On Thursday, it was reported that the Trump Administration might take action on both sides of the ongoing Saudi-Russia price war, pushing Saudi Arabia through diplomatic channels to cut production, while threatening new sanctions on Russia.
The aim would be to bring both sides back to productive negotiations, after supply talks between the expanded organization of oil producing countries (OPEC+) collapsed in Vienna earlier this month. The standoff—coming amidst an unprecedented drop in demand from the global spread of covid-19—kicked off a volatile selloff that culminated earlier this week in a 24% single-day drop in the price of oil, bringing it to an 18-year low near $20.
Last week, the Trump Administration announced plans to quickly purchase U.S. oil for storage in the Strategic Petroleum Reserve, seeking to relieve struggling domestic oil producers sent reeling by the demand shock from coronavirus and the impact of the OPEC+ price war.
The move may also have been meant to signal that the U.S. is aware and concerned about the potential impact that a disorderly fall in oil prices could have on sovereign credit markets.
Limited effect
Earlier this week, in a call for members of the Council on Foreign Relations, energy expert Amy M. Jaffe, the Council’s David M. Rubenstein Senior Fellow for Energy and the Environment and Director of the Program on Energy Security and Climate Change, offered thoughts on why even a halt of Saudi Arabia’s flooding of the oil market with excess supply could have a limited effect on prices in the near term.
“One reasons of the reasons why [Saudi Arabia] felt that pushing supply [on to the market] would be successful is that the history of ‘shock-and-awe’ can focus producers on cooperation…Normally when that happens, you get a boost to economic growth,” she said. “[The] problem is, in many places, even though we’re a seeing a resurgence of normal activity in China, we’re having these rolling curtailments [of economic and social activity] in Europe, and now in the U.S.— measures meant to slow the spread of disease. [So] these [oil market supply] measures will not have the same impact. That’s the challenge that OPEC faces today.”
Speaking on the same call, Neil R. Brown, the Managing Director of private equity giant KKR’s Global Institute and KKR Infrastructure, said that even if OPEC+ eventually resumes their prior supply restraint arrangement, it might not equate to much meaningful near-term price recovery.
First, Brown explained, the current oil price collapse reflects oversupply and demand destruction hitting at the same time, with demand destruction originating in China, the world’s largest importer of oil. As covid-19 has spread globally, its negative impact has deepened in 3 of the 4 top demand markets globally, adding to an existing economic slowdown.
This month’s unexpected breakdown [of OPEC+ talks] in Vienna magnified the effects of a market that was already oversupplied, adding to what Brown called an “augmentation of trends” already well underway.
Additionally, he said, the division remains, at core, a Russia/Saudi dispute. The issue leading to the OPEC+ breakdown was Russia’s hesitation that a price war could be sustained in a low-demand environment. The country has been resistant to production cuts for months, and recoiled at the Saudis’ forcefulness in Vienna and their support of U.S. shale. On the other hand, the Saudis have—unsurprisingly—been unwilling to lose market share unilaterally, or to serve as the cartel’s sole swing provider. The country has high fiscal needs, and the recent IPO of state-owned producer Saudi Aramco has made the kingdom’s domestic constituency newly sensitive to stock price.
He believes Saudi Arabia is keen see a near-term price floor, and doesn’t want to be seen as declaring war on U.S. shale producers.
Russia has, he added, more room to maneuver in the near term than Saudi Arabia does. The country is in a stronger position since its 2014-2017 financial crisis, with a more diversified economy and revenue base, and has replenished its sovereign National Wealth Fund to $150 billion. Its fiscal breakeven is $30 lower than Saudi Arabia, and per Brown, has more fiscal tools at its disposal to weather an extended economic downturn. The country continues to desire more cooperation with Saudi Arabia, and is keen to extend its influence in the region.
But Russia faces other constraints: U.S. sanctions are still in effect and may increase. President Vladimir Putin wants to extend his presidency and needs to allay the country’s oligarchs. Oil is existential for both Saudi Arabia and Russia, with neither side known for relishing compromise, and both signaling willingness to hunker down.
Not a great visual
“The reality is that because neither [Saudi Crown Prince Mohammed bin Salman nor Russian President Vladimir Putin] expected to be here, the policy plane is being built while in flight,” he said.
Brown suggests that rather than looking at “triggers” for a resolution of the ongoing price war, stability may result from a “constellation” of factors. These include signs of domestic unrest in either country, whether from elites or rank-and-file citizenry. Signs of a bottoming out of covid-19-related demand destruction would be another. A third would be signs of a physical supply reduction: both the Russians and the Saudis will have been encouraged by this week’s capex guidance from Exxon, and looking for a supply response, first and foremost in U.S. shale. Finally, Brown sees a “limited” role for international pressure as a stabilizing factor on prices. Pressure from the G20 could possibly encourage Saudi Arabia to ease up on rhetoric and supply, to a degree.
Ultimately, he believes, reconciling the aggrieved parties of OPEC+ will not solve the problem of persistently weak oil prices. The existing supply overhang will take years to work through. Transportation alone is one of most important uses of oil, and with multiple countries around the global imposing travel bans, and airlines cutting capacity, low prices can’t self-correct in the near term.
“We are perhaps getting a glimpse of the future of oil,” Brown said. In that respect, “OPEC+ is not a marriage, but an affair of convenience”
Jaffe concurs: “I do think the demand loss is going to be substantial. Thinking about a timeline for it to be restored, there aren’t a lot of good precedents to look at. After 9/11, it wasn’t really until 2004 that we saw global air travel back on the normal trajectory that one would have expected, had that event not happened…It’s going to take some while for things to move through the system, and to have an economic recovery [in which] the recovery itself will stabilize the energy markets.