Oil Price War 4.0 Series Part 3 – Major Wildcards
This is a three-part series. The first two parts can be accessed by clicking on the links below:
The first two articles in this series explained the rationale for Russian President Vladimir Putin’s oil price war, the second article in more detail than the first. Before delving into three major wildcards that could impact Putin’s price war, both in a positive and negative manner, I have one matter I wish to discuss related to the central thesis, based on comments by a few friends and colleagues over the past week.
Russia and Saudi Arabia are not geopolitical allies, despite relations between the two countries improving from the time of the original OPEC+ agreement in late 2016 until the ill-fated meeting in Vienna on March 6. For the Russians, it was merely a marriage of convenience that is no longer convenient — or necessary.
The Russian economy was in quite poor shape by late 2016, with its foreign financial reserves falling quickly, for two reasons: the U.S. and European Union imposing financial and economic sanctions on Russia in 2014 for its annexation of Crimea and other actions related to Ukraine; and the Saudi-instigated 2014-16 oil price war, which served as a double whammy for the Russian economy as prices for its natural gas exports tend to be tied to oil prices.
Since then, Putin has restructured his country’s economy to be less dependent on its oil and gas industry for government budget and export revenue, while building Russia’s financial reserves on the back of relatively high oil and gas prices. These actions increase the probability his oil price war, to permanently damage the U.S. shale industry, will be successful.
In addition, Russia is a geopolitical ally of Iran, the Saudis’ arch-rival in the Middle East. Lower oil prices ironically benefit Iran in its Cold War with the Kingdom, as the Islamic Republic’s oil revenue has already been hammered by U.S. sanctions.
The three major wildcards, which would lead to very different outcomes for Putin’s price war and oil prices, are: a financial crunch and global economic depression; Crown Prince Mohammed bin Salman (MBS) folding or falling; and the Trump administration adopting a domestic oil quasi-cartel to protect the U.S. oil industry.
To date, the economic and financial response by major governments to the novel coronavirus pandemic has tended to be both timely and substantial. Central banks have been providing massive liquidity and legislators massive fiscal support programs to preserve jobs, businesses and the financial sector. They obviously learned valuable lessons — both positive and negative — from their response to the 2007-09 Global Financial Crisis.
Then why even consider a financial crunch and global economic depression as a wildcard? Because the pockets of major governments are only so deep, and the depth of the damage caused by the COVID-19 crisis is yet unknown. Global economic growth was slowing and debt levels rapidly rising even before the global pandemic, with economic growth primarily powered by easy money and loose fiscal spending over the past decade.
To provide just one major example due to a lack of space, China’s rate of economic growth has been cut almost in half since the Global Financial Crisis, to around six per cent annually. This is despite Chinese non-financial sector debt nearly doubling to 300 per cent of GDP since 2010, and the International Monetary Fund (IMF) forecasting China’s general government deficit to be 6.3 per cent of GDP in 2020 — and that was before the coronavirus pandemic hit in earnest.
At this point in time, economic Armageddon certainly appears the least likely of the three wildcards, but if it were to play out it would have significant implications for Putin’s oil price war. In particular, the period of single digit oil prices would be longer, breaking the back of the U.S. oil industry quicker, and shortening the price war.
MBS folds or falls
As discussed in the second article of the series, MBS fell into a trap set by Putin at the failed OPEC+ meeting in Vienna on March 6, leading the Saudi Crown Prince to launch his shock-and-awe campaign to drive oil prices lower in an attempt to quickly force Russia back into the OPEC+ fold. Putin has certainly gotten more than he bargained for, with oil prices likely headed below US$10/bbl, but Russia is much better placed to survive low oil prices than Saudi Arabia, and the target of his price war, the U.S. shale oil industry.
The logical move at this point would be for MBS to fold his very bad hand quickly. Everyone at the table has seen it, and the Trump administration is providing diplomatic cover for such a move. In this case, oil prices would likely still hit single digits for a short period due to the COVID-19 pandemic, but rebound into Putin’s preferred price war range of US$25 to US$30/bbl along with global oil consumption later this year.
But in the few years he has been de facto leader of Saudi Arabia, MBS has proven himself a very stubborn young man who neither admits nor corrects his errors. Saudi involvement in the latest Yemeni Civil War, the notorious Night of the Long Knives at the Riyadh Ritz-Carlton in November 2017, and the assassination and dismemberment of dissident Jamal Khashoggi at the Kingdom’s consulate in Istanbul rank high on that list.
As a result, MBS may simply blunder on with his shock-and-awe oil policy, potentially bankrupting Saudi Arabia in the process, especially since foreign direct investment (FDI) has dried up since he took the reins of power and bondholders may become increasingly reticent to lend to a Kingdom in rapid economic decline.
Saudi princes living outside the Kingdom — and hence, free of MBS’s coercive control — and a number of well-connected academics living in the West have been claiming the litany of errors by the Crown Prince, along with the concentration of power in King Salman’s line of the royal family, are contributing to schism within the House of Saud.
According to the Political Instability Task Force, supported by the Central Intelligence Agency (CIA) to carry out country risk assessments for the U.S. government, the cohesion of ruling elites is the most important factor determining whether a country is prone to regime change.
If MBS were to fall from power, his successor would likely quickly end his failed shock-and-awe oil pricing policy. In this case, prices should quickly rebound into Putin’s preferred range, as the COVID-19 pandemic would likely be long past.
U.S. oil quasi-cartel
The one wildcard with the potential of putting an early end to Putin’s oil price war, but by providing the Russian leader with a partial victory, is a new U.S. oil quasi-cartel. This is not without historical precedent, as the U.S. has adopted protectionist measures twice in the past to protect the country’s oil producers from low-cost foreign competition: in the 1920s and 1930s; and from 1959 to 1973 — with domestic prices as much as 60 to 70 per cent above Mideast crude prices in the second half of the 1960s.
The U.S. was a net-oil exporter in the first instance, and a net importer in the second, low-cost foreign oil was kept from the American market by the use of import duties both times around, while domestic production was constrained primarily by agreement between producing states to avoid glut. The major exception was the federal government imposing production quotas on oil producing states in 1933, but the Supreme Court declared it unconstitutional two years later.
If the U.S. were to adopt a quasi-cartel system to protect domestic oil producers today, tariffs may be the best mechanism since the country’s oil imports and exports are basically balanced, and tariffs could be raised or lowered by the federal government to indirectly adjust domestic oil production, without running afoul of U.S. law. At the same time, some sort of international swap program would need to be implemented to allow sufficient heavy oil for U.S. oil refiners, given domestic production is mostly light.
Players in the U.S. oil industry may be mixed in their desire for substantial federal government involvement to protect it, but President Donald Trump in his three plus years in power has already adopted numerous protectionist policies from the past to protect U.S. companies and jobs — leading him to refer to himself as “Tariff Man.” As a result, a new U.S. oil quasi-cartel is a distinct possibility.
In this case, with U.S. oil producers protected behind Fortress America, Putin would lose the target of his oil price war, but he could declare partial victory, as U.S. oil exports to the rest of the world would become a thing of the past given their relatively high cost.