From scarcity to surplus: stability returns to energy markets

Go back a few years and news that the US and Israel had bombed Iranian nuclear sites would have caused oil prices to spike massively. When such an attack actually occurred this June, oil did spike, but nowhere near levels and not for nearly as long as they once would have. It's a stark example of the calm that has prevailed in the oil markets for some time now. Given that oil prices are usually very sensitive to the political turmoil we have these days, why haven't we seen them fluctuate more heavily?

There's not one reason that explains this calm, according to Warren Patterson, but rather a number of factors that are at play. "The first is a certain fatigue and complacency in the markets. We've been in a state of heightened tensions for a number of years now. Day after day investors read headlines that in effect spell out risk. After Russia's invasion of Ukraine for example, concerns were that we were going to lose two million barrels a day of Russian crude oil supply. How much did we actually lose? Nothing. So markets are no longer trying to decipher all the noise. Instead they have taken more of a wait-and-see approach now: 'We'll respond when we actually start seeing some disruptions.'"

But it's not only a matter of market psychology. Physical factors contribute too. OPEC countries have really been opening the taps and production levels are expected to exceed demand all the way through 2026. "We're talking about surpluses of some three million barrels a day. That does provide comfort to the markets and helps to explain why they're not as volatile as one might expect." An additional source of comfort is the fact that OPEC, even after the recent increases in their supply, still have around four million barrels per day of spare production capacity. "There is this expectation in the markets that if supply starts looking tight, OPEC will bring some of that spare capacity online. That effectively caps oil price levels."

All this leads ING to expect oil trading at an average of $57 a barrel through to 2026. That may not be a dramatic drop, but it still is significantly lower than the $60 to $70 range we've been in for some time. Patterson is quick to point out that ING is certainly not alone in this expectation.

There's a broad consensus in the markets that oil prices will come down and remain quite stable. That in itself creates a risk though. If everyone is positioned similarly, it takes just one big unexpected event to occur to catch everyone off guard. That could trigger overreactions and cause wild price swings.

One development that Patterson is watching closely in this respect is Russian oil exports. In particular, the effect of the secondary tariffs that the US has imposed on India for their purchase of Russian oil. "If I look at shipment data, I'm starting to see Russian oil flows to India trending lower. And if Russia is unable to find other buyers, they will have to start reducing their supply. If all that supply was lost, that could push oil prices up to $75 next year."

An even bigger risk is when Chinese imports are targeted more heavily with tariffs and sanctions. That could change the outlook for the oil market entirely, says Patterson: "Under a scenario where Russian oil exports were to stop completely, we're probably looking at $100-plus oil. But I don't really see that happening, not even as a result of the Ukrainian attacks on Russia's energy sector. The main actor in this scenario is the US. They have neither the power to force China to stop buying Russian oil, nor the willingness to do so because they don't want oil to become too expensive."

In the gas markets, prices are expected to drop too. After prices reached record highs following Russia's invasion of Ukraine in 2022, they've continuously been well above pre-war levels. Today they're about double that, but that's going to change, predicts Warren Patterson: "The key reason is that we've seen a lot of investment in LNG capacity. That is crucial for Europe, because since the loss of Russian pipeline gas, Europe is relying heavily on LNG.

Global LNG export capacity is expected to grow by about 40% between now and 2030. So we're going from a period with a lot of tightness in the global markets to substantial surpluses of LNG all the way to 2028.

That doesn't mean prices will fall back to 2021 levels, simply because transportation and regasification of LNG is more expensive than pumping it through pipelines. Patterson expects Dutch gas prices trending down from the current €31 per MWh to around €25 per MWh in 2028. Would a peace deal between Ukraine and Russia open the door again to imports from Russia and cause gas prices to fall even further? Not very likely, in Patterson's estimation: "The only way I could see that happening is when a resumption of Russian gas imports is made part of a peace agreement. The pushback would however be very strong. Not only from Europe, but from the US as well. A large part of the new LNG capacity is located in the US. It was built on the back of expectations that demand for it would come from Europe. So as much as President Trump might want a peace deal, he doesn't want Russian pipeline gas to start flowing to Europe again."

Patterson concludes that Europe has replaced its energy dependency on Russia with one on the US. The growing importance of the US as Europe's energy supplier does bring certain benefits though, in particular a diversification of supply chain risks and greater flexibility. "An important issue for European buyers of gas is that they don't want to lock into very long-term LNG purchase contracts that are typically 20 to 30 years long. That's because with the EU's decarbonization plans and the push for renewables, they don't know what their demand will be 10 years from now. US suppliers do offer more flexibility and shorter contracts, which is what European buyers are looking for."

What does this outlook of lower energy prices and ongoing stability mean for Europe as a net importer of energy? "After some difficult years, downward pressure on energy costs, electricity prices and inflation are very good news for European industry and consumers alike I would say." Apart from lower costs there are further positive aspects in the energy markets outlook. Stable oil and gas prices will help European corporates forecast energy costs more accurately, supporting investment planning and cost control after years of volatility. Says Patterson: "For European businesses, this period of stability offers a window to lock-in favourable energy contracts. That provides an opportunity to plan investments and possibly rebalance long-term energy and decarbonization strategies."