The fall of OPEC+ and the age of oil price wars

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For a while, it seemed as if Russia and Saudi Arabia were building a strong new relationship based on common interests in the Middle East and the oil sector. In December 2016, the joint efforts of Riyadh and Moscow led to the signing of the Vienna Agreement between OPEC and 11 non-OPEC countries (10 now, as Equatorial Guinea joined OPEC in 2017), which aimed at decreasing oil production to prevent the fall of oil prices and ensure their stability.

The initial six-month deal was then extended several times. It also led to the formation of a permanent forum-like structure – the so-called OPEC+ – with its own charter signed in July 2019, which allowed participants to coordinate and adjust their production policies.

This format proved to be effective and achieved, at least temporarily, relatively high and stable oil prices. In December 2019, the deal was extended until April 2020 and it was taken for granted that OPEC+ would continue leveraging the market with production cuts beyond 2020.

In the meantime, Russian and Saudi Arabian officials exchanged visits and signed various memoranda of understanding on political and economic issues.

What happened on March 6 surprised many, but not those who had been watching Russia closely. In Vienna, Saudi Arabia tried to push for additional oil production cuts to compensate for the slump in demand for oil due to the coronavirus. Russia not only rejected the move but also announced it will no longer abide by the previous cuts.

This basically led to the end of OPEC+ policies of production cuts. It was reportedly aimed at causing a drop in oil prices in order to hit US shale producers, who have continued to benefit from OPEC production cuts by expanding their market share. A price collapse could put some of these producers out of business as fracking has a high production cost.

This is an argument which Igor Sechin, the head of the Russian oil giant Rosneft and the main opponent of Russia’s participation in OPEC+, has repeatedly made. In February 2019, he even put it in an official letter to President Vladimir Putin, claiming that the OPEC+ deal to cut oil output was a “strategic threat” and played into the hands of the US.

Given that Shechin has been opposing production cuts for a while, the question that arises is, why now? The answer has much to do with Russia’s domestic politics.

When Russia concluded the Vienna Agreement in 2016, the Russian leadership believed that it would help prepare the country for the Russian presidential elections in March 2018. Higher oil prices ensured the Kremlin’s financial capacity to lead a successful electoral campaign.

In the run-up to the 2018 election, it was important for the regime to demonstrate a strong economic performance and to show that Putin was able to deliver on his promises of economic growth. Higher oil revenue helped pull the country out of the 2015-2016 economic recession and guaranteed stable economic performance through 2019.

It also allowed the regime to extend social security programmes and postpone painful austerity measures until after the vote. Putin was able to secure another six-year term with a high enough turnout and significantly high approval rating.

However, since then, the political goals of the Russian regime have changed, which require a different approach to cooperation with OPEC+. By 2020, the Russian authorities began preparations for the end of Putin’s fourth term in power in 2024. This changed the regime’s priorities – from satisfying the needs of the general population to ensuring the sustainability of the Kremlin’s alliance with powerful tycoons, including those controlling oil production who would, in the end, either approve a successor to Putin or a constitutional amendment that would allow him to stay in power for two more terms.

And not all of them were happy with Russia’s participation in OPEC+. In February 2020, Sechin and Aleksandr Dyukov, the head of Gazprom Neft, again voiced their resistance to further production cuts under OPEC+ as it was going against their production development plans.

Unlike the majority of the OPEC+ countries whose oil production is largely concentrated in the hands of government-controlled national oil companies, Russian oil producers enjoy relative market freedom. Consequently, the Kremlin has to use more “carrots” than “sticks” to persuade its companies to follow its decisions.

Yet, by the end of 2019, all existing “carrots” had already been used. The provision of further tax exemptions and financial support to Russian oil producers became economically unjustifiable while all potential loopholes in the Vienna Agreement that allowed the Russian producers to justify their low compliance with OPEC+ obligations had also already been used.

At the same time, ahead of the March meeting, the Kremlin’s own perception of OPEC+ has changed. It has come to believe that the cartel is losing its ability to shape the global energy market due to the growing oversupply and the beginning of a global energy transition.

The Russian leadership finally accepted that the era of high oil prices was gone and that it will not come back. This new attitude towards the future of oil prices is clearly reflected in the state budget planning that is built on the assumption of prices floating between $50 and $60 per barrel (pb) until 2036 in the best-case scenario. These figures may even be pulled further down following Russia’s decision to quit OPEC+.

By 2021-2023 Russia’s oil output will also likely start to fall due to the natural depletion of old oil fields and lack of investment in development and exploration – it is projected that Russia’s production will fall from 11.4 million bpd to 6.3 million barrels per day (bpd) by 2036. It will try to do its best to prepare for this by developing new oil production projects, which is hardly possible under any OPEC+ production commitments.

In this context, when Saudi Arabia proposed an additional 1.5 m bpd cut on top of the already existing ones, there was no reason for Russia to accept. It had already decided to pursue its own production strategy and no longer saw a reason to maintain its membership in OPEC+. What is more, Russia was not really convinced that such a cut would help the market stabilise given the drop in oil demand growth from 1.1m bpd to 650 – 800,000 bpd in 2020 and the expected growth in oil production by non-OPEC+ countries of 2m bpd in 2020.

After Russia’s rebuke, Saudi Arabia and others decided to go all in. Saudi Aramco not only announced that it would increase its crude supplies to the market from 9.7m bpd in January 2020 to 12.3m bpd in April, but also said it received instructions to increase its maximum sustainable oil output capacity to 13m bpd. Abu Dhabi National Oil Company (ADNOC), meanwhile, promised to raise its output to 4m bpd in April, and speed up its production capacity development efforts to pass the 5m bpd threshold in the future.

Under these circumstances, Russia’s response seems to be quite modest: according to its minister of energy, Aleksandr Novak, in the short-term, Moscow is planning to increase supply to the market just by 300,000 bpd with the potential of adding another 200,000 bpd in the long run.

The increase in oil supplies to the market will drive oil prices down and launch an economic “war of attrition” between oil producers. In the end, the companies that have the capacity to survive a prolonged period of low oil prices will succeed in securing their share of the market and win the war.

Moscow’s limited capacity to increase oil output means it will be unable to compensate for all losses caused by the reduction in prices by upping its production. However, the oil price Russia needs to keep its budget balanced is lower than the one needed by Saudi Arabia and the UAE ($42 pb compared to $70-80 pb). In other words, to survive the fall in oil prices, Russia will need to draw fewer reserves from its National Welfare Fund compared to its rivals.

For now, both Russia and Saudi Arabia appear to have the economic capacity to sustain a price level of $35 pb for four to five years. The rest will be determined by luck.

So will this move destroy the US shale industry? It is estimated that $40 pb will only slow its production growth, while $30 pb will keep it approximately at the level of December 2019. In order to make the US oil production fall, prices would have to either go below $20 pb or stay in the margin of $30-40 beyond 2020. And this is without taking into account Trump’s readiness to provide economic aid to the shale industry to protect it from the worst effects of the reduction in prices.

Moscow made the move to allow OPEC+ to collapse because it believed it could keep a balanced budget amid a drop in oil prices, at least for a while. It also probably expected other participants to get scared and succumb to its demand to not deepen production cuts without taking any major retaliatory action. It never expected OPEC+ countries to start preparations for a fully-fledged trade war.

The unexpectedly harsh response it received scared Moscow.

Despite having a higher budgetary resistance to falling prices than Saudi Arabia, Moscow knows that if the oil price falls below $42 per barrel, it will run a deficit. This will inevitably negatively impact the socio-economic situation in the country – something Putin would rather avoid.

Novak has already started to call upon OPEC+ members to keep their oil output within the January – March 2020 limits. Moreover, Moscow signalled that it may even attempt to reach a new agreement with Saudi Arabia at the next meeting of OPEC+, which is scheduled to take place in May-June 2020. Riyadh, however, said it sees “no reason” to hold talks in May-June.

While Russia would not mind to back down and return to the status quo, Saudi Arabia appears determined to continue the confrontation. Their next moves will be determined by their readiness to take on further economic losses and their appetite for escalating tensions.

Nikolay Kozhanov is a research associate professor at the Gulf Studies Center of Qatar University.

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