Oil Price War 4.0 Series Part 1 – Longer and Deeper?

I have worked as a world oil analyst during all four crude oil price wars since the creation of the Organization of the Petroleum Exporting Countries (OPEC) in 1960, having started my career at the Alberta Petroleum Marketing Commission (APMC) in the mid-‘80s. Based on what I’ve learned about oil price wars over this period, we should batten down the hatches, as this one could be the longest and deepest of them all.

The 1985-86 price war lasted 12 months, with benchmark light-sweet crude prices declining from a high of US$29 to a low of US$12/bbl (in nominal dollars and on a monthly basis). The 1997-99 oil price war lasted 16 months, with prices declining from US$19 to US$10/bbl. And the 2014-16 price war lasted 25 months, with crude prices declining from US$79 to US$31/bbl.

Longer?

There are at least four reasons this oil price war could last longer than the previous three: Russia instigated this one for geopolitical and economic reasons, not just to protect market share, as was the case for the three started by Saudi Arabia; Russia is far less reliant on oil revenues than the Kingdom, and has a floating exchange rate to better absorb economic shocks; an irreplaceable President Vladimir Putin appears to have been the architect of this one, not a replaceable oil minister; and finally, the Trump administration has already indicated it will do what it can to protect the U.S. oil industry, the key target of the Putin-led price war.

After a brief respite in historical terms, Russia and the U.S. are again locked in geopolitical rivalry. The wily fox Putin has outmaneuvered Presidents Barack Obama and Donald Trump in Eastern Europe and the Middle East, while the U.S. has been putting the boots to Russia economically, with increased competition from shale oil and gas and targeted economic sanctions.

It has been reported recent sanctions against state-owned oil giant Rosneft for continued commercial relations with Venezuela were the last straw for Putin, precipitating his instructions to Energy Minister Alexander Novak to reject the Saudis’ plan to cut crude oil production by an additional 1.5 million bbls/d at the OPEC+ meeting in Vienna on March 6 and end co-operation on April 1, the day the previous agreement expires. In recent years, U.S sanctions have devastated the oil industries of Kremlin-allies Venezuela and Iran.

Saudi Arabia may have had larger war chests prior to its three oil price wars, but Russia has far greater economic resiliency in a low price environment. The Kremlin needs only US$42/bbl to balance its budget, compared to US$82 for Riyadh, based on International Monetary Fund (IMF) estimates. Oil and gas revenues account for over a third of Russia’s budget and almost half of its exports, compared to four-fifths and two-thirds for Saudi Arabia. The Kremlin presently has US$570 billion in foreign exchange reserves, including its US$150 billion National Wealth Fund, compared to US$490 billion for the Kingdom.

At the onset of the latest oil price war, the Kremlin stated it could withstand oil prices in the US$25 to US$30/bbl range for six to 10 years. In contrast, King Salman ended the 2014-16 price war, Saudi Arabia’s failed attempt to destroy the U.S. shale oil industry, after being warned by Deputy Economic Minister Mohamed Al Tuwaijri that his Kingdom would be bankrupt within three to four years if the price war continued, barring major economic reforms.

This relates to the reason why an oil price war initiated by a leader, especially one as wise and ruthless as Putin, is likely to last longer than one initiated by an oil minister. Both the 1985-86 and 2014-16 price wars ended prematurely, when a long-serving Saudi oil minister appointed by a previous king was fired — Ahmed Zaki Yamani and Ali al-Naimi, respectively. Putin is unlikely to fire himself, especially since he’s currently in the process of rewriting the Russian constitution to allow the presidential clock to restart and allow him to serve two additional consecutive terms to the year 2036.

Finally, the Trump administration has indicated it will do all in its power to protect the U.S. oil industry, which is likely to prolong the latest price war as well. Trump has already ordered the purchase of 77 million bbls of crude for the country’s Strategic Petroleum Reserve (SPR). This increases market for U.S. oil and may provide some temporary support for crude prices. His administration has also indicated plans to provide a more direct lifeline to the U.S. oil industry, but has yet to announce what these measures may be.

Deeper?

The reason crude oil prices may fall farther during this crude price war than previous ones, especially on an inflation adjusted basis, is because oil market fundamentals appear substantially worse this time around. The two main reasons are: the global response to coronavirus pandemic is likely to cause a global economic recession — if not worse, if it leads to another financial crunch of the highly-indebted global economy — weighing heavily on oil consumption; and oil production increases threatened by Saudi Arabia, the United Arab Emirates (UAE) and Russia alone could dwarf output increases during previous price wars.

At the time of the failed OPEC+ meeting, OPEC was forecasting a 1.65 million bbl/d surplus in 2020, hence, why Saudi Arabia was pushing for an additional cut of similar size effective April 1. But OPEC was massively underestimating the potential impact of the global COVID-19 pandemic on oil consumption at the time, as were all forecasters, as it still had global oil demand growing by 840,000 bbls/d for the year.

Since then, China, the source, and until recently, the epicenter of the coronavirus outbreak, released data for January and February showing the largest slowdown in industrial output and consumer spending in the past 50 years — declining by 13.5 per cent year-on-year and 20.5 per cent, respectively.

As of now, the International Energy Agency (IEA) is forecasting global oil demand to contract 2.5 million bbls/d in the first quarter, led by a 1.8 million bbl/d decline in Chinese consumption, but to rebound over the rest of the year, to slice the annual decline to a mere 90,000 bbls/d.

This remains a highly dubious forecast given the spread of COVID-19 around the globe, and more and more countries adopting public health measures such as quarantines in an attempt to curtail it. At the same time, other countries may take a harder financial hit than China, lacking either the will — democracies, or resources — developing countries — to implement measures as draconian as the Middle Kingdom. 

Oil trading giant Trafigura, which is not handicapped by political considerations like the IEA and OPEC, has said global oil demand could collapse by 10 million bbls/d or more for at least part of this year.

On the supply side of the equation, in retaliation for Russian intransigence, Saudi Arabia has announced plans to open the taps and increase crude oil sales to 12.3 million bbls/d in April, an increase of 2.6 million bbls/d from March and 300,000 bbls/d more than its current productive capacity. The Kingdom’s close ally the UAE is planning to do the same, ramping up sales by one million bbls/d. In retaliation for the retaliation, Russia has said it will increase production by between 200,000 bbls/d to 300,000 bbls/d.

Adding up their planned production increases, and not even including threatened increases to productive capacity and production by the three through the end of the year, equals 3.85 million bbls/d. For the sake of comparison, OPEC crude oil production increased by a “mere” 2.33 million bbls/d during the 2014-16 oil price war.

In terms of the global oil balance, if oil consumption was to decline by a conservative 2.5 million bbls/d this year, oil production by Saudi Arabia, UAE and Russia was to increase by 2.57 million bbls/d on an annualized basis, and given the initial 1.65 million bbls/d surplus forecasted by OPEC, global oil supply would exceed consumption by an insane 7.88 million bbls/d in 2020. In the heart of the previous three oil price wars, global oil supply exceeded consumption by no more than 1.76 million bbls/d, in 1998.

To conclude, it is not realistic to expect the global oil surplus to reach 7.88 million bbls/d this year. Lower prices are already causing drastic cuts to capital spending in most oil producing countries, which will lead to significant declines in production over time — including the target of Putin’s price war, the U.S. — while there is only so much storage capacity available worldwide.

That being said, the current oil price war will likely be longer and deeper than previous ones, with the price of global benchmark Brent crude and North American benchmark West Texas Intermediate (WTI) hitting single digits.