The first months of the new decade are turning out to be all but peaceful. Last January, the prospect of a military escalation between USA and Iran spread anxiety among many. February saw the beginning of the fierce medical struggle of Western countries against the diffusion of COVID-19. Apparently, the battle reserved to March is an economic one.
On Monday 9, Saudi Arabia decided to lever on its crude stock to start a sudden, aggressive price war. At a time of unexpectedly scarce demand for oil, mostly weakened by the current pandemic, Saudi Aramco, the Saudi national oil company, started to flood the market with crude, causing a dramatic 30% drop in prices in one day. The consequences of such move were immediate, and quickly reached the financial markets, already depressed due to the international economic slowdown.
Unless the trend is reversed soon, in the long-term an oil-price war of this kind may turn out to be a dramatic driver of socio-economic and political instability for highly oil-dependant economies, among which Saudi Arabia itself.
Considering the gravity of the current scenario, it is necessary to analyse the reasons behind such a risky and potentially self-damaging Saudi strategy.
In order to fully grasp the implications behind the current tensions, AWARE had the pleasure to interview Lorenzo Colantoni, Researcher on Climate Change, Energy and Natural Resources at IAI (Istituto Affari Internazionali).
The Oil Industry, Opec+ and shale oil
As a starting point for a proper analysis, we need to identify the key players in the game.
Since the 1960s, the international oil supply was dominated by OPEC (the Organization of the Petroleum Exporting Countries), a permanent intergovernmental organization of oil exporting Countries that behave pretty similarly to an international cartel, coordinating crude prices and volumes at the international stage.
Currently, the member States include Saudi Arabia, Iran, Iraq, Kuwait, Venezuela, Libya, United Arab Emirates, Nigeria, Angola, Gabon, Guinea and Congo.
In 2016, the Russian Federation decided to align with Saudi Arabia and with the commercial policies of the whole group, giving birth to an alliance labelled as “OPEC+”. That same year, estimates set the share of global crude exports controlled by the group at 40%.
However, since 2014 in particular, the exponential growth in the US shale oil industry started to impact the international oil industry dynamics. Taking advantage of a period of high and stable crude prices, many US oil companies started to invest heavily on this non-conventional practice. As a consequence, US producers almost doubled their production, moving from 5.7 m barrels a day in 2011 to 11.6m b/d in 2018. Today, the US is the first oil producer in the world.
Clearly, such a peak in international production exacerbated the competition among exporters and led to an erosion of the combined market share of Russians and Saudi Arabia. From 2016, the two Countries experienced a 3% market share drop, vis-à-vis the 4% increase experienced by US companies.
Russian withdrawal, Saudi retaliation
Such competitive trends are essential to explain the recent developments.
On Monday 9, Moscow decided to disentangle from the strategy Saudi Arabia brought before OPEC+: in order to support crude prices, Riyadh was proposing a further 1.5m b/d cut on the oil exports of the group, on top of the 2.1m b/d approved previously.
Putin was convinced to withdraw from such joint strategy by his domestic oil companies, among which Rosneft: the day before, the company declared any new cuts to production to be contrary to national interest, due to the intensified competition stemming from US shale producers.
On their side, Saudis did not wait much to react to Russia’s’ decision to withdraw and move back to open market competition. That same day, Saudi Aramco flooded the market with supply, selling at discounts that led to a 30% Brent crude drop in a day. Oil prices fell from $45/b to slightly more than $30/b, the most dramatic price collapse since the first Gulf war, in 1991.
A drastic retaliation, with immediate repercussions on oil producers’ currencies, aimed at reasserting the dominant position of the Monarchy over the international oil production and at warning allies about the consequences of any insubordination.
However, such move entails enormous risks for any player in the game, and in particular for national economies with high dependence on crude exports, such as Saudi Arabia itself.
In fact, the current oil price is way below the breakeven point of anybody in the industry: was such situation going to last, a wide amount of oil producing Countries may be forced to cope with a number of undesired measures, such as running large budget deficits, resorting to foreign currency reserves, issuing debt, or experiencing painful cuts to public services. To put it simply, unless Russia bows its head in the short-term, Riyadh may cause severe stress to its historical allies and alienate them. In addition, it risks exposing itself to dangerous fragilities.
Considering these implications, and taking into account the risk-taking attitude of Prince Mohammad bin Salman, de facto ruler in Riyadh, analysts keep wondering: was the Monarchy move actually designed to hit Russia?
The Russian economy
Indeed, the oil price drop hit hard in Moscow. That day, Rosneft shares dropped by 22% and Gazprom shares lost 18% of their value. By the end of the day, the ruble suffered a 10% devaluation against the dollar, partially recovering only two days later, due to a selloff of foreign reserves by the Russian central bank.
Nevertheless, Moscow did not blink. On the contrary, Russia declared to have the resources to support their oil industry for a period estimated between 6 and 10 years, were the crude prices going to stabilize within the $25-$30/b price range. Super partes entities such as the Oxford Institute for Energy Studies endorse the credibility of the statement, even though they set the estimates at 3 years at most.
Since 2015, the Russian Federation undertook a process of economic restructuring that allowed it to achieve much greater stability and resilience.
Today, oil still accounts for about 40% of national income, but the Country can rely on $570bn in foreign reserves, vis-à-vis the $502bn in foreign reserves owned by Saudi Arabia. $150bn of such reserves are represented by a national Wealth Fund, financed with gas and oil surpluses accumulated from 2017 onwards. These are the funding the Russian Energy minister, Mr Novak, refers to when he claims Russia would be able to support the domestic oil industry for years, in case of necessity.
Moreover, it is worth noticing that during the last decade Russia was able to lower by almost 60% the breakeven oil price required to balance the national budget: from $100/b, they moved to the current $42/b, a source of competitive advantage that should not be underestimated.
Overall, among the economies taken into consideration, the Russian one seems to be one of the less exposed to oil prices fluctuations, and it looks even better equipped than Saudi Arabia to face a medium or long-term oil price war.
Why should Riyad attack from a weaker position, then? What if Russians and Saudis had some common interests in this fight? Who would turn out to be the true loser in this scenario?
The answer proposed by the industry experts was unambiguous: the key losers would be the US shale producers.
The US shale oil industry
Unconventional extraction techniques, such as the ones related to shale oil, are far more expensive than traditional ones: this is the reason why their diffusion become massive only during periods of high and stable crude prices. Concerns about the environmental impact of such practices, as well as about the industry profitability and the excessive exposition to debt of US shale companies, started to grow well before 2020.
The Financial Times reports that 10% of the high-yield US bond market today is represented by junk bonds issued by societies related to the energy sector. If oil prices were set within the $30-$35 per barrel range, the vast majority of US shale producers would turn unprofitable, and the financial markets are perfectly aware of it.
On March 9, bond prices of firms such as SM Energy, Callon Petroleum and Oasis Petroleum lost between 40% and 50% of their value in the secondary market. Funds such as Lord Abbett, heavily exposed to this market, saw most of their yearly profits fade away in a single day.
The increasing scepticism of investors about shale companies’ competitiveness will certainly harm their refinancing capabilities in the near future.
Were oil prices going to stay so low for much further, shale producers may be swept away from the market, to the advantage of traditional producers, in particular Russia and Saudi Arabia.
An insider opinion: Mr. Colantoni
In order to avoid trying to foresee the future without a good crystal sphere, we decided to rely on the experience of Lorenzo Colantoni, researcher at IAI on the Energy sector and on the geopolitics of energetic transitions.
Dottor Colantoni, what do you think about the theory of the bee in the bull’s ear? May Russia have deliberately provoked a Saudi reaction, in order to hurt shale producers?
We cannot exclude this possibility. Officially, the current face-off entails Saudi Arabia and the Russian Federation, but the consequences of the dispute will affect all the players in the game, including US companies and the OPEC Countries. Considering the characteristics of the Russian economy, the true losers in this scenario seem to be the shale producers.
On their side, Russian companies do not have enough volumes to cause a collapse in the oil prices: thus, we cannot exclude they may have deliberately triggered the Saudi “nuclear option”.
Anyway, we must underline that a similar move would expose Russia itself to great risks, as its economy is stronger than it used to, but not immune to such a threat.
With regard to the actual stability of the Russian economy, do you believe the Country may have the resources to bear the consequences of a similar price war, if protracted over time? Do you believe only oil-related income would be affected, or do you expect any impact on the gas market as well?
First of all, the interchangeability of oil and gas is very limited. Historically, gas prices used to be indexed to oil ones, especially in Russian contracts. However, as it is not common anymore, I do not expect relevant reactions in the gas market.
Nevertheless, the Russian economy is more fragile than it appears and less differentiated than it is claimed: it has been on the brink of a latent crisis for the last few years.
What is your opinion about Saudi Arabia’s capabilities to hold under a similar pressure?
The Monarchy must have considered its options. On the one hand, Saudi Arabia sets the rules, as it can manage the oil volumes in the market at any time. On the other hand, it is still highly dependent on oil income: when oil prices fell around $25, fears started spreading about the necessity of possible austerity measures in the Country, something unbelievable in Saudi Arabia.
I would like to stress that the weakness of Riyadh does not lie in the extraction costs, but in the crude price required to achieve the national budget balance: today, such price is estimated to be higher than $50, $60 per barrel.
May the collapse of oil prices, together with the international economic slowdown related to COVID-19, represent a setback for green transitions worldwide?
The answer is definitely no. Historically, the lack of negative correlation between low crude prices and transitions to sustainable economies have been widely documented. On the contrary, a low oil price can represent a powerful driver of interest in alternative energy sources.
In fact, high oil prices attract investment in the industry. In presence of instability or low prices, instead, investors prefer to focus on different sources, free from volatilities.
Today, the key energetic generation is the electric one, that has a pretty low correlation with oil prices: it is quite unlikely to find yourself choosing between the energy to light your house and gasoline for your car, generally the competition can be restricted to the selection between different means of private transport.
Also, remember that the effects of oil price variations usually reach the consumer only after months, and that electric mobility is still very limited.
I want to conclude saying that in a situation like the one we are facing, characterized by a temporarily drop and fluctuation in prices, the consumer loses confidence and insight and avoids investing on oil.