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Oil supplies: The Ukraine war didn't change the price of oil but it did change oil prices. Huh?

14:54, 6 July 2022

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Oil supplies and Ukraine explained, by Tim Worstall
Oil supplies and Ukraine explained, by Tim Worstall

Whether we call it a war or not, the impact of events in Ukraine on oil supplies didn't change the global oil price but they have changed global oil prices. On the other hand, the same events have changed the global wheat and sunflower oil prices, and therefore maize, barley, rice, soyabean and rape oil and so on. In there is one of the grand secrets about trading commodities.

We looked at whether something is fungible last week – commodities are fungible, it's part of their definition. They are rarely perfectly fungible, which is what drives trading strategies among them.

Oil Supply 1: Brent Crude Oil Spot Price

That Ukraine war, those events, sanctions have been put upon Russian oil. But the global oil price hasn't changed as a result. Different oil prices – Brent, WTI, East Siberian, they have changed relative to each other. We've an explainer here but the basic thought is that oils are slightly different, yes, but largely interchangeable – they're fungible. You've got to twiddle the refinery to move from one type to another, from sweet (sulphur light) to sour (sulphur heavy) and so on but it can be done. Which refinery uses which type of oil is largely determined by the transport costs of getting it from the wellhead to that refinery.

Oil Supply 2: West Texas Intermediate

What this means when sanctions are put on oil from one source – say Russia – but only by some countries – say, not China in the current example – is that whose oil goes where gets shifted around a bit. Europe buys some more Nigerian oil, say (Bonny Light is the benchmark there) and less Russian. But China and India and so on now buy more Russian and less Nigerian. Refineries need to be twiddled, transport costs change, but the same amount of oil is being pumped, the same amount of oil is being consumed. So, the global oil price stays the same, but the different benchmark prices change relative to each other. As we've said before, tradeable goods will be the same price globally, minus transport costs. So, if we change the transport costs then we change the price before transport costs even as the total global price remains the same.

This means that trading Russian oil sanctions is a matter not of trading the oil price itself, but of trading the different oil prices relative to each other.


Wheat is entirely different. The same events mean that less is being harvested, less can be shipped to the world, less will be planted. There's going to be less wheat around – Ukraine being a major supplier to the global market. The same is true of sunflower oil. So, the global price of wheat has risen – there's just less of it around.

There's more than one kind of oil recipe

That is not the end of the story though. Yes, wheat has risen, so has sunflower oil. But while barley, oats, rice, are not fungible with wheat – you can't do the same things with them – they are substitutes. Have that Chinese with rice, not noodles, you've just substituted from wheat to rice, so too if half of India decides for forgo the naan and have rice instead. Cook with palm oil, or rapeseed, not sunflower - substitution. So, when the wheat price rose so did rice, barley, when sunflower oil, so too palm, soyabean and so on. The price change in a substitute depends upon how good a substitute they are – how close are they to being fully fungible with the item that is now in shorter supply? 

So, as a useful guide to trading commodities and events it's necessary to work out exactly what has just happened. Are we going to see a movement around of where the same amount of whatever gets shipped to, as with oil? Then it's only relative prices that are going to change. Have we a change in the global amount available? Then the global price will change and so will those of all the varied substitutes.

With this basic intellectual structure in place we can now see how to trade a more specific event. Last week the Federal regulators said that Freeport might be operating dangerously and would require substantial testing before it could reopen. Well, OK – but that means that US natural gas prices are going to fall. We might trade the US natural gas spot CFD. We could trade the US natural gas ETF (UNG).

US Natural Gas Spot

What would we be thinking about as we traded?

We'd remember US natural gas is much cheaper than European. So, people arbitrage it across the ocean – the way that's done is with liquefied natural gas. Freeport is a major plant which does this, accounting for some 17% of gas supplied this way.

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But Freeport recently blew up. So, if that plant is to remain closed for longer then there will be less gas exported from the US. There will be more available domestically, the price might go down. And the gas price itself did go down some 16% in one day as the news of the explosion spread, the ETF some 13%. The news may be priced in now, but it's something to think about.

We could also think that the European gas price (or one of them, there are many) might be higher as a result and yes, that happened too. But there are many sources of natural gas for each European market, so the influence of this one event on those prices was less. This is akin to our substitutes point above – the influence of the change in the wheat price on that of rice was diminished to the extent that the one is directly fungible with the other, or an imperfect substitute for it. So too with European gas prices on restrictions of US LNG exports. The price change is diminished by the way in which there are other gas sources for Europe.

One of the definitions often used of commodities is that they are entirely fungible, wheat is wheat, oil is oil and so on. This isn't entirely true – wheat for bread making is a different type from pasta making – but it's close enough. So, when total global supply changes then there's a change in the global price. What is more common is that there's a change in where specific sources of such commodities get sent to. That changes different source prices relative to others. The size of the price movement depends upon how good a substitute each specific source is for the others. The same is true of those other commodities which are themselves substitutes for the one that has undergone the price change. 

Yes, supply and demand matter about commodity prices for they matter for everything. The big trick in commodity trading though is fungibility and that closely related concept, substitution.


Further reading

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