Oil War: Who Will Blink First?

When Russia refused to back Saudi Arabia’s proposal for a deeper oil production cut in Vienna on March 6, it effectively fired the first shot in what looks like being an expensive and prolonged oil price war.Against the backdrop of the coronavirus crisis, which looks set to cut at least 2 million barrels of daily global demand, at least through the first half of 2020, there is only one conclusion to be drawn — the price of Brent will test the low of early January 2016 when it briefly dipped below $30 per barrel (p/bbl).At last week’s meeting, Russia only offered to extend the existing OPEC+ deal, which is set to expire at the end of this month, for a three further months and then to assess the situation. Saudi Arabia wanted Russia to participate in cutting an additional 1.5 million barrels per day (bbl/d) through the second quarter in order to try and balance the global oil market. Having been rejected by Moscow, Saudi has responded very quickly with an announcement that it has no intention of extending the current deal and will “open up the oil taps” from April 1. It is already being reported that the kingdom is offering discounted oil.

At first glance, this looks like a battle between Russia and Saudi over oil policy. But the context of the relentless rise in U.S. oil production over the past 10 years is also an important factor. Both Russia and the major OPEC producers have been openly annoyed with the refusal of the U.S. producers to participate in past production cuts, and the fact that the U.S. industry has been the major beneficiary of the price support mechanisms.It is a stretch to say that Moscow and Riyadh are in any sort of cooperation to try and reduce U.S. oil production; the body language at the Vienna meeting strongly suggests otherwise. But if a price war results in some U.S. casualties and a greater reluctance by investors and lenders to fund future U.S. marginal production, then Moscow and OPEC will be relieved.The table below shows the steady rise in U.S. production over the past 10 years, from an average of 7.5mn bbl/d in 2008 to an average of 17.1mn bbl/d last year.U.S. production averaged 18.4mn bbl/d in 3Q19 according to International Energy Agency (IEA) data — and using its methodology, which also captures other oil liquids as well as crude. That means that U.S. market share has risen from under 9% to over 17% in the period. Saudi and Russia market shares have held steady in this period mainly because of the U.S. sanctions against Iran and Venezuela and disruptions in Libya and Nigeria, all of, which have removed at least 4 million bbl/d from the global market.It also raises concern over who may next be subject to U.S. oil sanctions if U.S. production continues to rise and wants to displace other producers in the global market? There are at least a few in Moscow and Riyadh who have raised that question.

So, who is best positioned to fight an oil war and to live with $30 per barrel Brent, or even lower?Moscow has bigger financial reserves than Saudi Arabia. Saudi Arabia holds the equivalent of $495 billion as of end-January while the latest figures from the Russian Central Bank show reserves at $570 billion as of end February.Saudi’s reserves have been declining during the last several years of oil price weakness and are down from a peak of $731 billion at end-2014. Russia’s reserves have been growing and are up $100 billion since January 2019 and are $190 billion higher than the low of early 2017.Russia has had to allow the ruble free-float from early 2015. This was a policy forced on the Kremlin as a result of the combination of western sanctions and low oil. That has turned out to be a major silver lining for the budget, as well as for economic competitiveness, and it means that the budget break-even oil price moves lower as the ruble weakens. Assuming the ruble-dollar exchange rate drops below 70 then the breakeven will drop to $45 per barrel. If the ruble-dollar rate hits 75 then the budget will breakeven around $40 per barrel without any cuts to current planned spending. This compares with a breakeven of $115 per barrel in 2013.Saudi Arabia reportedly needs $85 per barrel to balance its budget and does not gain from a currency offset as the riyal is pegged to the dollar.Russian oil producers now have a very low production cost, exactly for the same reason of the ruble flexibility and also efficiency gains that the industry also had to adopt because of western sanctions.

Source: The Moscow Times

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