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On March 9th, the oil price had its most severe crash since the sudden beginning of the first Gulf War in 1991. Taking the global financial markets down with it.

US-President Trump’s short explanation for it “Saudi Arabia and Russia are arguing over the price and flow of oil. That, and the Fake News, is the reason for the market drop!”.

The reality of the situation is a lot more layered and serious than that, with the OPEC+ alliance currently disintegrating. A looming global recession and the uncertainty about COVID-19, it’s certainly advisable to have a deeper understanding of the situation.

The effects of COVID-19

With current estimations, the COVID-19 crisis is reducing the global oil demand by at least 2 million barrels a day.

With the increased spread of COVID-19 around the globe and the increasing number of regional shutdowns and disturbances in the supply chains. Professionals estimate that the oil demand is further decreasing until Q3 2020. 

In response to the already cooling down economy, the Saudi-Arabian led OPEC and the Russian-led non-OPEC oil-producing countries extended the agreement of cutting oil production by 2.1 million barrels per day in December 2019 –.

This agreement runs out on the 31st of March 2020. In presence of the now even more looming global recession and the effects COVID-19 has on the global oil demand, Saudi-Arabia pushed in the latest OPEC+ meetings for an additional production cut to stabilize the oil markets.

While the latest news concentrates around a “price and production showdown” around Saudi-Arabia and Russia. US-Shale-Oil production is an important factor in the context of what has just happened.

The relentless US Oil production pushed the US onto the first spot of oil-producing countries in a mere 10 years.  At the same time, the US does not partake in oil production cuts.

Which left a lot of voices inside the OPEC and OPEC+ openly frustrated and annoyed. As the US became the major beneficiary of the OPEC price control mechanisms. 

OPEC meeting in Vienna

During the latest OPEC+ meeting in Vienna, the situation spiraled from bad to worse really fast. Russia went into the negotiations with the offer to only extend the current OPEC+ deal for another three months. While the Saudi-Arabian led OPEC demanded higher oil production cuts to stabilize the oil price in response to the declining market demand.

Citing insider sources of the negotiations, the Russians left the Saudi-Arabians frustrated even rejecting the offer of the OPEC countries to shoulder the majority of the production cut. While the OPEC+ countries, especially Russia would walk out with a better deal.

As Russia continued to block all Saudi-Arabian advances into further production cuts. The Saudi side ultimately decided to not extend the existing OPEC+ agreement, after openly presenting Russia an ultimatum to accept further production cuts or see the OPEC+ deal canceled. 

Right after the meeting concluded the Saudi-Arabian oil minister stated to his colleagues “This will be a regretful day for all of us” and just a few hours later the Kingdom declared that it will ramp up production starting in April to above 12 million barrels a day.

At the same time, the Saudis started selling their oil with heavy discounts, to undercut Russian prices and draw the Federation back to the negotiation table.

Assessment of the current situation

Drama and negotiations between Russia and the OPEC go hand-in-hand. This wasn’t the first time Russia has withdrawn from the negotiation table to strengthen its position in a possible deal.

However, the Russian Federation seems rather confident in the position it took, while the Saudi-Arabian Kingdom is in its role as aggressor in this “oil-war” and it’s a draconian and fast act of retaliation seems light-headed and overreaching.

Russian Federation

To fully understand the position of the Russian Federation we need to scale a few years back and take a look at the 2014 sanctions against Russia. Imposed by the United States and its allies in response to the war in Donbas and the Crimean crisis.

Over the following years, the United States would continuously exert its power against Russian individuals and companies and impose new sanctions at will. This exposure to repeated financial and economic attacks by the United States shifted the Russian reserve strategy.

Which culminated in Russia selling 90% of its US-Treasury-Bonds from 2017 onwards. At the same time, the Russian Central Bank increased the holding of policy-neutral assets like gold by a large margin.

While the sell-off of US-Treasury-Bonds was widely cited as an “Economic attack on the US”. It was more likely an act of self-defense against further sanctions by the Trump administration. This could and discussed potentially freezing those Russian held Treasury-Bonds and a strategy shift back to a more foreign policy resistant reserve pool. 

Furthermore, the sanctions shifted the Russian trade and economic policy. Further relying and strengthening the domestic economy. While seeking trade partners that were willing to trade in direct currency exchange. Which decreased the dependence on the US-Dollar even more.

Russia current measures

Currently, Russia is drawing about 35% of its fiscal budget revenues out of crude oil production. Something worthy of note here is that the ruble is a free-floating asset since 2015.

Which also has been a result of the international sanctions and the low oil price of the time. The free-floating Ruble means the Russian oil break-even costs decrease as the ruble weakens. 

Right after the Saudi-Arabian ARAMCO announced discounts on their crude oil products. The Russian Financial Ministry announced they could bear an oil price of 25,00 USD for up to ten years, tapping their reserve pools to compensate the budget deficit.

How does Russia benefit

While a low oil price is certainly not in the interest of the Russian fiscal budget. The benefits seem to outweigh the distress the conflict puts onto the Russian economy. But what are those Benefits? 

As Alexander Dynkin, of the Russian state-run Think-Tank “Institute of World Economy and International Relations” put it: 

“The Kremlin has decided to sacrifice OPEC+ to stop U.S. shale producers and punish the U.S. for messing with Nord Stream 2”.

Alexander Dynkin

Alexander Novak, Russian Minister of Energy stated during the Vienna conference: 

“The frackers had added millions of barrels of oil to the global market while Russian companies kept wells idle. Now it was time to squeeze the Americans.“

Alexander Novak

Meanwhile, Mikhail Leontiev of the Russians oil-giant Rosneft called the former OPEC+ deal “masochism”, stating: 

“By yielding our own markets, we remove cheap Arab and Russian oil to clear a place for expensive US shale oil and ensure the effectiveness of its production, . . . Let’s see how American shale exploration feels under these conditions.”

Mikhail Leontiev

The Russian strategy has become clear from this point and unlike the Saudi-Arabian attack on the American Shale industry in 2014 / 2015. The Russians may just have chosen the right time to do so.

United States Shale Oil

With the current global uncertainties, COVID-19 imposed on the markets and the looming global recession the US markets currently are under heavy distress.

The failed OPEC+ talks in Vienna and the consequences the Saudi-Arabians drew from it have hit the Dow Jones Industrial Index with a tremendous loss of almost 2000 points in a single day.

While US-President Trump played down the happenings of the past days as “Russia and Saudi Arabia arguing over oil price”. The implications for the United States are way heavier than these words would suggest.

While the United States has become the largest oil producer on the globe over the past years, they also have the most fragile and most expensive extraction technology. 

US Shale oil became incredibly important for the economy of the United States, culminating in over 10% of the GDP. The Break-Even of US-Shale oil is estimated to be between 45 USD to 54 USD. It is estimated that a sustained price below 40 USD will create an existential crisis for these companies.

At the same time, the US-Shale oil companies are heavily indebted. As the low crude oil prices continue over an extended period of time, many of the companies will be unable to service their debt. In 2019 about 50% of US-Shale oil producers went bankrupt. The outlook for the industry in the current market is grim and will put a considerable amount of distress on the US economy as a whole.

US energy sector

The links of the US energy sector into other sectors of the economy are countless. First and foremost, the banking sector will be hit with massive loan defaults. Right now, the banks don’t uphold the needed reserves to take such a loan exposure, with most of the exposed banks holding 1% reserve ratios for the energy sector loans in Q4 2019.

The current developments in the markets suggest this number needs to increase drastically. In Q1 2016, the last energy crisis after the Saudi-Arabian attack on US-Shale oil, banks needed to uphold up to 9% reserve ratios.

If the banks are unable to act fast enough and the low oil prices start to take a toll on the US-shale oil industry, it has the potential to create a very ugly snowball-effect for the US economy as a whole.

As Martin Enlund of the Nordea Bank puts it:

“if “unforeseen losses” show up in the high yield sector (very energy-heavy), it might damage the credit cycle… and if the credit cycle cracks, forget about buybacks, M&A, and SPX’s current valuation.”

Martin Enlund

Saudi Arabia

The political happenings in Saudi-Arabia at this moment are an absolute mess and transparency has never been something the Saudis liked.

So aside from the sparse news coming from Saudi-Arabia of the Crown Prince arresting family members who present troublesome to his succession to the throne. Civil unrest and armed conflict with the neighbors Yemeni Houthis movement, what is there to say of Saudi-Arabia and it’s take in this “oil-war”?

Saudi Arabia vs Venezuela

Let’s take a step back to 1997 when the Saudi-Arabian led OPEC waged a price war on Venezuela. Venezuela previously claimed to maximize its oil production output, which angered the Saudi-Arabians, as the global oil demand was stagnant.

In turn, the Saudis convinced the remaining OPEC members to increase output by 10%. Which led to a historic low of under 10 USD per barrel crude oil.

Immediately after the price crash reached the global markets, Venezuelans and the OPEC tried to save what was salvageable. This took over a whole year to prop the prices and trust in the markets back up.

While Russia was driven into an economic collapse and political as well as social unrest, they have certainly learned a lesson from the 1998 crisis. But is that the case for Saudi-Arabia as well?

What did Saudi Arabia learn

Saudi-Arabia increased its holdings of US-Treasury-Bonds over the past decade. Becoming one of the largest holders of US-debt (180 Billion USD). At the same time, the Saudi-Arabian riyal is pegged to the USD and does therefore not absorb lower oil prices as the Russian ruble does.

Saudi Arabia’s fiscal budget is 87% dependent on the sale of crude oil. The break-even for the fiscal budget needs an oil price of around 85 USD. Saudi-Arabia has been dealing with shrinking reserve assets for a while. Especially after they waged the oil price war on US-shale oil in 2014 (Which the Saudis lost because US-Shale and the US economy presented to be very robust at the time). With that said, Saudi-Arabia’s 495 Billion USD reserve assets can surely stabilize the oil-state for quite a while as well.

Despite the act of crashing the oil markets, the primary interest of Saudi-Arabia is to get Russia back to the negotiations and to stabilize oil prices. To reach that target the Saudis play a game with fire in the current market environment.

Not only that they try to get the Russians to the table by force and threats, but also by wanting to dictate the terms. From the outside, it seems like Crown Prince Mohammed bin Salman lost his temper and it’s questionable if the Russians are impressed by this act of overconfidence and power.

Noteworthy Saudi-ARAMCO (98.5% Government owned) has just taken a heavy hit lately and seems to enter a continuous decline in appreciation. The Kingdom is ill-prepared to take a lengthy price war. Especially with its heavy financial involvement in the US and the recession that could hit them.

Other OPEC members

When there are two elephants fighting, the grass suffers the most. While the production costs in most OPEC countries for oil are very low, the dependency on the oil returns for the fiscal budget is high.

The minor OPEC nations will suffer most from this shock-and-awe policy of Saudi Arabia and the stubbornness of Russia. That being said, several nations are struck by sanctions and have a hard time selling their oil with discounts already.

Several minor OPEC nations already declared to ramp out production as well, putting additional supply shock to the market. It remains to be seen how countries like Iran. Which has a fiscal budget break-even price for oil of 110 USD and is also heavily struck by COVID-19 will be able to deal with the current market environments.

Where to go from here

From here on out there are two scenarios drawing on the horizon. The first being Russia returns to the table of negotiation with the OPEC and works out a renewed agreement of the OPEC+ alliance.

Russia has announced they will encounter in new talks with the Saudis. After the Saudi Arabian oil ministry declared Saudi Arabia will ramp up production to 12.3 million barrels a day (300k more than the maximum sustainable output capacity). In this scenario oil prices should recover above 40 USD quite quickly, keeping the US-Shale oil companies in the market.

On the other side, if there is no agreement worked out between Russia and Saudi Arabia. ARAMCO will ramp up production output beginning in April, Rosneft is likely to do so as well.

If both sides keep this up for several months the US-Shale oil companies have to stop production or have to declare bankruptcy. Oil prices will decrease to new post-1998 lows. The effects on the US-Dollar as currency and the US economy cannot be assessed in this scenario.  

Russia will hold a meeting between Government officials and the leading figures of the Russian energy sector. This to figure whether to continue the work with the OPEC or continue the current path of action.

Seeing the high-ranking voices from Russia who want to escalate the situation further in the response to the US sanctions and market shares. There is little hope for a positive conclusion of the talks.

Sources

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