Can Russia win (or survive) the oil price war?
As prices per barrel plummet, Vladislav Inozemtsev considers the latest standoff between Russia and Saudi Arabia
During negotiations in Vienna on March 6, 2020, the Russian government refused to sign up to Saudi Arabia’s new plan to reduce oil production. Riyadh’s economy is critically dependent on oil production and prices; according to various estimates, the Saudi state budget can be reduced without a deficit should prices range between $73-81 per barrel. By the time of the summit, an apparent slowdown in the global economy had led to a reduction in demand; Saudi representatives had advocated a dramatic cutback in oil production by 1.7 mpbd, or thousand barrels per day. Unlike Russia, which supplies oil to China primarily at the expense of state oil company Rosneft’s debts to Chinese companies and banks, Saudi Arabia’s producer Saudi Aramco was faced with a glut of supplies to the Chinese market and understood that these would not return to the volumes seen in January until at least the beginning of June. For Russia, this deal would have meant a reduction in exports of approximately 300 mpbd, which risked depriving the country of a billion rubles every day (calculated at a price of $46 per barrel at a rate of 66 roubles to the US dollar.) The consensus was that while this proposed decrease in production might curb the fall in prices, it could not increase them.
Russia had reached its position on March 1, following a meeting between Vladimir Putin and the leaders of the country’s oil and gas companies at Moscow’s Vnukovo-2 airport. Here Igor Sechin, head of Rosneft, categorically opposed joining any such deal with the Saudis, believing that a reduction in the share of OPEC+ producers in the oil market would only have a positive effect on competitors: namely, American producers of shale oil, who occupy an important stake in the emerging market. Both tactically and strategically, Sechin’s assumption was incorrect for several reasons.
Firstly, the US is not the net oil exporter Sechin claims it to be. The Americans’ net imports now amount to 3.6 mpbd; net exports only enter the equation when taking other petroleum products into account, which the US produces from raw materials for export (mostly to Mexico.) Secondly, the very idea that American companies are “not allowing [Russia] to develop” is mistaken; on the contrary, Russia has been unable to increase production itself (since 2011 this has grown by 900 mpbd, compared to the US’s 5.4 mbpd.) And even if the Americans had managed to increase their own output “by sheer force of will,” Russia would not have been able to match that growth even by one mbpd; there was simply nothing new to push on the market. Thirdly, one is left with the impression that Moscow was not at all interested in the timing of a possible “oil war,” which in any case they had expected to fight with the Americans, not the Saudis. Meanwhile, shale oil producers have long been hedging their supply prices for up to a year ahead, meaning that they will not feel any serious repercussions earlier than the fourth quarter; in addition, under new circumstances where rates have been lowered to almost zero (which was foreseeable, given Donald Trump’s constant pressure on the Federal Reserve), companies can simply roll over their debt to avoid negative consequences — at the very least for another year and a half. Finally, unlike Russia where a company’s bankruptcy essentially spells its utter ruin, American shale oil companies can simply invoke Article 11 of the US Bankruptcy Code and defer on paying their creditors for a restructuring period of up to two years. In other words, any real success in the case of an outbreak of “oil war” depends on the ability to weather the storm until at least next summer. I strongly doubt that Sechin appreciated this fact, which is important given that he then explained the situation to Putin.
In the end, the steps taken by the Russian authorities were not completely mistaken. Minister of Energy Alexander Novak announced during the negotiations that Moscow’s position could not be changed and that there would be no reduction in oil production.
From that moment on, things began to develop in ways the Kremlin had not anticipated. Oil prices fell by just four percent to $44.2 per barrel after the Russian delegation walked out of the negotiations; their position elicited a fierce reaction from the Saudi authorities. The king’s heir, and in essence the owner, of the kingdom attempted to find out Putin’s position for himself, but was informed that the Russian leader was too busy for a telephone call. The next day, Saudi Aramco announced an increase in production by 2.3 mbpd to 12 mbpd, and the high probability of further growth to 13 mbpd in the following days. At the same time, company management offered discounts of up to eight dollars on every barrel to their European customers. These steps drove oil prices down by 30 percent at morning trading in Asia by Monday, March 9. Developments over the following days (such as the release of data on the decrease of oil demand, a reduction in British and American rates, the cancellation of flights between many countries, and the endless sales on stock markets) put pressure on oil prices, leading them to fall from around $33-34 per barrel to $26-26.5 a barrel. I would stress that all of these events have occurred over a short period of time and some of them even before the Saudi producers even started their cheap deliveries (formally, previous agreements remain valid until April 1.) Preliminary GDP data for leading countries’ first quarter on are about to be released, and we can be sure that they will be grim reading. I would not expect a further collapse in oil prices in early April, but nonetheless believe that they will remain stuck at today’s levels.
What can we expect next? I believe that there are now two basic scenarios:
On the one hand, there are less than two weeks before April 1. Representatives of Russia and other OPEC states may indeed decide to return to the previous deal. At the same time, of course, the reductions in that case will be even greater, as Russia’s share in them is much more extensive than previously believed. In many respects that would be a reasonable decision: if oil prices remain at $30 per barrel, Russia owes up to eight billion rubles a day (calculated on the basis of prices dropping from $46 to $30 a barrel, at a rate of 80 rubles to the dollar.) Even a reduction of 700-800 mbpd, provided that prices return to levels seen in early March, would seem an obvious blessing. However the fundamental position of the Russian leadership (and their Schadenfreude at the sharp decline of American shale producers; for example, Marathon Oil has fallen by almost 80%) may blind them to recognising ways out of this situation. This is further compounded by the fact that there are no signs that the Saudis are willing to compromise: unlike Gerhard Schröder, it seems unlikely that Mohammad bin Salman could simply be bought off with the offer of a cushy post and stable salary at Rosneft or Nord Stream 2. And unlike Putin, whose friends have devised sophisticated schemes for siphoning money from the state budget into their own pockets, Mohammad bin Salman simply owns his country and all its wealth outright.
On the other hand, either could simply launch a war of annihilation. Since this option is the more likely one, it is worth evaluating the balance of power between the two sides. It is often said that the Russian state budget, in contrast to the Saudi, hinges on oil prices hovering at around $42.4 per barrel. In reality, that is not the full picture given that the projected federal budget for 2020 included a price of $57 per barrel with a surplus of 800 billion rubles (Russia’s Minister of Finance Anton Siluanov now speaks of a loss of three trillion rubles in income.) However, even if these budget limitations are to be accepted, it must be remembered that Russia faces real limitations in raising taxes any higher; its tax burden stands at 33.8 percent of GDP, while Saudi Arabia raises just 5.3 percent of its GDP from taxing citizens and businesses. Furthermore, Russia’s sovereign wealth fund now holds $124 billion (or 9.5% of GDP), while Saudi Arabia’s Public Investment Fund has $322 billion in its coffers, a sum equal to 41.2 percent of the kingdom’s GDP. Meanwhile, the Saudi budget allocates almost $60 billion a year to defence expenditures (unlike Russia, these are not used to support an immense domestic military-industrial complex, so can be reduced with fewer problems.) And although both countries’ foreign exchange reserves are roughly equal (Russia’s $571 billion compareed to Saudi Arabia’s $502 billion), Riyadh enjoys almost unlimited borrowing opportunities internationally, and its companies are not burdened with huge external debt. Last but not least, in 2019 Russia exported $1,820 worth of fuel per capita per year, compared to Saudi Arabia’s $10,400. In Russia’s case, the consequences of any loss of income from exports will be felt much more keenly by the population.
In my opinion, under the current circumstances dragging out this confrontation any further will be extremely painful for all concerned. That’s speaking about the long term, but over the next year or year and a half, that prospect would be disastrous for Russia. We should not forget that the defiant slogans about Russia’s ability to weather any storm were informed by the hard times of 2008-2009 and 2014-2016: hard times where the negative repercussions for the Russian market were relatively short-lived. By 2011-2013, average annual oil prices had climbed to their highest level in history (more than $110 per barrel), and from spring 2016 to summer 2018 they more than doubled, climbing to $64 per barrel. But times are different now. Today, we are more likely to encounter a long downward slump in oil prices similar to that which the world faced in the 1990s. Today, industrialised countries are unlikely to be able to ratchet up demand as China did in the 2000s — moreover, Europe and the US have been reducing their fossil fuel consumption since 2006 and will continue to do so. Combined with the sharp increase in production volumes in America, it can be safely assumed that throughout the 2020s the market will have to reckon with huge excesses in fuel supplies. Under those conditions, prices will not rise. Mizuho Bank’s recent prognosis that oil prices could even fall to negative levels remains a fanciful opinion, but then again negative interest rates were also unimaginable until recently. Nevertheless, it must be admitted that there are as yet no serious and objective grounds for a quick recovery of oil prices and therefore few reasons to hope that the current collapse is merely a temporary phenomenon. In other words, stories about oil prices returning to $50-60 per barrel after the end of the coronavirus pandemic are about as reliable as Sechin’s forecasts about oil selling at $150 per barrel by the end of the 2010s.
In light of these developments, I can draw some obvious conclusions. Firstly, the promises of Russian leaders to “get off the oil train” was just a bluff. Russia is nothing other than a classic petro-state, like Saudi Arabia, Iran, Venezuela, and several other countries. The assumptions that China will soon become the leader of the global economy are as well-grounded as those made about Japan in the late 1970s. Essentially, that means that there will no longer be a rapid growth in the oil market. And with the ongoing development of alternative energy sources in the EU and USA, oil will begin to suffer the fate of coal: if in the mid-20th century it was a highly strategic commodity consumed in significant quantities in developed countries, its burning is now a hallmark of lesser developed economies and of China. The main markets for oil in the 2030s and 2040s will be Bangladesh, India, and African states; their demand may be large, but not large enough to knock prices up to $100 per barrel. Manufacturers will undoubtedly need to be open to negotiate for control of these markets.
Therefore it seems to me that sooner or later (and better sooner than later) the “oil war” between Russia and Saudi Arabia will end with a new agreement. The whole scenario can be compared with the First World War, which was sparked on a minor pretext, fuelled by the imprudent behaviour and ignorant preconceptions shared by all warring countries’ monarchs, and essentially ended without any serious territorial gains by any of the combatants. That war spelled the end of the political order of the 19th century; similarly, an “oil war” waged to utter exhaustion could spell the end of the economic order of the 20th. I find that outcome rather sad, if only because of the ample evidence of our unwillingness to face up to and to live in new realities…