In this episode, part II of our series on the Coronavirus, your resident foreign policy nerds dive into the geopolitics of oil. We’ll talk about the Saudi/Russian oil price war, the impact of COVID-19 on demand, and last week’s historic deal to cut oil production.
INTRODUCTION
HUNTER:
Most of the news right now is focused on the coronavirus and its impact on our health and our economy. What you might not have seen on the daily news is the all out brawl over oil production, a huge story that’s been lost in the noise.
Coronavirus has created a demand shock for oil. This has left global oil producers in a situation where they are scrambling to agree on production cuts.
This story began in March, with a price war between Saudi Arabia and Russia that flooded the market with oil. Then, when the world experienced the worst demand shock in history, the entire oil industry was thrown into the middle of this conflict.
RYAN:
In this episode we will talk about four key elements of this scenario:
- How and why this price war began
- The deal that all oil-producing countries desperately threw together to stop the bleeding
- How coronavirus is forcing the world to make the largest and most widespread cuts to oil production in history.
- And what this means for the key actors: Russia, the United States, and Saudi Arabia.
RAMYA:
Before we get into the price war, let’s talk about how the international oil market works.
There are 23 major oil producing countries in the world.
12 of these countries form a cartel called the Organization of Petroleum Exporting Countries, or OPEC.
As a group, OPEC controls a majority of global oil exports.
This helps them coordinate to set prices and production levels to maximize their profit.
For OPEC countries, oil exports are the backbone of their state budgets. That means that OPEC is as much a political organization as a market majority.
RYAN:
But even a coalition like OPEC has competition; the United States and Russia are two other powerful players in the oil business.
Russia has frequently cooperated with OPEC in the past, leading to an informal union known as OPEC+, but the US has always remained outside of both’s influence.
A lot of the divisions between OPEC and non OPEC members can be attributed to how these countries acquire their oil.
HUNTER:
That’s right, and it’s because not all oil is created equal. Hydraulic fracturing, or fracking, which is practiced primarily by Russia and the US, opens up more natural gas for production, but the technology adds massive costs to the oil extraction process.
The oil produced from this method, called shale oil, costs more than conventional oil, commonly found in the Middle East, to extract. Saudi Arabia can produce oil for less than $10 a barrel, while it could cost the US and Russia anywhere between $40 to $90 a barrel. This inherent advantage for Saudi Arabia will come into play during the price war.
RYAN:
So then let’s pivot to the price war, and we’ll start with a brief timeline of it.
Officially, the price war started on March 8th, when Saudi Arabia began ramping up production, but there are some crucial events that took place beforehand that laid the way for that.
In February of this year, demand for oil was already falling by 500,000 barrels per day, a sign of things to come.
The most precipitous fall occurred when China experienced its largest demand drop since 2008.
China’s lack of demand caused OPEC, led by Saudi Arabia called a meeting on March 5th. There, OPEC called for cuts in production to the tune of 1.5 mb/d, but Russia refused their demands. Two days later, the Saudis increased their oil production by 2.5 mb/d, instigating the price war.
HUNTER:
So why would Russia walk away from the table?
RAMYA:
In short, they did it to hurt the US.
HUNTER:
So what would be their reason for that?
RAMYA:
Well, there are a few reasons. In February, the US imposed sanctions on Rosneft, Russia’s largest oil company.
Those sanctions hurt Russia’s ability to distribute the oil it works hard to pump. On top of that, the US was not held accountable to the production cuts that OPEC proposed.
RYAN:
Basically, Russia wanted to incite a price war with Saudi Arabia as a way to lower prices beyond what US oil companies can sell to make a profit.
So that begs the question: why would Saudi Arabia respond the way it did?
HUNTER:
It comes down in large part to internal saudi politics. The crown prince Mohammad Bin Salman (MBS) needed to shore up his internal support within the royal family.
When Russia refused to cut production, MBS saw the opportunity to outmaneuver his older brother, Energy Minister Prince Abdulaziz bin Salman, and show that he could force Russia’s hand.
Unfortunately for MBS, the Coronavirus escaped China, driving a catastrophic drop in demand that forced both countries back to the negotiating table. MBS took a risky gamble, and it backfired.
What’s interesting is that MBS most likely knew by March that Corona would go global. Whether he continued out of ego, or just out of poor strategy is hard to tell. But he overestimated the necessity of Saudi oil and underestimated the effect Covid-19 could have on the oil industry as a whole.
RAMYA:
Of course, once coronavirus took hold and prices dropped sharply, all of the oil producing countries–Saudi Arabia included–saw the need to return to the negotiating table.
Their goal: to hammer out a deal that would save the oil industry and the countries that depend on it.
THE DEAL
RYAN:
Since the US is the largest oil producer in the world, it stands to reason that without their involvement, the deal would prove meaningless in the long run.
HUNTER:
Given how important US cuts are to making this work, President Trump became the de-facto dealmaker in this crisis, trying to work with all sides to reach an agreement quickly.
He hammered Russia, Saudi Arabia, and other oil producers with phone calls, and when Mexico threatened to tank the entire deal he increased US cuts to keep the deal alive.
RYAN:
Yeah Mexico almost throwing a wrench into the deal was one of the bigger shocks to come out of this. Saudi Arabia was pressuring Mexico to cut 350,000 b/d, but Mexico would only be willing to cut 100,000 barrels a day. To save the deal, the US pledged to compensate for the remainder of Mexico’s obligations with 300,000 barrels of reductions of its own. This is a big play that likely averted more torturous negotiations.
HUNTER:
I mean I guess its the “Art of the Deal”
RAMYA:
Yeah but Trump’s position as chief negotiator is largely driven by outside forces. His back is against the wall here: he needs to make this deal happen if he wants to save his buddies in the oil industry.
HUNTER:
So all of that hustle resulted in an agreement on April 11th that included all of the world’s top oil producers.(WSJ) As part of the agreement, all these countries committed to withhold a collective 9.7 million barrels a day of oil from global markets for the next two months, and then slowly increase the amount over time until the reduction is just 6 mb/d by Spring 2022.
RYAN:
What’s important is that the length of time the deal covers indicates that every country involved believes that demand for oil will stay low for at least the next two years.
IMPACT OF CORONA
HUNTER:
Coronavirus has touched every single aspect of our lives, so it’s easy to imagine that it would affect the oil industry too, but it’s not as easy to piece together exactly how oil is affected.
RAMYA:
The Impact of coronavirus on the oil industry can be summed up elegantly by a quote from the head of analysis at Rystad Energy, one of the top energy consultancies in the world.
“The war against the virus is to stop people moving around, but that is also the purpose of oil. Oil is made for people to move around by cars, airlines, ships. So this war hits right on the nerve system of the global oil industry.”
RYAN:
(WSJ) So in terms of numbers, the world generally consumes 100 mb/d. Right now, experts say that we’re only consuming between 65 and 80 mb/d. A dropoff like that hasn’t been seen since the oil shortages between 1979 and 1983.
But it’s important to keep in mind that that plunge took 4 years to get to those levels, while now it only took 4 weeks.
RAMYA:
Regarding the deal, the cut backs made will keep the oil industry from imploding, but that means that there will be less oil to spare when economies need to scale back up again when the Covid-19 threat fades. The price will only remain this low while economic activity is stalled. When things open up fully next year, expect prices to soar
Lets pivot to how all this affects each country more broadly
EFFECTS ON EACH COUNTRY
RYAN:
Saudi Arabia can tolerate lower oil prices in theory, but since so much of their state budget comes from oil, low prices pose a political problem. This is because Saudi Arabia is a rentier state. You’ve heard the phrase no taxation without representation. The rentier state is the opposite– no representation in exchange for no taxation. All political legitimacy is derived from the government’s public spending and social services.
HUNTER:
Essentially, Saudi Arabia’s government keeps its people on board through the profits derived from its oil sales. Lower sales means lower social spending, and increases the possibility of unrest. For context: Saudi Arabia needs oil prices of around $82 a barrel to balance its budget. Right now, prices are hovering a little over $20 a barrel.
RAMYA:
So to remain strong and in power, Saudi Arabia may need to borrow money to fill the gap between what it spends and the revenue it receives. A likely benefactor of such a loan would be the United States, who’s been a strong economic ally of the Saudis for decades.
HUNTER:
So if Saudi Arabia can offset low returns with a credit line from the US and avoid domestic turmoil, the kingdom can emerge from this fiasco with a firm grip on the global oil industry.
RYAN:
As for Russia, the country is finding itself in a mess of its own making. Putin and the Kremlin stalled the initial March 5th meeting because they wanted to hurt the US oil business, but by doing so they’ve left too much money on the table with the Saudis. By not taking the Saudi’s deal when they had the chance, they’ve ruined relations with them (and OPEC by extension), and they will have to cut production ten times more than they would have in March.
HUNTER:
As well, they will have to contend with the still-dropping prices of oil. Russia needs to keep oil prices above $40 a barrel in order to turn a profit, but prices are hovering at nearly half that right now, which means that not only will they have to take the costly measure of plugging wells to cut production, but they will also incur a huge loss on every barrel that they have.
RAMYA:
HUNTER:
Russia did gain a small victory, in that Putin achieved his goal of hurting American businesses, but even so, Russia may just end up the biggest loser in this situation. Speaking of the United States, how do they shape up in all this?
RAMYA:
The United States is staring down the barrel of its worst recession since 2008, and that is the middle of the road projection.
However, this current economic downturn could prove far worse, because unlike 2008, the United States has a much larger stake in the oil business.
RYAN:
The US won’t have to cut as much as Russia and Saudi Arabia based on the deal, but it still will hurt US companies immensely. Like Russia, the United States’s costs for production of oil are far higher than the current prices. If US oil prices remain around $20 a barrel, over a hundred oil-based industries in the US may face bankruptcy through 2021.
RAMYA:
If that outcome occurs, gas prices will soar for the next few years, because eventually demand will rise but supply will still be quite low.
HUNTER:
However, internationally the United States can gain some leverage. They will most likely continue with the sanctions on Russian oil, which could allow the US to gain some market share in Europe.
A distribution deal with the Saudis could help this outcome along, but it would take years for returns to materialize, and it’s clear that Saudi Arabia only has its own interests in mind.
RYAN:
The US must carefully weigh its options if it hopes to salvage this desperate situation.
HUNTER:
So now it’s time for us to wrap this up and give our final takes. Let’s all give one point that you think everyone should remember from this episode.
RAMYA:
The Global oil industry is headlined by OPEC, led by Saudi Arabia, and outside that Russia, and the United States.
These countries set the prices of oil and how much of it to produce. Saudi Arabia has the most oil reserves and the cheapest means to acquire it, while the US and Russia must resort to more expensive methods in order to get their oil out of the ground.
RYAN:
When Russia did not want to cut its production, Saudi Arabia retaliated by flooding the market with its oil. This led to precipitous fall in oil prices across the world, which was only exacerbated by coronavirus and its effect on transportation. To combat this, every oil producing country in the world co-signed an agreement to cut oil production to the tune of 10 mb/d for the foreseeable future.
HUNTER:
While there are some who will fare better than others, practically every country in the world will feel the adverse effects of this unprecedented oil glut. It’s important to remember that oil forms the backbone of many state budgets, and a catastrophic drop in price will put the squeeze on these governments to maintain the necessary social spending during this recession. In short, expect to see political effects as well as economic ones.
OUTRO
HUNTER:
We’ve reached the end of our episode today, part 2 of our series on the coronavirus. Stay tuned for the third part of our series. Special thanks to my co-hosts Ryan and Ramya for the heavy lifting on researching this episode. If you enjoyed the show please subscribe and rate us on Itunes, Spotify, or however you’re listening. Thank you for tuning in…this has been Geopolitics Rundown.