The Oil Price War of 2020: Winners, Losers and Ways Forward

Oil Well file photo

(Russia Matters – russiamatters.org – Li-Chen Sim – March 25, 2020)

Li-Chen Sim, an assistant professor at Zayed University in the United Arab Emirates, is an expert on the political economy of energy in Russia and in the Middle East.

Two broad themes have dominated analyses about the failure of OPEC+ to arrive at a new consensus on oil production cuts on March 6, 2020. The first explores the sources of disagreement between Saudi Arabia and Russia that informed the split. The second examines the fallout, with consuming countries typically assumed to be the winners of the situation thanks to lower oil import bills. Much less explored is a third theme, namely, the paths toward a resolution of the oil price war. While the first theme has already been well explored, the other two have not and this article will seek to fill this gap. In particular, it will focus on answering three key questions related to these two themes. First, is China the major beneficiary of the oil price war? Second, what is the pain threshold of the key protagonists, such as Russia and Saudi Arabia? Finally, will market forces play a decisive role in ending the oil price war?

China as the Major Beneficiary

As a rule, lower prices are good for oil-importing countries and bad for oil exporters. During the oil price collapse in 2014-2016 for example, China, the world’s largest oil importer, saved an average of $2.1 billion annually with every $1 fall in the price of oil. Therefore, theoretically, if crude oil prices now average $30 in 2020 instead of $60, China would be able to save around $300 million per day on imported oil based on demand projections by the Energy Information Administration and Morgan Stanley. Conventional wisdom also holds that lower oil prices stimulate consumer demand and economic recovery. Consequently, China should be able to leverage lower oil prices to feed its significant oil import requirements and to re-start economic activity in the country. This optimistic perspective, however, needs to be nuanced.
First, China’s economic recovery is dependent on demand elsewhere. For example, it is a key supplier of intermediate components for companies based in the U.S., Europe, Japan and South Korea. About 20 percent of global trade in manufacturing intermediate products originates in China, up from 4 percent in 2002. The current lockdowns in the U.S. and Europe, as well as the rise in imported cases of coronavirus in China, will dampen the benefits of lower oil prices.Second, lower oil prices may negatively affect key sectors of the Chinese economy that are independent of overseas customers. Chinese oil majors suffering revenue declines could reduce upstream expenditures, thereby undercutting orders by the country’s president to increase energy security.

Third, China’s economic slowdown pre-dated the outbreak of coronavirus. Structural impediments, including the declining productivity of labor and capital and the fragility of the financial sector, need to be adequately addressed before China can reap the full benefits of lower oil prices. In any case, the experience of Asian Tiger economies suggests a more moderate rate of growth could be the new norm for China.

Finally, oil traders and tanker owners, more so than China, are the outright beneficiaries of the oil price war. On the assumption of a widening price difference between crude bought now but delivered later, oil traders have secured storage facilities on land and at sea for transactions that will result in enormous short-term profits. Tanker owners have seen charter rates skyrocket as a result of competing bookings by oil traders and by Gulf producers intent on flooding the market with cheap crude. However, even before the oil price war, tanker owners were already profiting from the squeeze on the availability of oil tankers due to U.S. sanctions against tanker subsidiaries of China’s Costco.

Pain and Resilience

There are no winners among key oil producers and exporters. The question here is who is worse off and will be first to fold. Experts are divided on the pain threshold of the three main players: Russia, Saudi Arabia and U.S. shale companies.

On the one hand, Saudi Arabia’s currency peg to the U.S. dollar gives it less flexibility than the freely-floating ruble. Russia’s oil-dependent budget gets an extra 70 billion rubles for every 1 ruble decline against the dollar, since oil-related expenditures are mostly priced in rubles but oil revenues are earned in dollars. Saudi Arabia is selling oil to Europe at $25-28 per barrel, but Russia’s well-established distribution networks, quicker delivery times and $4 per barrel lifting costs could be difficult to overcome. On the other hand, even though Saudi Arabia’s fiscal deficit of 15 percent of GDP compares unfavorably to Russia’s near zero with crude at $35 in 2020, the former’s larger foreign cash reserves can sustain deficit financing for at least five years. It can also access foreign debt markets unlike sanctions-hit Russia, although China could step in with a new loans-for-oil offer. Ultimately, Russia and Saudi Arabia seem to be on par in terms of economic and financial buffers, particularly since history suggests this oil price war is unlikely to last more than two years.

It is in the socio-political realm that Russia is arguably more resilient. In Russia today, stability is privileged over growth. Russia’s elites are cognizant that systemic reforms to invigorate the economy may anger key domestic stakeholders and loosen the Kremlin’s control over Russian politics. Even as public trust in Russian President Vladimir Putin has declined, he looks set to be president for life. The siege mentality in Russian culture are likely to be assets in tolerating the fallout from low oil prices. In contrast, Saudi Arabia’s Crown Prince Mohamed bin Salman appears less politically secure. With the pandemic sharply curtailing foreign investment and inbound tourism upon which his signature reform program rests, the Saudi public may be even less willing to bear the costs of an oil price war. All the more so since around one-fifth of Saudi citizens bought shares in the national oil company, Saudi Aramco, whose shares were 11 percent below the floatation price in December 2019.As for U.S. shale producers, the most indebted with acreage outside the Permian basin may not weather low oil prices. Indeed, a $35 oil price in 2020 could result in the loss of over 3 million barrels per day of production compared to 2019. Nevertheless, shale producers have proven to be efficient and resilient. They increased output in 2019 despite a significant fall in rig count; as a result, average breakeven prices for shale oil declined from $68 per barrel in 2015 to $46 today, with the very best coming in at $20. Some will gain financially from hedging the further oil prices fall below $40 per barrel. International oil majors, which account for one-fifth of production in the Permian, are also likely to outlast low prices and thereafter acquire and turn around surviving independent producers.

Ending the Oil Price War

The oil price war of 2020 is underpinned by simultaneous shocks in demand and supply. This makes it highly unusual but not unprecedented. The key protagonists have also squared off before, in 1985, when Saudi Arabia’s decision to increase production five-fold caused oil prices to plummet to $10, puting additional financial stress on the Soviet Union, which collapsed in 1991. What is different now is the global scale and depth of the fall in demand amidst worries of a worldwide recession; oil demand could be reduced by 10 million barrels per day in the next few months.

There are three possible ways the oil price war can end. The first is demand recovery, especially in China, which accounted for three-quarters of oil demand growth in 2019, one-quarter of total global growth and almost one-fifth of global GDP. As noted earlier, however, China’s role as a locomotive is tempered by its intermediary role in global supply chains and its own structural shortcomings. A quick fix based on demand recovery is therefore highly unlikely.

Eliminating the oil supply overhang would be the other way to end the oil price war. However, Gulf oil producers and Russia have announced intentions to increase oil supply to win back market share lost during the OPEC+ production curbs. In the U.S., the likely purchase of domestically-produced crude to fill the U.S. Energy Department’s Strategic Petroleum Reserves is akin to a production cut. However, the volume amounts to only a week’s worth of oil production. The global supply surplus appears to be too large at this point to absorb expeditiously.

This leaves the re-negotiation of an OPEC+ agreement as the most realistic way to end the oil price war. The way back to Vienna may rest with the United Arab Emirates and Oman. Leveraging on the Gulf’s only Declaration of Strategic Partnership with Russia, the UAE has tried to reduce the distance between Russian and Gulf policies over Syria and Libya. Saudi Arabia, for instance, turned to the UAE in December to sway Russia in favor of deeper production cuts. Oman could also draw upon its niche role as a regional mediator. With public debts that already exceed the assets of its sovereign wealth fund, it is least able to afford a prolonged period of low oil prices among the Gulf states.The UAE and Oman can take heart from conciliatory messages by Russia and Saudi Arabia that have left the door open for a future OPEC+ agreement. Sweeteners by the U.S. to ease sanctions against Iran and Venezuela on the pretext of easing difficulties during the pandemic could facilitate Russian buy-in. A promise from the U.S. to look favorably upon the sale of the much-desired F-35s to Saudi Arabia and the UAE could likewise incentivize deal-making.

In the meantime, brinksmanship, bruised egos and battered demand will continue to inform the oil price war of 2020.

 


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