There are no winners from oil price wars. Surviving requires political strength more than economic strength; and then economic strength more than industry strength. Now the Organization of the Oil Producing Countries, Russia and the US shale industry have embarked on this test of strength. How will they fare?
Since the breakdown of the OPEC+ agreement with Russia, every oil-producing state that can boost output has done so. Russia itself says it can add 500,000 barrels per day (bpd). Saudi Arabia made its “shock and awe” announcement designed to win a quick victory, slashing its prices by US$6-$8 per barrel and promising to boost April production to 12.3 million barrels per day, above its nominal capacity, and to expand that capacity to 13mbpd, likely the work of a few years.
The Abu Dhabi National Oil Company (ADNOC), will raise production from 3mbpd to test out its newly minted 4mbpd capacity. Iraq could add 350,000bpd if its creaky export facilities hold up; Nigeria might raise production around 100,000bpd, and Kuwait can add 250,000bpd from its joint-production Neutral Zone with Saudi Arabia. The other regional oil exporters – shattered Libya, fragile Iraq, vulnerable Iran, Oman and Algeria – will have to cope as best they can.
OPEC has ended up fighting the right battle, but perhaps at the wrong time. Between the oil-price crash in late 2014 and the OPEC+ agreement to limit production that went into force at the start of 2017, US oil production fell by 1mbpd. Since then, as the deal boosted prices, the US added 5.5mbpd, Russian production rose slightly despite its promises to cut, and Saudi output dropped 1mbpd.
Now OPEC is about to regain that lost market share very suddenly, as its crude oil floods a market evaporating in the face of the Covid-19 outbreak.
The price received by Saudi Arabia for its crude-oil exports fell from about $50 per barrel before the meeting to about $26 now. However, the volume of exports will rise from about 7.25mbpd to more than 10mbpd: a halving in prices has reduced revenues by some 28%.
Exceptionally low production costs keep state oil firms highly profitable, but they have to fund government budgets with pegged exchange rates and break-even budget prices that range from $50 to more than $100 per barrel. Sovereign wealth funds, debt and asset sales can keep the stronger Gulf states afloat for years, but weaker Middle East countries could quickly sink.
Assuming Russia slashes prices to compete, its revenue will drop 45%. Its oil companies, which need heavy reinvestment and development of new costly fields in the Arctic and East Siberia, will see their production gradually fall. But since 2014, the Russian budget has been fortified against lower oil prices and Western sanctions. Its break-even oil price is around $42 per barrel, its exchange rate is flexible, and it could spare $25 billion annually from its sovereign wealth fund to prop up the budget over several years.
The Kremlin’s resilience has been bought at the cost of ordinary Russians’ living standards. This is where political strength comes in. As long as President Vladimir Putin enjoys his people’s support, or at least acquiescence, he can cope with low oil prices.
Meanwhile, US shale producers face decimation. Much of their hedging is ineffective at prices below $45 per barrel, and anyway expires almost totally before 2021. Shale output may drop as fast as 250,000bpd monthly without reinvestment. Investors were already tired of a lack of financial returns, while most potential efficiency gains have been reaped post-2014. Supermajors such as ExxonMobil and Chevron had bet heavily on shale and they will survive. But if they acquire assets of smaller bankrupt competitors, it will be to sit on them until prices improve.
The fine-tuning of OPEC quota meetings has always been something theatrical. It has been effective at times in the short term, but more important for the oil market’s long-term evolution is the way the OPEC framework restricts any one member from making a dash for much higher market share by permanently expanding capacity ahead of its peers. When a country falls out of line, as Venezuela did in the 1990s, Saudi Arabia can punish it.
That did not work with the North Sea in the 1980s; it might have worked with shale in 2014-2016, but it was not given enough time. OPEC should learn its lesson this time – in the coming era of electric vehicles and a possible peak in oil demand, it needs to be gaining market share, not ceding it. An oil price of $100 was not sustainable after the 2011-2014 period; $60-80 proved unsustainable during 2017-2019; but $40-50 might work when the smoke clears.
So although the price war was triggered by the Russia-Saudi falling-out, shale will be the first casualty. The US will learn that producing a lot of oil at high prices is not the “energy dominance” it has made a centerpiece of foreign policy. The American economy as a whole will not be severely dented – motorists will gain from lower fuel prices, but individual states that produce oil or industry equipment will be hurt.
Middle East states can use this crisis to prepare for the challenging energy future. First, they have to survive the energy present, and that means reducing their economic exposure to oil prices and building a new economy, work that was hardly started during the respite of 2017-2019. Their people have to be prepared for austerity and perhaps painful restructuring. Ultimately, political strength is the decisive force in this campaign.