In the latest installment in our ongoing dialogue with several of Bain’s Oil & Gas experts about the intersection of energy industry dynamics and the global macroeconomy, we looked at the inflationary risks of the Russia-Ukraine war. The discussion also touched on whether the conflict could exacerbate preexisting investment disincentives in the longer term, leaving energy inflation free to haunt the next expansion cycle as well.

In the aftermath of Russia’s invasion of Ukraine, oil prices have fluctuated wildly. European (Brent) crude prices briefly surpassed $139/barrel on Sunday night, the highest level since July 2008. US (WTI) benchmark oil prices surged to $130/barrel, also a level not seen since 2008.

In search of perspective on these price spikes, we talked to some of our experts in Bain’s Oil & Gas practice—Michael Short, Ethan Phillips, Dave Rennard, and Luis Uriza—who warn that there’s no sign that supply-side conditions will ease in the near term.

Well before Russia launched a ground war in Ukraine, both oil and gas markets were not functioning as well-balanced markets, with supply running tighter than normal. We explored this dynamic in depth in an interview we published on the Bain Macro Strategy Platform last year. Here’s how Bain’s Michael Short explained the dynamics of the oil markets in that interview:

There were two big new forces that emerged over the last few years—one is a longer-term, structural supply-side factor, and the other was the demand destruction event of 2020. On the structural side, long-cycle capex in exploration and production among Western companies has been persistently restrained due to a combination of poor returns on capital (resulting from the multiple shale-driven price collapses), the near-death experience of 2016 when bond yield spreads blew out and began to impose discipline on the long-term borrowing that funds capex, and the steadily increasing pressures from ESG stakeholders to divest or throttle investment into oil and gas in lieu of other energy sources.

The second major force reshaping oil market dynamics was, of course, the Covid-19 pandemic. In 2018 and 2019, the market was characterized by a decent “managed cooperation” condition. But by January 2020, global oil markets were about to enter a “competitive regime,” with OPEC+ poised to unleash flat-out production, potentially driving prices to the $40–$50 range or below to regain share from US shale players. The pandemic brought about a complete reversal—a period of massive demand destruction to which all global oil suppliers had no choice but to match with massive supply curtailment. A supply response (to rebalance the market) of this magnitude would never have taken place absent a massive demand shock. While there were periods of low (and negative) prices during the adjustment, the end result has been a boon to OPEC+ management; it gave producers a huge incentive to cooperate and re-baseline to a heavily constrained level of production. Shale producers also had to back off on their short-cycle spending, arresting the steady growth rate that had been a consistent source of supply-side stress for a decade.

As a result of these fragile dynamics, relatively small supply shocks now have the potential to drive outsized price increases, forcing demand to adjust to impaired supply, as we’re currently seeing. But the nature of energy price risk is not evenly distributed across oil and gas, nor even across geographies. For gas, the price risk is most acute in Europe because, as Short explains:

The global liquefied natural gas (LNG) market already did not have slack before Putin’s invasion, as we saw in the winter. And obviously Western Europe is physically and logistically collocated with the current geopolitical hotspot—even if the market had been in better balance, the pipeline volumes from Russia are simply not replaceable in the short run.

The downstream effects in Europe could be painful—here’s Bain’s Dave Rennard:

Gas will be the marginal electron many days, so higher gas prices will translate to higher power prices. High gas prices also resulted in high-intensity industrial users going offline—we saw ammonia producers go offline; lower fertilizer production could contribute to even higher food prices.

But, as Bain’s Luis Uriza notes, the effects won’t be limited to Europe. “East Asia will not escape the trouble; traders and marketers will play the location arbitrage between Europe and Asia,” warns Uriza. “It is ultimately a global market—whether Europe, Asia, or even the US Northeast, destination flexibility leads to prices moving together.”

Short agrees, noting that “[t]he US Northeast, because they have not allowed gas pipelines to be built from Appalachian shale into the demand centers, is also subject to this global market—as we predicted, Boston gas priced with European LNG when it was cold.”

While Asia’s gas storage reserves—which are less transparent than Europe’s—could provide a potential shock absorber for that region, Short is skeptical the reserves will be sufficient to fully mitigate the effects of a meaningful supply shock.

Imagine a hypothetical in which LNG volumes are redirected en masse to Europe rather than Asia. First, it’s hard to imagine this taking place in a free market construct. Second, Russia can’t simply redirect its gas to Asia as a backfill. Russia is big. In general, its western fields supply Europe, and its eastern fields increasingly supply China. I do not think there is enough pipeline capacity at present from Russia to Asia to satisfy demand, and even if there were, you can’t get the same molecules to China that currently flow to Europe.

The supply and price risks are somewhat lower and more diffuse in the oil industry, but even a relatively small decrease in supply could quickly lead to price increases. Even before the deepening of sanctions, market participants’ concerns over future risk were already having the effect of freezing new Russian oil supplies. As the Wall Street Journal reported on March 1, “Traders are offering Urals [the benchmark for Russian oil prices] at massive discounts—as much as $18 a barrel below the price of Brent—and even then not finding buyers.” And when a tranche of Urals crude did recently eventually trade (at a $28.50 discount), the move was met with immediate public criticism, prompting the buyer to commit to not retaining any profits from the trade. Short is not especially hopeful that the oil industry will be able to escape the conflict’s effects:

There is an open question of whether OPEC could ride to the rescue—although the potential volume loss from Russia is again quite large. But the fact that we’re even asking the question is itself a concerning development. (It’s worth noting here that OPEC+ has not even met its previous quota ramp-up plan for the last three months.) There are also issues of crude slates and how they match to refineries—while oil has been a fairly liquid global market for some time, a Urals barrel from Russia is not exactly the same as a Brent barrel, which is not exactly the same as Arab light. They are not perfect substitutes for one another, and these things matter.

“The oil futures curve is in extreme backwardation, meaning the markets are betting tight supply won’t last for long,” adds Bain’s Ethan Phillips. “But that assumption might not hold, due to both geopolitical developments in the near term and longer-term issues in the industry.”

The key takeaway from these conversations is that energy prices are likely to impose a second wave of supply-side shocks on the global economy, which has not yet fully recovered from the first wave. These shocks will be a bit more acute in Europe (vs. Asia) and in Asia (vs. the US), as each region has a different energy mix. And unlike in years past, the usual supply-side buffers—such as spare OPEC+ capacity sidelined for price stability purposes or the US shale industry’s ability to quickly ramp up production—have been sidelined.

We’re also concerned that a subtler feedback loop could emerge over the medium term between the macroeconomy and the oil and gas industry. An inflation-induced recession in the near term, such as the type that could result from the Russia-Ukraine conflict, in one or more of the major global markets could conceivably cause prices to plunge just as the industry recovers from the pandemic price shock. Short warns that such a scenario would exacerbate the preexisting investment disincentives discussed above:

Another quick bust cycle would be the nail in the coffin on needed thermal energy investment. Case in point are drilled uncompleted wells (DUCs) in US shale plays. This is shadow inventory, and it’s running out. After two years of labor migration and equipment warm/cold stacking, there are real concerns about how quickly the industry could ramp back up if it decided to open the capital spigot. And even if the industry did open the capital spigot, there are concerns about how much of that capex increase would be eaten up by service-sector and materials cost inflation. This inflation could then impact well economics, which would then impact breakeven price, which would then limit the potential growth rate of supply, even as we’re asking shale to pick up the slack for underinvestment elsewhere.

Our scenario for an inflation-throttled growth path always contained the proviso that such a trajectory rested on the absence of any new shocks, in a world in which quite a few potential shocks loomed large. The Russian invasion represents a clear new shock, and our conversations with Bain’s Oil & Gas experts lead us to the conclusion that there are no obvious factors that could mitigate this shock. Unless something changes quickly, the near-term path from rising inflation to falling growth just got much shorter.

This article was originally published on the Bain Macro Strategy Platform as part of our ongoing coverage of the geopolitical forces that will reshape the world in the coming decade; it has been modified slightly for publication on Bain.com. You can request more information about the Macro Strategy Platform here.