Measures aimed at containing the spread of Covid-19 have caused acute economic pain among major oil-producing countries, as the collapse in economic activity has suppressed the demand for energy. The magnitude of the crisis forced the world’s largest oil producers to cooperate on enormous output cuts to stop the downward spiral in prices. That unusual step seems to be paying off: oil prices have recovered from their lows in April. Achieving that goal, however, was probably the easy part.
The question now is at what price the market will have to settle for producers to consider the mission accomplished. The answer is not obvious, especially given the wide variance in economic vulnerability among the world’s top producers: the United States, Saudi Arabia and Russia. Once the crisis is over, economic arguments alone will likely not suffice to maintain the pact between them.
In less than five years, oil markets have witnessed the creation of strange alliances that have grown and brought unusual partners together.
Faced with the dual challenge of low oil prices and a resilient U.S. shale petroleum industry, OPEC joined forces with 10 other oil producers, led by Russia. The outcome was OPEC+, which managed to set a floor under the price of oil. The group became a victim of its own success: the more effective it was at defending prices, the faster U.S. production grew. Thanks to shale, the U.S. has moved from being the world’s largest oil importer to its biggest producer of oil and gas, and a net exporter of both. In only 10 years, it has doubled its share of the oil market, to the frustration of OPEC+.
Furthermore, by February 2020, oil prices were back where they had been in December 2016, when the first OPEC+ production cuts were announced. No wonder former Russian deputy prime minister and current Rosneft CEO Igor Sechin called his country’s cooperation with OPEC “meaningless.”
Russia’s concern about the U.S.’s increasing market share goes a long way toward explaining its decision in early March, when, for the first time since OPEC+ was formed, it refused to join the group in cutting production further. Had it not been for Covid-19 and the unprecedented decline in demand that followed, OPEC+ would have ended then. The severity of the crisis forced OPEC+ to reconvene in April and agree on historic production cuts of 9.7 million barrels per day (mb/d).
It was not the scale of the cuts that was most astonishing but the fact that this time, the U.S. called the shots. President Donald Trump personally asked Saudi Arabia and Russia, the world’s second- and third-largest producers respectively, to put their differences aside and reduce their supplies to support oil prices.
The irony is that only a short while ago, Washington was condemning OPEC+ for manipulating prices. Now the U.S., which portrays itself as the world’s free-market leader, has helped OPEC+ reach an agreement on production cuts to put upward pressure on prices.
The partnership between Russia and Saudi Arabia is the foundation that has supported OPEC+. However, their economic interests, at least before the Covid-19 crisis, were not aligned.
Despite having similar production capacity, Russia lacks Saudi Arabia’s technical capabilities to alter output rapidly and cheaply. Russian producers typically implement cuts gradually. Also, Saudi Arabia’s proven oil reserves (298 billion barrels) dwarf Russia’s (106 billion barrels). Russia’s proven reserves represent only 26 years of remaining production compared to more than 66 for Saudi Arabia. Russia’s focus is, by necessity, shorter-term than that of its OPEC partner.
Whereas all Saudi oil is produced by the national oil company, Saudi Aramco, Russian production comes from several independent companies that must be coerced into cooperation. Russian producers can be hurt when the price of oil rises, since some taxes are applied on a sliding scale that varies with prices. However, much of Russia’s oil production comes from small old fields, which can be abandoned prematurely when prices drop. By agreeing to the April OPEC+ deal, these fields now stand a better chance of an orderly suspension of production (being “shut-in” in industry parlance), increasing their chances of being brought back online.
Economically speaking, Russia is better positioned than Saudi Arabia to cope with lower oil prices. In March, its finance minister stated that the country could handle oil prices of $25-$30 per barrel for six to 10 years. After the West imposed sanctions on Russia for its annexation of Crimea, and the subsequent collapse in oil prices in 2014, Moscow implemented several economic reforms. It devalued the ruble and adopted a flexible exchange rate to better shelter its economy from oil price fluctuations.
Russia’s fiscal breakeven oil price – the price needed to balance the budget – dropped from almost $100 per barrel in 2014 to a little above $42 per barrel. Extra oil revenue that came in when oil prices rose above that level were used to replenish the National Wealth Fund. Analysts believe the fund can cover a shortfall in income from lower oil prices for more than five years.
Although Saudi Arabia announced a major economic reform agenda in 2016 called Saudi Vision 2030, progress has come at a snail’s pace. The substantial economic dependence on oil revenues continues to be the kingdom’s Achilles’ heel, keeping it from becoming the low-cost producer that can sustain low oil prices the longest.
While Saudi Arabia managed to reduce its fiscal breakeven oil price from more than $90 in 2014, it is still at nearly $80, well above current market prices. To support its budget deficit, the government is drawing down its foreign financial reserves. In March 2020, according to the Saudi Arabian Monetary Authority (SAMA), the kingdom’s net foreign assets fell to $464 billion from a peak of $746 billion in August 2014. It was the lowest level in 19 years, while the monthly decline of nearly $27 billion was the biggest such drop in at least two decades. In April, the reserves fell by another $20.9 billion. If they continue to shrink, it could threaten the fixed exchange rate of the Saudi riyal to the U.S. dollar.
No wonder Saudi Finance Minister Mohammed Al-Jadaan recently called for a sharp reduction in budget expenditures – an example of the pro-cyclical fiscal policy that has typified Saudi Arabia for decades. To raise non-oil revenues, in May, the government tripled the value-added tax (VAT) from 5 percent to 15 percent, cut cost-of-living allowances for government workers and delayed major projects. Riyadh also made the surprise announcement that it was deepening its production cuts by an additional 1 mb/d, to “further expedite the [market] rebalancing process,” according to Saudi Energy Minister Prince Abdulaziz bin Salman. In reality, the move is more about shoring up oil prices.
Meanwhile, thanks to its shale petroleum industry, the U.S. is now both the world’s largest oil consumer and its largest oil producer. Although Washington made no formal commitment to limit supplies as part of the coordinated production cuts with OPEC+ in April, the expectation was that supply would decline because of lower prices.
While its oil industry benefits from rising prices, the U.S. is nowhere near as dependent on them as Saudi Arabia or Russia. On the contrary, it will increasingly become apparent that the U.S. needs low oil prices to support economic recovery.
Furthermore, even if the pandemic-induced collapse in demand leads to unplanned, emergency shut-ins, the U.S. oil industry is flexible enough to sustain itself and preserve the value of its assets better than Russia’s. In this respect, among the three largest producers, the U.S. could sustain a race to the bottom the longest. Political interests – in this case, the votes in oil-producing states in the upcoming presidential election – have taken precedence so far.
When OPEC+ was formed, few expected it to last for more than three years. After its near collapse in March this year, the pandemic not only provided it with a new lease on life but enticed other producers (like Canada and Brazil, along with the U.S.) to follow suit. Some have called the bigger group OPEC++.
Once the crisis is over, it is difficult to see how the latter arrangement can survive, at least based on oil market-related arguments alone. It would be difficult to find a price level that could keep all parties happy.
U.S. shale oil may be the first to leave the market when prices decline, but it is also the first to return to the market when prices recover. Then, it will cause the same headache to OPEC+ as it did before Covid-19, and the fierce competition for market share will return.