Russia, OPEC, Shale Oil: How the Coronavirus is Undermining an Alliance
A few years ago Russia entered into a strategic partnership with the global Oil Cartel - the Organization of Petroleum Exporting Countries (OPEC) - to stem the fall in oil prices by agreeing to coordinate with the OPEC on cuts in oil production in order to stabilize prices. As Russia and OPEC (which comprises 14 major oil producing nations led by Saudi Arabia) jointly comprise a major share of global oil production, a coordinated cut in production will cause oil prices to go up or reverse any downward slump in prices.
And so this partnership having had success at the time, continued with the promise of lasting long into the future until things went south yesterday. At a strategic meeting in Vienna, Austria, Russia backed out of a plan to commit to deeper cuts in oil production in order to stabilize oil prices, which were forecast to fall due to an expected reduction in global oil demand, driven in large part by the impact of the coronavirus on economic activity.
Unraveling... and Trigger
As the coronavirus has spread across the world disrupting supply chain networks and imposing increasing financial costs and strain on government budgets, many have had to employ a range of fiscal and monetary policies to help stabilize their economies. For those that tend to be heavily dependent on oil revenues, falling oil prices from reduced demand is undesirable. Their economies will be prone to economic contraction as they will find it difficult to utilize fiscal policy to provide needed stimulus if there are already plunging revenues from oil sales.
To prevent this, further cuts in oil production were called for by the OPEC which would create the scarcity intended to keep prices propped up, but surprisingly Russia which also stands to gain from the higher oil prices was not too keen, opting instead for a wait and see approach. The real reason though was eventually teased out: a stronger desire to upend US oil production.
US shale oil production has continued to thrive so long as oil prices are high as it enables producers to continue to drill using expensive technology whose costs can be covered from resulting higher oil revenues (when oil prices are high). As profit margins for these producers are razor thin, depending largely on higher output levels, a sudden fall in oil prices could potentially send them into losses and possible bankruptcy as an article from the Financial Times on this issue points out.
The article further stated that Saudi Arabia, probably irked by Russia's defection, cut its oil price today by $8, a move that looks to be a sort of scorched earth or grim trigger strategy that is certain to lead to a price war as oil producing states attempt to undercut each other by offering lower prices in a bid to get a bigger slice of the current (and perhaps future) global demand. The current prediction is that oil prices now hovering around $45 a barrel may soon fall below $30 in no time.
Blessings and Curses
A price war will have mixed outcomes for economies across the world.
For oil producing countries, this is generally bad but worse for countries almost entirely dependent on oil revenues. Low cost oil producers such as Saudi Arabia, Iraq, UAE, Algeria, Iran, Qatar and Oman may be able to absorb the impacts of the price war better but relatively higher cost producing countries including Venezuela, Ecuador, Angola and Russia may find themselves struggling.
Nigeria and Kazakhstan are not among the lowest cost producers of crude oil, but their marginal costs are not as high as the countries just listed, so while they will be hard hit, they may still survive a brutal price war but their economies will most likely contract.
Perhaps high cost producing Russia might rethink its position even though it also hurts the US and pretty much other oil producers who are high cost suppliers. The US though might not be perturbed as much, for while the oil industry may wince from the squeeze, this move could be just the welcome news the Trump administration would prefer.
The coronavirus problem currently threatening to slow the economy down is a supply side problem, and lower oil (and energy in general) prices will serve to perhaps counter this. At a time when it may be difficult to stimulate the supply side of economic activity sufficiently, lower energy prices, by making it cheaper for businesses to produce and to supply output, couldn't have come at a better time...
Perhaps markets that have been down the past week may see this and cheer up a little. Fingers crossed.