The Race to the Bottom in Oil
With the developed world in transition towards a short and medium-term economic self-flagellation as a means of reducing the impact of the SARS-COV-2 virus spread, there is little room for economic news that is not related to markets tumbling and toilet paper becoming contraband. While it started with the shutdown in Hubei province in China and the associated tough (but successful) quarantine and social distancing measures, the economic crisis has moved onto Western nations, where the collective impact of the virus has already exceeded that in China. The measures which the experts (and, reluctantly, and too late for comfort, the politicians) are calling for are throwing prodigious amounts of sand in the gears of a system that developed organically to thrive on mobility, access, just-in-time logistics and a global division of labor. Regardless of the terrifying human costs of the crisis, the economic consequences will be the making of the leadership and will unravel carefully synchronized supply and production chains, as well as industries on which the (precarious) livelihood of millions depends, such as tourism.
With this in mind, the news that the OPEC+ negotiations in Vienna broke down unexpectedly (to some, including this author) on March 6th, leading to a “drill baby drill” event that sent oil prices tumbling. Oil was not going to go well either way, since any economic crisis will lower the demand for energy and, therefore, the consumption of oil and other fossil fuels. Russia and Saudi Arabia, the two countries that more or less ran OPEC+, went to the mat in getting oil prices even lower. Saudi Arabia, in particular, outdid everybody else. Saudi Aramco, the national oil company and darling of the IPO crowd vowed on March 10th that it would pump out 12.3 million barrels a day, which would be almost 30% higher than recent levels (when the OPEC+ deal was working), but also 300,000 barrels over its “maximum sustained capacity”, meaning that it would overleverage its infrastructure.
This conflict sent stock markets tumbling just as the markets were reacting to the impossibility of containing the latest coronavirus outbreak in China, proving that (these) markets react to news, rather than participant information. Particularly hard hit were energy stocks, with the SPDR S&P Oil & Gas ETF (basically, a fund aggregating energy stocks) trading at its lowest levels since 2006, and US crude oil costs fell 26% the next Monday (to 31.13 dollars) after the Vienna meeting, its worst day since 1991, according to CNN. Brent crude oil went from a high of 68 dollars per barrel on January 6th to 28 dollars on March 18th.
This has the making of a geopolitical confrontation few would have asked for, because price coordination is only the surface area issue. The underlying issue may also be the attempt to stick it to the United States, which had, in 2018, replaced Russia as the world’s largest oil producer through unconventional resource extraction (shale).
The underlying issues
The first important issue for energy is supply. OPEC is an intergovernmental cartel that seeks to maintain price stability on energy markets (preferably higher prices) and to coordinate its members in this direction, while occasionally flexing its geopolitical muscle (as it did, memorably, in 1973, during the Yom Kippur War). Its website gives the following details of its shifting membership.
The Organization of the Petroleum Exporting Countries (OPEC) was founded in Baghdad, Iraq, with the signing of an agreement in September 1960 by five countries namely Islamic Republic of Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. They were to become the Founder Members of the Organization.
These countries were later joined by Qatar (1961), Indonesia (1962), Libya (1962), the United Arab Emirates (1967), Algeria (1969), Nigeria (1971), Ecuador (1973), Gabon (1975), Angola (2007), Equatorial Guinea (2017) and Congo (2018).
Ecuador suspended its membership in December 1992, rejoined OPEC in October 2007, but decided to withdraw its membership of OPEC effective 1 January 2020. Indonesia suspended its membership in January 2009, reactivated it again in January 2016, but decided to suspend its membership once more at the 171st Meeting of the OPEC Conference on 30 November 2016. Gabon terminated its membership in January 1995. However, it rejoined the Organization in July 2016. Qatar terminated its membership on 1 January 2019.
This means that, currently, the Organization has a total of 13 Member Countries.
The OPEC Statute distinguishes between the Founder Members and Full Members - those countries whose applications for membership have been accepted by the Conference.
The Statute stipulates that “any country with a substantial net export of crude petroleum, which has fundamentally similar interests to those of Member Countries, may become a Full Member of the Organization, if accepted by a majority of three-fourths of Full Members, including the concurring votes of all Founder Members.”
OPEC’s role is to coordinate production so as to prevent a race to the bottom of countries producing too much oil and ruining it for everybody else. High energy prices mean that everybody is incentivized to deliver as much as possible to energy markets, which would lead to price stabilization, in a perfect market, near the marginal production cost for crude oil (which differs from one country to another). While there have always been suspicions of countries defecting from assigned quotas and actual threats of doing so, Saudi Arabia has maintained leadership not just by being the largest producer, but also by shouldering the largest cuts in production to maintain prices.
After a heated past, things had been settling down prior to the September 11 attacks. Brent crude had reached a low of 17.7 dollars by November 1998. America’s misadventures in the Middle East not only created significant economic uncertainty regarding supply by taking out on of the largest oil producers, Iraq, which took over a decade to recover, but also, later on, the so-called Arab Spring led to civil war in Libya and Syria, as well as the so-called Islamic State accruing power in Western Iraq and Eastern Syria. The high point for oil was in Jun 2008, during the “surge” in the Middle East, when oil topped out at 165 dollars per barrel, briefly. The petrostates, so-named because they do not produce much else and are dependent on oil revenues from a state subordinated industry, had been spending with abandon all throughout the period. Giddy Saudi officials tried to reassure the West, at one point, by claiming that OPEC would do its best to raise production and stabilize prices at 125 dollars. The 2008 financial crisis and the recovering supplies in Iraq led to a signifying drop in oil before it began to rise again on the back of the economic recovery in China and the US and the events in the Middle East which led to further supply shocks. A glut in production led to a new low in 2015, at 36 dollars, which then rebounded to 76 dollars on the back of consistent supply coordination on the part of producers.
For those producers, the oil windfall had become not just a nice bonus, but a life and death situation to maintain social spending, including on subsidized fuel and energy, at a level where the population would stay quiescent. Large deficits and unsustainable expansions and contractions in budgets became the norm for many of these countries, and even Saudi Arabia started to feel the pinch as its money reserves became depleted.
A burgeoning prisoner’s dilemma
The country which was obviously missing from this story is Russia and the Soviet Union before it, which preferred to make its own policies and which had stripped Saudi Arabia of the title of largest oil producer in the world by the early 2010s on the back of strong energy prices and better technology for exploration and exploitation, as well as the completion of infrastructure to bring the energy to markets.
The OPEC+ formula came about from the realization that OPEC was headed towards irrelevance because of the new producers – not just Russia, but also the US and Canada (the famous Alberta tar sands). In 2018, OPEC had 79.4% of the world’s proven oil reserves, but only 44% of the world oil production (and 21% of its gas, the fastest growing single source of energy) and that was fast eroding because of the shale producers. Enter Russia, along with Kazakhstan and Azerbaijan, which created the OPEC+ formula. A deal between Saudi Arabia and Russia kept prices at a somewhat agreeable level. This was not just profiteering, as we can see that the market is very sensitive to news of economic results, energy supplies, proven reserves and geopolitical mischief. A great many industries, such as air travel and maritime transport, are critically dependent on energy prices and the market seesawing does them no favors. However, the political equilibrium level is not the same as the economic equilibrium level, and these are both different from one country to another. Neither country wanted to cut more of their production to push prices higher and basically cede market share to greedy shale producers in the West spurred by higher prices. Neither could they, ultimately, agree on how to share the cuts. Russia has been running a “discount price” power projection operation in the Middle East and has been, at least to some extent, affected by continuing sanctions after the 2014 illegal annexation of Crimea. Saudi Arabia still faces a ballooning population which is 60% under the age of 19 (youth bulges are always politically and socially dangerous, as the Muslim world found out in 2011) with an unreformed, energy revenue-addicted economy and the opposite of Russia’s “discount price” military intervention, but in Yemen.
This is a classic prisoner’s dilemma which had relied on a tenuous solution to cooperate until the Coronavirus swept the legs from under the world economy. Deeper cuts in production were warranted to maintain prices, and the partners has a falling out in Vienna. Now, they are both trying put on a good show before they come back to the negotiating table. It is uncertain whether economic amelioration as China moves past its Coronavirus moment and reaches for full economic restoration (and energy consumption) by early May will broaden the gap between the two energy powers or provide an incentive for a compromise.
As the Asia Times reports, Russia is in a better position to weather this storm. Oil accounts for less than 10% of its GDP, compared to 16% in 2012, while the Saudis still rely on oil for 50% of their GDP. The Saudis have the cheapest oil extraction in the business, at 6 dollars a barrel, which is how they were able to shoulder such prolonged cuts in production, but Saudi Arabia’s military and especially social spending require oil at 85 dollars a barrel to break even. Its 2020 budget reportedly relies on oil at around 62 dollars per barrel and it still ends up generating a 50-billion-dollar deficit. Meanwhile, the Saudis have been dipping into their rainy-day fund for years. The Central Bank’s reserves now stand at 500 billion dollars, but shrank, for instance, by almost 50% between 2014 and 2016, when another round of fiscal woes and price shocks hit the Kingdom.
At the same time, Russia is supposedly losing 150 million dollars a day from the fall in energy prices, according to Lukoil boss Leonid Fedun, but its sovereign wealth fund holds an estimated 150 billion dollars which can cover any budget deficit. The official version is that National Wealth Fund, can cover 6-10 years of deficits, even with oil at 25 dollars per barrel. Russia has also amassed foreign exchange reserves worth 570 billion dollars. This is not the “bottom of the barrel” as far as predictions go, since Goldman Sachs is reportedly considering that oil may go as low as 20 dollars per barrel. 37% of Russia’s budget comes from oil, and the balancing is possible at 42 dollars per barrel, supposedly. With the Russian ruble having become free floating, it is possible a massive devaluation is in the works in order to restore competitiveness without sacrificing Russian foreign exchange reserves, thereby pushing the costs of the conflict onto the population and incentivizing the “import substitution” trends which had manifested with the sanctions. Nevertheless, a global economic crisis will also affect other commodity prices, which will further affect Russian economic and fiscal prospects.
Still, Russia appears to be better equipped to deal with the consequences of the OPEC+ deal falling through than Saudi Arabia. And, either Russia or both of the countries may have another ulterior motive for the play, at least as a secondary benefit.
Hitting Trump where it hurts
There is a tantalizing possibility that the blitheness with which Russia has assumed this oil conflict has less to do with bringing Saudi Arabia back to the negotiating table than with striking at the US now, while it is vulnerable. Just like every other country, Russia is made up of different interest groups that offer up different perspectives. While some are glad for OPEC+ cooperation and the maintenance of prices, others have not failed to notice that the market share ceded by Saudi Arabia and Russia through production cuts has been captured by the United States. The world superpower has added energy independence to its advantages and a growing propensity (though still modest, compared to other tools) to use it geopolitically, such as in relation to Poland and the Baltic states. The only thing holding it back is its own sturdy consumption, its lack of specific infrastructure for energy exports, its lack of a legal framework for this (until recently) and the fact that US oil is mostly light sweet crude while its refineries are configured for heavier imported variants from Venezuela and Saudi Arabia.
The chink in the US energy armor is that its energy fortune is being made by unconventional resources companies exploiting shale oil and shale gas. These companies have several problems. The first and the largest is that their extraction costs are quite high. They do not benefit from amortized investments like established and traditional energy extractors, and the process itself is more capital intensive. As a result, they require high energy prices to be viable, let alone profitable, which is why the energy headwinds of the last 20 years have been what has spurred US energy independence without sci-fi mixes of green energy and nuclear fusion power. This price dependence and the cutthroat business in which everybody is on his own, without the centralized industrial politics common to countries like Russia and Saudi Arabia, have made the US uniquely vulnerable to price warfare. Meanwhile, these energy companies have become significantly overleveraged. Their high level of debt stems from the specifics of the shale industry and its rapid growth. This makes them particularly vulnerable to cascading economic disruptions which can wipe them out, even if they are temporary. The markets know this, which is why they reacted badly to both the certainty of Coronavirus impact on the rest of the world, but also to the prospect of a price war initiated by Saudi Arabia and Russia competing to outproduce eachother following the failure of the OPEC+ negotiations. Not only were major companies like ExxonMobil and Chevron battered, despite being hedged against cheap oil, but companies like Pioneer Natural Resources and Occidental Petroleum lost 37% and 52%, respectively. Some companies may be able to save themselves, but only by reducing their size and curtailing new and expensive projects, which will, again, impact US energy independence.
We saw this in 2014-2016 when dozens of companies went bankrupt and thousands of workers were laid off because of energy prices. Overall, energy stocks have done poorly this decade because of this volatility, and Russia and others have noticed this particular Achilles’ heel. Which is just as well, since the US had announced sanctions against a Rosneft subsidiary for its energy deals in embattled Venezuela in mid-February. And let us also remember the role that US lobbying had in delaying the Nord Stream 2 pipelines which would bypass several areas which are hostile to Moscow to deliver natural gas directly to its main customer in Europe, Germany.
CNBC quotes on the head of commodities for Royal Bank of Canada as saying:
“While OPEC leadership retains hope that the price collapse will be a catalyst for a reconciliation between the two oil heavyweights, President Putin may not quickly capitulate. […] We fear that it could be a [protracted] struggle, as Russia’s strategy seems to be targeting not simply US shale companies— but the coercive sanctions policy that American energy abundance has enabled. […] Trump administration officials have repeatedly bragged about the ability of the US to punish its foreign policy adversaries by sharply reducing their oil exports, and to be shielded from the price impact because of abundant domestic energy supplies.”
The US Department of Energy reacted in this way:
“These attempts by state actors to manipulate and shock oil markets reinforce the importance of the role of the United States as a reliable energy supplier to partners and allies around the world. The United States, as the world’s largest producer of oil and gas, can and will withstand this volatility.”
A Bank of America analyst formulated the mystery thusly:
“The market expected the Saudis to act as they always do, which is to basically curtail production to balance the market, but they went out and did the exact opposite […] They could have just stayed where they were and then the question is, is this something the Saudis are doing because they wanted to teach the Russians a lesson and bring them into the fold, or is this alternatively something the Saudis are doing because they believe the Russian theme in this is the right way to deal with the virus? The question is are Russia and Saudi joining forces to hurt U.S. shale or are they fighting against each other.”
The OPEC+ debacle has become a further geopolitical crisis point in the background of the SARS-COV-2 crisis. Both Saudi Arabia and Russia wish to gain as much as possible with as little sacrifice as possible, but must coordinate sacrifices to make price support for oil remotely feasible. At the same time, they both, but Russia especially, have hit upon this crisis as an opportunity to take out the US shale oil producers, who are like mayflies – here today, and gone tomorrow. They feature overleveraged balance sheets, high extraction costs and creditors on their backs without the benefit of coordinated energy financial policy on the part of the US that makes a true petrostate like Saudi Arabia tick. It is quite feasible for the US producers to capsize, taking the markets to new lows, despite the new round of quantitative easing, unless the US reforms its way of doing business with strategic sectors (which it has not done in the post-Cold War era). This will be politically damaging to Trump, personally, and represents a potential master coup in an election year. It is all the more interesting that Saudi Arabia is apparently acquiescing to this program, despite the US being the protection and guarantor of the continuation of current political arrangements in Saudi Arabia.
There are two lateral conclusions that we may end with. The first is that lower energy prices would, ordinarily, be a boon to the rest of the energy-consuming world and would lead to economic redress. This is not going to happen because the current recession and possible depression is not a result of economic phenomena, but of deliberate undermining of productive capabilities through measures intended to fight the Coronavirus outbreak. If and when the restrictions on the circulation of goods and people are lifted, then the lower energy prices will provide a much-needed stimulus towards recovery.
Secondly, the quarrelling OPEC+ powers may get their wish in sinking the US oil industry but, having tasted energy independence and protectionist policies under Trump, their success is not likely to last. The US excels at “creative destruction” and at reintroducing assets into the economic circuit. Therefore, they may find that killing US energy producers and making the US a net importer again will raise prices to the level where shale becomes profitable again. And, then, new companies with new letterheads will stare out at them from the stock market rolls, but the same fields and infrastructure will be behind them as well.