At the end of March, Urals spot prices in northwestern Europe fell below $15 per barrel, a huge drop from the end of February when Urals spot prices had exceeded $50. Many observers attributed such a strong price collapse to the breakdown of the OPEC+ deal, and they blamed Russia for the suspension of the agreement. The breakdown of the agreement, however, was inevitable from the moment the OPEC+ deal was first signed in 2016.
By Fares Kilzie
Russia agreed to cooperate with a very weak OPEC in order to salvage the balance of the market as well as to better its own economic status by raising revenues and achieving price stability for all members of the deal. In the end, Russia accomplished these goals. A decrease in production led to an increase in oil prices. From 2016 to 2018, the average annual price of a barrel of Brent rose from $44.1 to $71.1, according to the World Bank, and the Russian budget deficit (3.7 percent Of GDP in 2016, according to IHS) was replaced by a surplus (2.8 percent of GDP in 2018).
But history has taught us that the breakdown of a cartel is never pretty. As well as affecting consumers, cartels normally harm their members and leaders, hence why almost all governments worldwide forbid cartels by law. Yet this is precisely why the collapse of the OPEC+ deal was inevitable.
The Deal-Ending Process
The fact that the breakdown of OPEC+ was inevitable does not explain why the March talks on the extension of the OPEC+ deal ended in failure. Regarding what happened on the ground, one can assume that Saudi Arabia had prepared a plan A and a contingency plan before entering the talks. Plan A was to surprise Russia in Vienna by pressing for a 1.5 bpd cut, including an unplanned prolongment of the deal until end of 2020. The contingency if that didn’t work was to pump as much oil as possible.
Understanding that Russia was neither technically nor contractually able to match the ‘surprise cut’, Saudi Arabia went ahead with its contingency plan and presented Russia as the antagonist in what is today referred to as a “price war”. However, Russia had no intention nor any desire to disrupt any supplies or vital revenues, especially during the harsh and unpredictable times of the COVID-19 pandemic. Therefore, in my view, stating that Russia is responsible for this crude dumping process is misleading and not at all logical.
A Price War versus the Dumping Strategy
Today, everybody seems to consider the current situation to be a price war. Well, I don’t see it that way at all. I see it as a price shock and a dumping strategy by only one participant: Saudi Arabia. Saudi Arabia chose to play hardball and present Russia with an ultimatum just as the COVID-19 pandemic was majorly disrupting the global economy. The impact of this action on the other OPEC members will be horrific and even fatal for some. We know very well how European consumers and end-users react to “dumpers”. No long-term contracts will be signed, and usually dumpers are set on a “blacklist”. Sooner or later, this is exactly what will happen.
Consequences for Russia
A drastic drop in oil prices will become a “stress test” for the Russian budget, which will have to adapt via its many monetary alternatives. However, Russia is much less dependent on oil than many observers think. For example, extraction accounts for 43 percent of the Russian industrial structure, a bit less than manufacturing (47 percent, as per Rosstat data). At the same time, revenues from oil exports contribute to 21 percent of Russia’s GDP, according to the estimates from CREON Energy, while in Norway this figure is 32 percent. Moreover, in terms of oil production per capita, Russia is far behind Norway (4,128 VS 18,002 liters per year, according to CIA), Saudi Arabia (18,502 liters per year) and Kuwait (35,536 liters per year). Therefore, the consequences of oil price collapse will be no more dramatic for Russia than it will be for other major oil-producing countries.
Consequences for the US Shale Industry
The free fall of oil prices is now affecting the vulnerable U.S. shale industry. In the last four years, shale has come under the control of the financial sector, which heavily invested in companies without any sustainable competitive advantage in the global oil market. For example, they invested in companies producing “light” grades of oil that are not required in the US local market nor are they required for exports as massive volumes of these grades are available on the market already. Several OPEC and non-OPEC countries produce these grades and are highly reliant on them.
Therefore, most of the “new” oil-producing companies in the US are highly over-valued, while proving low covering assets. The claim of US “energy independence” appears to have pushed authorities, Wall Street investors, banks and funds into chasing uneconomical investments. They then demand additional investments and further expansion, which in turn required even more capital to cover the deep ongoing losses. These companies sold billions of dollars in notes, bonds, and shares in order to fund semi-viable or even questionable acquisitions and, naturally, the value of those bonds have crashed instantly due to their real “balance sheets”. These papers turned into “junk”.
This picture was more than clear for policymakers around the globe and it is now time for the US to clarify this rapidly growing “cash-burning” phenomenon and to ask the question – Was this the correct way to conduct business? More than 6000 local drillers, for what? Maybe, we could consider a new rational approach or a logical consolidation eyeing the real national interest in oil?
Consequences for Environment
Finally, COVID-19 will bring awareness to the environmental issues within the industry. I’m confident that the green approach will be stronger than ever on the other side of this crash. Investors will understand that all green energies, such as wind, solar and hydrogen are much safer and much more sustainable to invest in. All gambling, non-viable, unsafe investments in hydrocarbons will simply disappear forever. It is true but sad that the COVID-19 symptoms, syndromes, signs and its outcomes for mankind are very similar to the occurrences that are taking place in the world economy. The virus fatally harms branches that are old and chronically sick, leaving the young and healthy ones to live long and prosper.
Unfortunately, there is always collateral damage, but it will certainly not be the vision of a “green economy”. The remaining post-COVID-19 oil operating countries will definitely continue to actively fund this new green era. But this can only happen under one condition: no more oil nations dumping crude onto markets.
Ironically, as I am finalizing this article, a plane with medical equipment is on its way from Russia to the United States, and the OPEC+ output cut deal is officially coming to an end today on April 1st.
By Dr. Fares Kilzie