% goes to taxes.

We have relatively high taxes but they are lower than several other EU countries.

The differences are mostly attributable to taxes.

Here is how the price of fuel in Latvia compares to the rest of the EU:
CHART #1 (LATVIA vs EUROPE)

Taxes serve two main purposes: to generate revenue for the government and to encourage or dissuade behavior. Europe and Latvia have made a conscious decision to have higher fuel taxes to make driving more expensive and encourage people to seek more environmentally friendly transport alternatives. As such, taxes constitute a much higher proportion of fuel prices in Europe than elsewhere in the developed world – especially the US.

While successful politicians in Europe are keen to keep abiding by a ‘green agenda’, spikes in gasoline prices can hurt consumer spending and confidence elsewhere in the economy. It is therefore to be expected that those not in power would take advantage of opportunities such as this to play to the angry crowd and demand that gasoline taxes be lowered.

Such a course of action is the exact opposite of what should be done in the current environment. Why? Because it does not address the core issue at hand: that demand exceeds supply. Subsidizing buyers by cutting taxes without encouraging more supply is a short-sighted maneuver that would only set us firmly on the path to even higher prices in the future.

In any functioning market, price is dictated by supply and demand. Putin’s invasion of Ukraine has caused chaos in the supply part of the pricing equation. Buyers reacted to a lack of certainty by bidding up all available, non-sanctioned supply. The price shock has hit each component of the fuel supply chain. As always, this has been passed down to the consumer.

So what happens next? To understand the current state of gasoline prices you have to look at the underlying dynamics and recent history of the crude oil market and understand that Putin’s invasion of Ukraine is just his most recent – albeit very serious - disruption in what is a far bigger game than this most recent spike in oil.

Two years ago, oil prices were negative. There were two primary reasons that this happened. The most prominent cause was the Covid-19 related negative shock to the global economy, and thus, oil demand. Prices went negative because producers had to pay to offload excess supply.

However, many often forget that just as the gravity of Covid-19 was starting to be realized, Russia started a price war with its previous partners Saudi Arabia and OPEC.

From 2016, Russia and OPEC (The Organization of Petroleum Exporting Countries) had established an informal alliance wherein they agreed on mutual oil production quotas in an attempt to manage the price of oil. The raison d’etre of OPEC has always been to control oil supply. In so doing, they could support relatively high and stable oil prices. Adding Russia to the gang made them more powerful than ever before.
The rationale behind this new alliance - referred to as OPEC+ - was formulated in response to the massive recent increase in US oil production due the development of shale oil reserves.

Shale oil production involves fracturing rocks to extract oil from tight oil formations. Prior to the advancement of oil fracking technology, US oil production had been in terminal decline since the early 1970s. But starting from around 2012, US oil production began to soar and attract billions in investor capital. Higher US production sent the price of oil lower, and this severely impacted OPEC and Russia’s revenues.

OPEC was founded in 1960. Since then, they have set production quotas for their members, only for their members to exceed their quotas on a fairly regular basis in order to get more oil revenues. Quota breakers would invariably be brought into line by Saudi Arabia who could legitimately threaten to out produce everyone and drive down the price of oil as a form of punishment. Realizing the ‘error of their ways’ the smaller OPEC member would sincerely apologize and promise not do so again. They would then fly their retinue back from their meetings in Vienna – possibly by way of Paris or London in order to go shopping and visit their bankers – and fly back home on their newly purchased private jets. And then they would cheat and overproduce again.

No one could really stand up to the Saudis in terms of production until Russia joined the gang. So when Russia came out and said they would not abide by their previously agreed upon quota, the Saudi’s decided to counter with a classic game theory maneuver and increase their crude oil production as well. This happened just as the world was entering the biggest economic shock of all time caused by the Covid-19 outbreak. Right after they had set in motion a huge increase in oil production, both Saudi Arabia and Russia were forced to ‘turn off the taps’ so to speak as oil demand vanished due this massive global epidemic.

But here’s the thing: you do not, in fact, get crude oil from a ‘tap’ that can easily be turned off and on. In the case of Russian and Saudi Arabia, you pump it from massive oil fields that are mature and are very sensitive to pressure changes. This means that large short term production increases jeopardize potential future production. Conversely, shutting wells results in lower production capacity if they are reopened. Therefore, by dramatically increasing and then shutting down supply in a very short amount of time, Saudi Arabia and Russia did the worst possible combination of actions to negatively impact their future ability to produce oil.

As this was happening, bankruptcies were tearing through the US shale oil patch. It had been clear for some time that shale production was not as sustainable or profitable as investors had been led to believe, but crashing oil prices left no doubt that whatever scarce capital remained should jump ship. This caused unprecedented levels of shareholder wealth destruction and significantly reduced US oil production.
By the end of last year it became clear that global oil demand had resumed a strong uptrend and was higher than it was before Covid-19. However, despite rising OPEC production quotas and crude oil prices that should incentivize independent US oil companies to bring on new supply, production was not keeping up to demand. This resulted is rising prices.

At the start of February of this year, OPEC+ even issued a curious statistic: member compliance was 120.8%. What does this mean? It means that as prices were already headed to their highest level in eight years, an organization infamous for breaking quotas could not produce enough crude oil to meet their quotas, let alone engage in their favorite activity: capture excess revenues by overproducing.

Where are we headed from here?

Goldman Sachs has an average Brent Crude target of $135 USD/barrel for 2022 and a $115 USD/barrel target for next year with ‘upside risks’. As I write this commentary Brent Crude is trading at $103 USD or 93 euro/barrel, after having already touched highs of $139.15 or 127.93 euro.
Goldman Sachs comments that during the previous oil crisis of 1980, peak household spending on petroleum products in France as a share of income was 4.7%. This is 72% higher than December of last year. They go on to state that “reaching such a level today would already require a 33% increase in current retail fuel prices from €2.10/Ltr to €2.8/Ltr (+72% from December's price of €1.63/ltr).”

Latvia’s retail fuel prices are around 0.10 euro cheaper per liter than French fuel prices due to lower taxes. Therefore we could theoretically expect a maximum pain level of up to 2.70 euro per liter of Euro 95 gasoline before politicians around Europe give in to popular outcry and lower taxes to offset higher crude oil prices.
For those that argue higher oil prices in Europe are causing economic pain and suffering, I will leave you with this statistic: in the fourth quarter of 2020, Russian oil exports doubled from $16 billion to $32 billion. $16 billion per quarter on an annualized basis is $64 billion.

That same year Russia’s military budget was $62 billion.

For the foreseeable future oil will remain the lifeblood of the world economy, supply will continue to struggle to keep up with demand and prices will rise until demand is destroyed.
There will be pain at the pump, but we must not lose sight of the secure energy future that we want to build. If higher gasoline prices turn out to be our generation’s biggest struggle, history will judge us as having been very fortunate. 

The Latvian version of this article originally appeared in the April 2022 issue of Forbes Latvia.