The coronavirus pandemic may inspire a rapprochement – if the global demand for oil is falling as is, price wars that worsen oil oversupply on the market are counterproductive. Considering the levels in storage facilities all over the world, the desirability of a new agreement between leading oil suppliers in Eurasia is becoming harder to deny.
The collapse of the OPEC+ deal in early March 2020 erased much of the progress made in the world energy market. After several years of successful cooperation between leading oil producing countries, it’s every country for itself once again. In this new decade, it appears that preserving market share regardless of price considerations will be the norm. Russian gas exporters have already been moving in this direction, given the emergence of liquefied natural gas on the market. For oil, it was triggered by the unwillingness of the three leading oil powers – Russia, the United States and Saudi Arabia – to accommodate each other’s interests.
Moscow, Riyadh and Washington arrived at the present moment in different positions. Russian oil and gas companies have overcome the damage inflicted by the downturn in oil prices in 2015-2016 and gradually started to improve their financial indexes notwithstanding all the sanctions-related difficulties. Saudi Arabia’s national oil company Saudi Aramco, the pillar of the national economy, was hit hard by the air strikes against its key infrastructure facilities in September 2019, and despite the sidelining of Iran, one of its main rivals, is in the process of restoring market confidence. The United States, which has never had a national oil company, experienced historic growth rates in oil production.
Pain Today, Payoff Tomorrow
For Russia, its withdrawal from the OPEC+ deal promises both economic losses and political advantages. In 2019, with an annual average Brent price of $64.3 per barrel, the Russian budget was in surplus, making it possible to consolidate the financial positions of both companies and the government. Conversely, the current price range of $25-30 per barrel pleases no one: the budget slipped into deficit and companies started cutting costs and revising investment plans. We can assume that prices will recover, but at present leading investment banks and world rating agencies don’t see it: all forecasts for Brent Dated annual average price in 2020 are below the Russian budget breakeven point – S&P Global ($30/b), Barclays ($31/b), Morgan Stanley ($35/b), Goldman Sachs ($35.89/b) and BNP Paribas ($41/b).
At the same time, given the unprecedented growth in US oil production, inaction was fraught with numerous risks. First, it is rather easy to track how US oil producers managed to increase production by four million barrels a day (up to 12.8-12.9 mln bpd) since November 2016, when the Vienna agreement on a coordinated cut in oil production was concluded. There were some cursory attempts to deal with the US “fare dodger” but they failed. Second, the growth in US oil production proceeded in parallel with the growth of political pressure on Russian companies (primarily through sanctions). In other words, the “fare dodger” attempted to oust Russia from the market using non-market means.
By all appearances, the sanctions imposed by the US Department of the Treasury on a Rosneft subsidiary in Switzerland, Rosneft Trading SA, was the last straw, which severely constrained the ability of this leading Russian company to trade in third-party oil. It just so happened that all these developments took place while the coronavirus pandemic was sweeping the world. Saudi Arabia suggested cutting the OPEC+ aggregate production quota by at least another million barrels per day. Instead it saw the basic agreement collapse entirely. According to high-ranking Russian officials, Russia was not seeking to antagonize Saudi Arabia, although we did not go out of our way to avoid it either.
After oil prices took a nosedive, Saudi Arabia launched a sneak attack: Saudi Aramco quietly began a price war against Russia by reducing the price of all its oil grades by $5-8/b all over the world. After several years of backwardation, the market was in a contango again – the futures price was higher than the spot price. The Saudis’ actions eroded all the differentials in Europe and Asia, and all this happened when the demand for oil products was reduced as the market was naturally responding to the measures to contain the further spread of the coronavirus (border closures, flight cancellations, layoffs, etc.).
Who Will Win?
After the initial shock, the oil market is gradually getting accustomed to the new reality: a small number of analysts believe the previous price level will be reinstated soon notwithstanding the contango. Moreover, the spread of the coronavirus in Europe and other continents may send oil prices plunging even lower. Considering the strengths and weaknesses of the United States, Russia and Saudi Arabia, American oil producers are most vulnerable, given that the cost of oil production is highest there. The average cost of US shale oil is at the level of $46/b while in Russia this figure is around $32-33/b. Therefore, it is not surprising that although the price drop occurred relatively recently, the US oil industry has already experienced the first big wave of layoffs.
Russia’s main trump card in the long-term struggle for target markets is the relative diversification of its economy and a large internal market, which cushions the shock in times of low prices. The phrase “relative diversification” means just that: the share of oil and gas in federal budget revenues has been fluctuating in the range of 40-45 percent of late, which is high enough, although it is lower than in the leading OPEC producers. Both Saudi Arabia and Iraq receive about 90 percent of their gross income from oil sales, and they have a much more bloated public sector to compensate for the lack of economic dynamism.
A heavier dependence on oil proceeds means a higher budget breakeven point, i.e. the average oil price needed to balance the budget. The Russian budget in 2020 is non-deficient with the price of Urals at $42.4/b compared to over $83/b for Saudi Arabia. This means that Saudi Arabia currently makes $60 less for each barrel of oil sold. It’s worth noting that Saudi Arabia has a solid foreign currency reserve – a bit over $500 billion as of January 2020 – however in the case of a protracted price war it will be depleted quicker than Russia’s.
The winner in the battle between Russia, Saudi Arabia and the United States will not emerge in the next few months or even years.
The competition between Russia and Saudi Arabia is much fiercer, and, unlike the United States with its huge domestic demand, both countries are greatly dependent on oil exports. But the clash is entirely avoidable: a separate deal between Moscow and Riyadh is what both countries need, but it will all come down to a number of sensitive issues. For instance, the matter of trust will be high on the agenda: after Russia’s failure to meet its OPEC+ obligations in the crisis years of 1998 and 2001, Moscow has again drifted away from its agreements with Saudi Arabia, which could make the Saudis markedly less open to compromise. At the same time the current market situation is different from previous crises because differentials have slumped in addition to benchmarks.
