The Crude Report: The effects of surging gas and coal prices

Author Argus

The current strains across power, coal and natural gas markets will likely increase fuel switching around the world, ending with a domino effect on crude oil demand.

In this episode of The Crude Report, Alejandro Barbajosa, VP Business Development and David Fyfe, Chief Economist, discuss how fuel substitution will likely pan out as the northern hemisphere heads into the winter.

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Alejandro Barbajosa: Welcome to the Argus Crude Report. My name is Alejandro Barbajosa, and today, we're gonna have a very interesting conversation with our chief economist, David Fyfe.

He will walk us through some of the implications of the current strains that we're seeing across power, coal, natural gas, and oil markets, and how that is likely to increase the rate of fuel substitution, where we might see increased demand for crude in coming months.

As you well know, international gas and coal prices have surged in recent months. So, David, before we discuss the implications of this for the crude market, what are some of the drivers of these surging prices, and how durable could they be?

David Fyfe: Hi, Alejandro, great to speak with you again. It's a very good question. I think essentially what we're seeing at the moment in the energy space is that the sort of supply chain bottlenecks that have bedeviled other industrial sectors for much of 2021 are now afflicting the energy space.

In Asia, we've had a number of constraints on coal supply, in China, and India, and elsewhere. At the same time, we've had surging power demand, partly because of price caps in the region. So power demand has rebounded alongside industrial activity and at the same time coal, which, for China and India, is up to 70% of the fuel mix into the power generation sector, has been in short supply.

And so what that's done is, in a sense, boosted LNG import demand into the Asian market. That's up by around 5%, regionally year-on-year, so far in 2021. And in fact, LNG imports into China so far in 2021 are up closer to 25% year-on-year. So, you know, very, very high levels of prices driven by some of the distortions within the market that we've seen. Meanwhile, in Europe, we've also had some gas supply issues. We've had low levels of wind power generation, which is an important source of power generation in Europe.

We've had low levels of natural gas stocks through the summer after a very cold winter last year. And at the same time, there seems to be limitations on sort of supply upside for US LNG and Russian pipeline gas. So really everyone's focus now is on what sort of winter weather we're gonna have over the next five to six months. Some people are pointing to the La Niña climate phenomenon, seeing there's perhaps an 80% probability of La Niña this winter. And that all of the things being equal would be suggestive of rather colder than normal weather conditions in parts of the Northern hemisphere.

So, yeah, we've got limitations on gas supply, limitations on coal, and prices have been a bit higher as a result of that. Essentially, natural gas prices now, the marginal cost of spot LNG is up around, you know, $35, $38/mn Btu, and that's gonna cause demand destruction and fuel switching.

Alejandro: So you spoke about what's happening across different regions. And I think it will be quite helpful if we understood a bit better how fuel substitution takes place across these different regions. What types of consumers may be looking at fuel switching and what are the limitations on switching capability? I mean, are we talking only about bulk power on industrial markets or does this also involve smaller-scale consumers, which may have their own generators?

David: Great question. I think one thing important to set out at the start is not all gas consumers either can or will switch. If your gas supply is on a long-term contract that is indexed crude, you won't be paying sort of $35, $38/mn Btu for gas. You'll be paying crude-indexed prices, which are considerably lower than that. So what we're looking at is, you know, areas where there's very, very strong levels of industrial power demand and where at the margin consumers are being forced to consider paying these very, very high levels of gas prices.

You know, essential preconditions to be able to switch, there has to be dual fired capability. You have to have in place the storage and logistics capability to be able to burn oil in place of gas or coal. And, you know, you need to be free of the sorts of environmental regulations or air quality regulations that would prohibit the burning of oil or coal in place of gas. So with those limitations sort of clearly stated, where do we think the bulk of incremental oil demand over this winter is likely to occur?

I think you're right, the bulk of power generation sector is probably...would account from maybe 60% or 70% of any switching. We think the majority of switching is gonna take place in Asia, or at least in markets east of Suez, a little bit in Latin America, North America, and Europe, but really Asia is gonna be the focus. And I would say residual fuel oil is probably the single product that we'll see potentially the biggest uptick in demand. We're probably gonna see smaller quantities but still significant volumes going into the industrial and commercial sector in particular, where there is power rationing taking place.

And we're already seeing that in India and China, for example. And their smaller-scale industrial and commercial consumers, if they have diesel generators, off-grid diesel generators, then they'll be looking potentially to switch into diesel burn. And we're already seeing that, you know, diesel cracks, particularly in Asia, have widened quite significantly. So there's some indication that that is already happening. And then finally you have, you know, marginal switching capability and let's say the marine bunker sector and refinery fuel use as well. But I would say power generation first and foremost on-grid, and then behind that, extra diesel consumption for smaller-scale off-grid consumers.

Alejandro: Thanks for clarifying the picture for us. What would you say is a reasonable estimate for current potential additional demand for crude and refined products due to fuel switching around the world? And how would do expect that volume to change through the course of the Northern Hemisphere heating season?

David: Again, I'd go back to what I said earlier on, a lot will depend on winter temperatures in the Northern Hemisphere. We saw last January, February, Asia, Europe, and indeed even Texas in the United States hit by much colder than seasonal weather, but the price spikes were relatively...for natural gas were relatively short-lived. So a lot will depend on the extent of winter temperatures in the Northern Hemisphere and the duration of cold winter weather.

Our sort of ballpark number that we're working with at the moment is around about half a million b/d, potential incremental oil demand for the fourth quarter of 2021 and the first quarter of 2022. Now, that is premised on, you know, seasonal average winter temperatures. So obviously the number could be higher than that if we see a markedly colder than the normal winter. Other estimates out there in the market, I've seen numbers as low as 250,000 b/d, and numbers as high as 1mn b/d. But I think that latter, 1mn b/d number would be in the instance of, you know, markedly colder than the normal winter weather.

Now, our number, as I said, is about half a million b/d, which we think could persist in the fourth quarter and into the first quarter of 2022. So that's 500,000 b/d spread over 2 quarters. When you annualize that for 2021 and 2022, it's about, you know, 125,000 to 150,000 lb/d on annual oil demand. As I said, probably 60% or 70% of that is residual fuel oil. Maybe something between 100,000 and 150,000 b/d of diesel and, you know, smaller volumes of direct crude burn and LPG potentially.

Alejandro: And would you expect this incremental oil demand? Because, you know, today we hear people talking about the two sides of the coin. One is the increasing consumption as a result of the fuel substitution but also we may have an economic slowdown. So would you expect this to fully offset the potential declining consumption triggered by the slowdown of the Chinese, Indian, and European economies? Because, you know, outages are plaguing their manufacturing and industrial activity. And also, how do you think that, overall, this will affect underlying crude price levels?

David: No, you're absolutely right to identify that there's a series of synchronous influences that play here. And, you know, we've already seen manufacturing activity particularly in China but also in North America and Europe. You know, the rebound has sort of lost a bit of momentum and, you know, supply chain bottlenecks across the commodity space are slowing industrial activity. I think that's already baked into most people's GDP expectations. The IMF in their October forecasts really didn't alter their outlook for GDP in overall terms very much.

Other people have been more aggressive, particularly revising down expectations for Chinese GDP growth over the next 12 to 18 months, potentially knocking maybe 0.5 percentage points of China's growth. Our view is that macro impacts are gonna be sort of medium and longer-term, a bit more of a slow burn, if you like, there. I think what fuel substitution is gonna do is it's probably gonna keep oil prices, crude and refined products cracks relatively strong over the course of the winter. You know, it's quite easy to see crude using North Sea dated as a sort of benchmark, you know, crude remaining $80 and above, you know, through the fourth quarter and into the first quarter.

Having said that, you know, I think our view is that this fuel substitution impact, it doesn't really change the overall dynamic for the crude market. It may well defer the emergence of surplus in the crude market in 2022 until the second quarter or beyond, but we still see crude being subject to some bearish pressures later in 2022, assuming that this fuel substitution is primarily a winter phenomenon. So we would still expect crude prices at some stage in 2022 to begin to ease somewhat but not over the course of the winter quarters.

Alejandro: Ultimately, fuel switching is likely to result in some incremental release of carbon into the atmosphere, an increase in emission. So with COP26 beginning at the end of this month in Glasgow and, you know, surging gas and coal prices coinciding with the recent release of the IEA's and Opec’s views about markets in the short and longer terms and the energy transition, from your perspective, what are the key lessons of this fuel crisis for crude and for the energy transition in the longer term?

David: No. I think it's, in some ways, ironic that this is occurring just ahead of COP26 at the end of October. I think what the energy crisis has illustrated is that the energy transition is gonna be a long drawn-out process. And in a sense, energy transition, you know, switching the energy infrastructure over to new fuel forms over time, in a sense, builds an element of volatility into markets. I think what it has demonstrated is that legacy hydrocarbon fuels are gonna be with us in end-use markets for a long time to come.

And really that contrasts with the sort of recent policy focus that we've seen, which is, in a sense, deprioritized upstream oil and gas spending while emphasizing investment in new renewables capacity. That trend will continue, but arguably, what we should be doing is ensuring adequate upstream and infrastructure investment in oil and gas until such time as demand-side transition spending catches up. The reality is that oil and gas reservoirs, without investment, deplete faster than even the most ambitious oil demand trajectories under energy transition scenarios.

So oil and gas upstream investment has to continue until that demand-side transition catches up and we manage to lower the carbon intensity of the fuel mix. So I think, you know, what it tells us is there's probably a bumpy road ahead, a lot of volatility. And, of course, that means, as ever, a need for market transparency.

Alejandro: David, as always, it's really a pleasure to speak to you and listen to your very insightful analysis. We thank you for your time.

And we remind our listeners that similar analyses on the direct linkages between crude oil and the various downstream markets are readily available in our Argus Global Markets service. You can find more information on this service at Thanks for tuning in. And we look forward to you joining us on the next episode of The Crude Report.

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