by Amy M. Jaffe
It’s happened several times before: geopolitical tensions between Saudi Arabia and Russia have led to a dramatic drop in oil prices in years past. But the breakdown in Saudi-Russian cooperation in oil markets over the weekend is strikingly different this time.
It’s happened several times before: geopolitical tensions between Saudi Arabia and Russia have led to a dramatic drop in oil prices in years past. But the breakdown in Saudi-Russian cooperation in oil markets over the weekend is strikingly different this time. That’s because the backdrop of the COVID-19 crisis could significantly influence outcomes.
That two major producers would differ on oil strategy has been a frequent occurrence in the geopolitics of oil. As I have chronicled in my book with Rice econometrician Mahmoud El-Gamal, petro-states have been struggling to manage the up and down cycle of oil prices for decades, with a host of negative outcomes including wars, terrorism, financial meltdowns, and social repression. But the current conflict comes amid strikingly new circumstances. First and foremost, COVID-19 is rapidly destroying demand for oil. Secondly, the oil demand shock comes amid long run signals that some of the world’s oil reserves will need to remain unexploited.
Oil prices fell over 20 percent on Monday to just over $35 for international marker grade U.K. Brent in the largest drop since 1991 amid reports that Saudi Arabia had slashed its sales prices for its April crude oil exports, initiating a price war in the aftermath of a failed meeting between the Organization of Petroleum Exporting Countries (OPEC) and Russia. Saudi Arabia said today it would raise its April supply to customers to 12.3 million b/d. Saudi Arabia previously announced its production had been averaging 9.7 million b/d earlier this year.
Leading into last week’s OPEC plus meeting, Russia expressed its reservations about instituting a new round of production cuts to help shore up sagging oil prices. Russia’s market share concerns are different than Saudi Arabia’s and those of other major exporters because Russia’s exports are concentrated in a few discrete markets, with a majority of shipments going to Europe and a smaller percentage by pipeline to China. Not only does this mean that the immediate impact of COVID-19 would hit Russia’s chief export outlets, it also makes Russia more vulnerable to competition from other suppliers seeking to sell in Europe, including the U.S. shale exporters. Saudi Arabia has a vast network of global customers including useful oil storage arrangements that enhance operational flexibility.
Prior to the COVID-19 outbreak, OPEC had been working on the assumption that global oil demand would expand sufficiently in 2020 to absorb all of the rising U.S. production, meaning that the cartel’s output restraints could be effective in stabilizing markets. But the sudden loss of demand due to curtailments of industrial output, freight movements, and both international and every day local travel threw OPEC for a loop. OPEC insiders say that the demand loss could be substantially higher than initial assessments, with upwards of 9 to 10 million barrels a day potentially shaved off world oil use in the near term as key economic activities and trade continue to grind to a halt. An analysis by Citi today also suggested that worst case scenarios involving wildcards similar to the China lockdowns and a sharp decrease in travel could leave second quarter oil demand down as much as 12 million b/d, leaving global oil demand as a whole about 4.3 million b/d lower than previous projections for the year, or 3 million b/d less than last year. Stockpiling of low priced oil is masking transparency of real consumer consumption rates.
In normal times, price warring oil producers find some solace in the stimulus that low oil prices can bring, both in fueling a rebound in economic activity and in incentivizing consumers to use more. Lower fuel costs won’t necessarily prompt businesses to invest in labor or capital goods because COVID-19 is disrupting operations and sales. By the same token, lower gasoline prices could similarly fail to encourage more driving since travel is on the downswing due to virus quarantines, regional lockdowns in high infection regions, and increasing social distancing in major cities in the United States, Europe, Japan, South Korea, and Singapore. In the United States, for example, commuting accounts for nearly half of all vehicle miles travels by cars and light trucks. With more and more companies suggesting its employees work remotely, commuting miles are becoming sharply diminished. Temporary trends to increase the use of robotics in factories and shift workers from in person meetings to cloud services (think emails, remote working, and video conferencing) shifts demand from transport oil to electricity.
The challenge of the spread of COVID-19 couldn’t have come at a worse time for OPEC plus Russia deliberations. OPEC members were already miffed at Russia by what they believed in retrospect to be a tricky request that Russia’s condensate production, a byproduct very similar to crude oil, not be counted in any production reduction agreement. Russia then increased its condensate output by 1.68 million barrels a day in the weeks following the December OPEC meeting. For its part, Russia is also frustrated with Saudi Arabia, which it feels has not reciprocated its cooperation over oil prices by forging stronger collaboration in other areas such as arms sales and co-investments in each other’s energy industry.
But underlying tensions were also driven by other geopolitical backdrops, not the least of which was Russian anger that its flagship national oil company Rosneft was targeted for new sanctions by the United States over its ongoing oil trade with Venezuela. Russia is clearly angling to concessions from somewhere, and Washington might just be the place it is targeting. Still, tensions between Saudi Arabia and Russia on who dictates outcomes at OPEC plus Russia meetings have been brewing for some time and leave the United States in an awkward bind on how to proceed. U.S. Treasury Secretary Steve Mnuchin met with the Russian ambassador to the United States yesterday and emphasized the “importance of orderly energy markets.”
In a hint to what is on the Kremlin’s mind, Igor Sechin heavily criticized the U.S. polices and shale overproduction in a speech in October 2019 to the Eurasia Economic Forum in which he questioned how “justified” U.S. investment in shale would be and said that the increase in the share of “the U.S. oil on the global market is often achieved not so much via economic as via political methods—by ousting key players and foisting products.” Sechin went on to complain that a fifth of global output is under U.S. oil sanctions, while the U.S. “virtually extends its jurisdiction over other countries, including the European Union, which is forced to comply with U.S. sanctions policy.” Sechin adds, “It was they (the U.S. shale industry) who became the main beneficiary of sanctions on the European market.”
Analysts are predicting that a prolonged period of oil prices below $30 a barrel could cause U.S. oil production to contract by 500,000 b/d to 1 million b/d later this year. To put that in perspective, U.S. crude oil exports have been running at around 3 million b/d, on top of healthy U.S. refined product exports. Any slowdown in U.S. output is likely to take some time as American companies carefully assess the likelihood of sustained low prices. The distribution of companies responsible for growth in the prolific Permian Basin is multi-variegated, with the oil majors currently responsible for over one-fifth of production. Independent producers with stronger balance sheets represent another third while private firms, thought to have largely locked in higher prices on futures markets, are another large portion of the production base. U.S. analysts suggest that smaller, more vulnerable firms make up about 20 percent of Permian production. Some U.S. independents have used oil futures markets to lock in 2020 oil prices more than others, with the percentage of production protected ranging from 20 percent to 70 percent. Last year, some shale companies opted to hedge a portion of their 2020 production by locking in hefty oil prices on futures exchanges back in the summer and fall of 2019 when oil prices were rising back in the wake of attacks against oil facilities in the Middle East. Some hedging strategies could prove more effective than others, depending on price trends, with some companies using a practice using multiple derivative tools to establish a price floor and ceiling as well as a third leg of a right to sell put option at a third price point. The market is currently below the prices used in some of these common derivative vehicles.
Beyond the use of oil price hedging tools, capital discipline practices post-2015 will help many U.S. shale companies weather the current storm, and some companies have been experimenting with increased automation and process improvements using data analytics as a way to boost productivity and lower costs. Any drop in U.S. shale production as vulnerable companies lose access to capital could prove short-lived once oil prices recover and productive properties move to stronger players through market consolidation.
In dealing with the current oil geopolitics, the United States has some possible market-oriented cards up its sleeve, in addition to other kinds of geopolitical levers. Russia may be hoping to play on the U.S. Treasury Department’s concern about the negative affects too many failures could have on the high yield bond markets where energy companies represent a high proportion of issuances. To respond, the U.S. administration is weighing a number of options to avoid a meltdown. It must certainly consider postponing planned Congressionally-approved sales of crude oil from the U.S. Strategic Petroleum Reserve (SPR) and might gainfully work with other governments who need stocks, like Australia, to buy U.S. production to store oil in the SPR on their behalf. Given the wide range of levels of financial leverage among industry players, increased tax breaks to industry might be less effective than other more direct measures to intervene to shore up credit markets. One such last resort approach could be special targeted lending facilities that allow lenders to distressed shale firms to gain liquidity by offloading some risk directly to the Treasury Department. While it remains unclear how long the rout in oil markets could last, some blinking was already taking place this morning as both Russia and Saudi Arabia indicated a possible willingness to come back to the table. The next official meeting of OPEC’s joint technical committee is scheduled for March 18.
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