The Fuse

Explaining the Price War

by Gregory Brew | March 18, 2020

More than a week has passed since Saudi Arabia and Russia went to war over the price of oil. And while the impact of this struggle has been fairly immediate—low prices, pushing WTI into the $20s and Brent into the teens, with markets in supercontango amidst a supply glut and depressed demand—the motivation behind the Saudi and Russian actions remains opaque.

But as the price war has escalated, a more nuanced understanding of this showdown, and the motivations behind it, has begun to take shape.

The immediate cause is easy enough to track. In the run-up to the OPEC annual meeting in March, Saudi Arabia was busy marshalling support from the rest of OPEC for another round of production cuts meant to mitigate the impact of COVID-19. Russia, which had joined Saudi Arabia in cutting production since 2016, was known to be growing frustrated with the perceived shortcomings of the cut strategy. There was considerable argument over cuts at the Summer conference, with new disagreements emerging in December 2019.

It was clear the OPEC-Russia arrangement had collapsed.

When they met at the negotiating table, Saudi Arabia had assembled consent from the rest of OPEC for an additional cut of 1.5 Mbd. But Russia refused, and walked away from the meeting promising to ‘pump at will.’ It was clear the OPEC-Russia arrangement had collapsed, in part due to frustrations within the alliance and a breakdown at the negotiating table.

Rather than push through cuts without Russian support, Crown Prince Mohammed bin Salman chose to rapidly expand production. Cuts would be abandoned, and all OPEC members were now free to pump at will. The news brought a crash in the oil price, which fell by 30% on Monday, March 9.

Why did “OPEC+” break down? And why are Russia and Saudi Arabia now engaged in a price war that will cost each nation billions in revenue, at a time of stagnant prices and diminished demand?

The demand question could be at the heart of the Saudi strategy. Flooding the market will lower prices, encourage consumption, and cushion the global economy from the ravages of COVID-19. “It looks like this is Saudi Arabia’s strategy,” wrote Dr. Ellen Wald for Barron’s, who notes Riyadh’s concern that the Chinese economy could use “ a stimulus package” in the form of cheap crude.

“It’s all about egos now.”

There are other dynamics at play. MBS, the de facto ruler of Saudi Arabia, has experienced growing dissent at home and a disastrous war abroad. His economic reforms have stalled, and the much-touted Saudi Aramco IPO generated middling enthusiasm. The sudden Russian challenge offered an opportunity for Saudi Arabia to display its market power, as it did in the mid-1980s, and bring other oil producers in line with its agenda. “It’s all about egos now,” according to the Wall Street Journal’s Summer Said and Benoit Faucon.

For Russia, the concern seems to be over market share and protecting the national interest. Unlike Saudi Arabia, which exports oil all over the world, Russian exports travel to a handful of markets, including Europe and China via pipeline. Since 2016, Russia has faced increased competition from the United States, while U.S.-backed sanctions have impeded the growth of Russian exports. Executives in the major Russian energy companies reportedly pushed President Vladimir Putin to abandon the cuts strategy, increase Russian production and punish U.S. shale.

In a speech from October 2019, Putin adviser and Rosneft head Igor Sechin criticized the U.S. production growth, which he blamed for “ousting key players and foisting products” onto a glutted market. Sechin also drew attention to U.S. sanctions, which have impeded the operations of Rosneft, in Venezuela and elsewhere. One-fifth of global output, he argued, was held back by U.S. actions, opening more of the market to U.S. shale.

It is clear that American shale companies, burdened by debt and low profitability, will be damaged by the price war. But killing the US shale sector is probably not the root cause of the Russian decision to walk away from more cuts. Amena Bakr of Energy Intelligence notes there was “long-standing skepticism” in Moscow over the efficacy of production cuts. The move to pump more, even if it meant lower prices in the short term, aligned with Russian national interest. “Killing shale” did not emerge as a prime concern. Moreover, there is a chance the shale companies may weather the storm, thanks to hedging strategies, fiscal discipline imposed by the 2014-2015 price crash, and access to additional credit. A bailout by the Trump Administration is also a possibility.

“Killing shale” did not emerge as a prime concern.

Instead, it is the threat of COVID-19, and the impact the disease has and will have on demand this year, which has compelled Riyadh and Moscow to take drastic action. Before the outbreak, demand forecasts predicted sufficient market growth to absorb new U.S. production, which was set to increase by 500,000 barrels per day (bpd) to 13.2 million barrels per day (Mbd). Demand, according to the EIA, would grow in 2020 by 1 Mbd. There seemed to be enough demand growth to manage U.S. output and OPEC without causing further decline in prices.

But COVID-19 took an axe to such predictions. Before the price war broke out, analysts foresaw a decline in demand for the first time since 2008. China alone was set to experience a 1.8 Mbd demand decline in the first quarter of 2020, according to the IEA. For 2020 on a whole, demand would fall by 90,000 bpd compared to 2019, with significant declines in Q1 and Q2 and a recovery in Q3. The short-term impact could be enormous, with IHS predicting on March 5 oil demand in Q1 would fall by 3.8 Mbd, just as OPEC gathered in Vienna. New estimates from Citi has demand falling by 12 Mbd in Q2, a decline of more than 10 percent.

Against such a backdrop, the Saudi and Russian strategies suddenly make more sense. With demand set to collapse in the near term, each side could anticipate low prices, regardless of whatever actions they took. Production cuts, in such a scenario, would do little to forestall a general fall in prices.

Once it became clear a short-term agreement on production cuts was out of the question, Russia and Saudi Arabia decided to boost production. This would allow them to seize market share and crater prices, damaging the competition—in this case, U.S. shale—while mitigating some of the short-term effects of COVID-19, potentially spurring a more rapid recovery.

Both Russia and Saudi Arabia believe they can endure this period of low prices without succumbing to economic collapse.

Furthermore, both Russia and Saudi Arabia believe they can endure this period of low prices without succumbing to economic collapse. Russia has cash reserves that will cushion the fall in oil revenues. Five years of saving has built up a reserve of $550 billion, which officials claim will allow Russia to survive a prolonged period of $25-$30 prices. President Vladimir Putin has reason to be confident that this crisis will not weaken his political position, as the Russian parliament has essentially named him President for Life.

MBS is in a somewhat weaker political position. But Saudi Arabia has plans for prices hitting the low teens, and is going to maximize production and offer steep discounts that consumers abroad will find hard to resist. When demand picks back up—hopefully in Q3—the kingdom will be able to reduce production and regain some spare capacity, which will boost prices just as demand increases, accelerating the recovery.

While the breakdown in Vienna was the result of miscalculation—the Saudis did not believe Russia would walk out, and the Russians probably didn’t think the Saudis would abandon production cuts altogether—an examination of motives reveals some method to this madness. And while the price war is likely to be long and damaging, particularly to U.S. shale companies, the fact that it has emerged from such unique circumstances means it is unlikely to happen again. We are experiencing history in the making.

 

 

 

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