After OPEC ally Russia refused to cut production, Saudi Arabia launched a price war, sending global oil prices to as low as $32 a barrel on March 9th. However, there is currently no demand for energy because of the coronavirus. And, more importantly, both rely on high oil prices to prop up their economies. Therefore, this is likely a means of getting Russia back to the negotiating table.
OPEC+
The driving force behind the initial drop in oil prices was the spread of Covid-19 in China and, eventually, into other parts of the world. Lower energy demand cut the price of oil, placing the petro-economies of OPEC+ on high alert. Supply reductions were expected. This would support prices.
In early February, members of the alliance recommended reducing production by an additional 600,000 b/d. But Russia hesitated. Energy Minister Alexander Novak insisted on more time to assess the situation.
Unlike Saudi Arabia, Russia can sustain much deeper price drops. To reach a fiscal break-even, it can see prices reach $42. Saudi needs them closer to $80. This disparity strains negotiations.
Moscow’s political ploy?
OPEC+ met in Vienna on March 6th. However, an agreement was not reached. Saudi Arabia, angered by Russia’s refusal to cooperate, responded by asserting that it will raise production in April. It will also offer it at a discount – $6 to $8 per barrel – to its Asian, European and North American customers. These are battlegrounds for oil exporters.
The news shook energy markets. Prices dipped to $32 in the days after, so far the lowest point in 2020.
Moscow refused to restrict production because it hopes to undermine the US shale industry. North American shale producers can sustain price drops to around $48 – $54. For most of February and early March, prices generally stayed within that range. At those prices, Russia benefits while US shale producers barely break-even. This may explain Russia’s reluctance to come to an agreement.
Indeed, higher oil prices can compensate for the losses associated with reduced output. However, propping up prices would also benefit Russia’s competitors, namely US shale. These factors suggest that there is probably a strong political element to Russia’s unwillingness to slash production. After all, if US shale production grinds to a halt, additional market shares become available for Moscow.
Other political considerations, such as the Trump administration’s sanctions on Russian oil company Rosneft as well as the Nord Stream 2 pipeline, also probably influenced Russia’s decision.
Impact on Russia
Nevertheless, Saudi’s price war comes at an awkward time for the Russian economy. It has stabilized for the first time in the post-Crimean period. The budget is in surplus and inflation has dropped to almost 3 percent. The government has vowed to increase social spending to curtail falling approval ratings, which stand at 68 per cent, compared to 85 percent in 2015.
It has $570bn in foreign currency reserves, which it can use to artificially prop up the ruble. That includes the $150bn national wealth fund. Yet, it would ideally spend this money elsewhere. If the price war persists, its proposed social programs will take a hit, undermining the legitimacy of the presidency.
Impact on the United States
US shale is particularly vulnerable. The industry has $86bn in debt that is reaching maturity. Moody’s, the rating agency, said that speculative-grade debt makes up more than 60 percent of the total to be repaid between now and 2024. Diminishing profit margins won’t help.
In terms of the domestic political consequences, a price war may raise unemployment in states that rely on the shale industry, such as Texas and North Dakota. However, it is unlikely to have a significant effect on Trump’s reelection campaign, since both states have a track record for voting Republican.
What to expect
Despite seeing prices drop to nearly $30 per barrel, markets have rebounded and the price is hovering around $35 as of March 11th. Promises of major government interventions have boosted investor sentiment, but $35 is not good enough for any of the aforementioned countries.
According to the Russian Finance Ministry, it has enough resources to manage price drops to $25-$30 a barrel for six to ten years. But that would place severe pressure on the economy, particularly on its currency. The ruble slumped from 68 to the dollar to around 73, the weakest since January 2016. It rebounded slightly after Russia’s central bank started selling foreign reserves. Elina Ribakova, deputy chief economist of the Institute of International Finance calculated that if Crude continued to be traded at $35, $1 billion of foreign currency reserves would be sold per month.
A weak ruble jeopardizes the feasibility of completing domestic infrastructural projects. It also undermines the purchasing power of its citizens. Russian workers have seen their disposable incomes fall for five of the past six years. If it wants to keep its currency strong, it has to use its reserves, but using its reserves means there is less available for domestic spending. The situation is risky for Moscow.
Saudi Arabia has a foreign reserve chest of its own, amounting to some $502bn. However, this would set back its modernisation plan. It plans to reduce its dependence on petrodollars and create new growth sectors. However, with oil prices this low, economists expect the government to slash spending and increase borrowing, which means its diversification strategy will see less money allocated to its realization.
A price war, in the context of the coronavirus, is neither profitable nor sustainable. Saudi’s gambit rests on the assumption that there will be demand. Indeed, with China’s outbreak decelerating, it will likely take advantage of low oil prices. This would eventually drive prices up. Important to consider, China is just about the only place where the virus is slowing. Italy has placed the entire country in quarantine. Death tolls have hit 31 in the United States.
Therefore, Saudi’s gamble is likely meant to pressure Russia into another round of negotiations. Alexander Novak has not ruled out measures with OPEC to stabilize markets.
Though both sides can endure a price war for some time, it is improbable that the current state of affairs will last for an extended period. Both countries have their eyes set on growing their economies. Low oil prices ensure the inverse. Do not be surprised if Russia plays hardball. It may seek to capitalize on weak US shale by temporarily engaging in the price war.
