After Russia refused last week to accept OPEC's proposal to cut oil production by 1.5 million barrels per day to prop up oil prices, Saudi Aramco announced on March 7 that it would lower its April pricing differentials by $4-$6 to Asia and $7 to the United States. The move took Asian differentials from premiums to steep discounts and Saudi Arabia strongly hinted at a substantial production increase, which Saudi Aramco sources confirmed to media outlets on March 8 without attaching specific numbers. The development, in turn, produced a shock to financial markets, with Brent crude oil down to $35 per barrel in late trading on March 9.
Why It Matters
The Saudi move is a declaration of a full-blown price war, which most observers did not foresee on March 6 when talks between OPEC and its nonmember partners fell apart, given that it would blow up the Saudi budget deficit, as well as the fact that Russia, even unconstrained by OPEC+ commitments, has limited potential to raise production quickly in 2020. It takes a situation in which the world oil market had been hit by a demand shock (shutdowns and other disruptions caused by the COVID-19 outbreak has sharply reduced the demand for oil) amid a modest slowdown in economic growth and added a supply shock of an unknown but potentially massive quantity. As a result, inventories will be building much more rapidly, though price drops are somewhat mitigated in the short-term by the availability of storage. But an extended COVID-19 crisis could easily force prices down to levels below where they were in 2015-2016. An extended price collapse into the $20s-$30s range, which is now likely for at least the next several months and perhaps much longer, will have broad knock-on effects on other markets. Other than energy equities, the worst impacts will be on sovereign finances of oil exporters with less-diversified economies and low sovereign reserves. In particular, Iran and Venezuela will suffer the most, as both have already been forced to sharply discount their sales to find buyers amid U.S. sanctions.
Saudi Arabia's decision to increase output likely reflects Crown Prince Mohammed bin Salman's hope that if he puts acute pressure on Russia, it will cave and agree to a significant production cut. But this all-out price war is counterproductive; as state oil company Rosneft outlined in a detailed statement on March 8, Russia was unwilling to cut production because in its view production restraint had simply led to growth in competing supply. This competition includes not just U.S. shale oil but also a lot of deep-water offshore investment in places like Guyana and Norway, stimulated by the period of higher prices in 2017-2019. That longer-cycle supply facilitated by OPEC+ restraint is just starting to come online, and the economics of those projects are such that they are not subject to delay for price-related reasons once they are started. Tensions were building between Russia and the Saudis even without the demand shock from COVID-19 because of Russia's unwillingness to equitably share the burden of restraint, which brought things to a head last week.
The Saudi move is also counterproductive in that U.S. shale production would have felt a major impact before the end of 2020 just from the lack of further production restraint, but would have bottomed out at a higher price, perhaps $40 per barrel. The difference between $30 and $45 as an average crude oil price is huge in terms of fiscal impact on producers but is not nearly as significant in terms of the volume loss that will be seen later this year from U.S. producers.
Russia's economy is going to take a major hit from the price collapse, but Moscow is in a much stronger position than Riyadh. Moscow has been accumulating reserves in its National Wealth Fund since 2017 at any price above $40 per barrel (with 2 percent annual inflation adjustment) and the most recent public data had the fund at $150 billion and cash reserves at $570 billion. Its budget balances with Brent in the mid-$40s, but drawing from the National Wealth Fund will help to cushion the blow if prices fall below that range. Russian President Vladimir Putin taken some criticism for implementing austerity measures and putting money away while oil prices were comfortable, but this now looks prudent. It reflects the fact that Putin accepts that the "lower for longer" price outlook is real and wanted to be prepared for precisely this type of shock.
The Saudis, on the other hand, are looking at a scenario in which the dividend payout they receive from Saudi Aramco will leave them obligated to finance roughly half of government spending from reserves and borrowing during the balance of 2020, with reserves of $502 billion. Their low debt-to-GDP ratio of 26 percent means that they can borrow, but that borrowing could become more expensive with renewed doubts about both future oil prices and the rationality and impulsiveness of Saudi policymaking. This, along with losses in the value of foreign investments held by the Public Investment Fund, will make it more difficult to maintain spending on Crown Prince Mohammed's Vision 2030 economic diversification program, which thus far has failed to make much progress generating increased private-sector employment for young adults despite ambitious stated goals. As with Putin, it would be politically difficult to admit having made a mistake and back down, since the only option on offer at present would probably be a continuation of current quotas, not any concessions from Russia.
All of this leaves the world facing an extreme level of uncertainty about where the oil market is headed, but it does not seem likely that we will see a sharp recovery in prices in the next few months.
