OIL: theater of war

OIL: theater of war

2020-03-11 • Updated

Disposition

So we have now an all-out oil price war between Saudi Arabia and Russia.

Russia is planning to increase its oil supplies undoing the December output cut once its term ends in March. It is assuring that its fund reserves are ready to absorb the damage from lower oil prices for as long as up to 10 years (with oil prices at $25-30 per barrel).

Saudi Arabia, in response, prepares to increase its own supplies for up to 12mln barrels per day. It also offers its crude under huge discounts, especially in Europe, to push away Russia from its core market.

The opposition doesn’t end here, however: the situation is actually a triangle of relationship rather than a Russia-Saudi Arabia standoff. The US is involved heavily, but indirectly, although it may be not that obvious: recently they just commented that they were hoping to see the oil market in an “orderly” condition.

Let’s observe the starting points of each protagonist here.

The US

Strengths

  • The strongest world economy gives the US the highest strategic resilience to withstand any economic damage in the long-term.
  • The “newly-founded” domestic shale oil production satisfies a big part of domestic oil demand and enables oil exports.

Weaknesses

  • The strongest world economy pushes the internal domestic oil demand chronically higher than the domestic oil production capacities and hence obliges the country to import oil from other countries.
  • With the exception of just a few, the US shale oil producers' break even price for a barrel of oil is well above the current price - that means, they are losing the game now and will most likely stay out as drilling new wells is not profitable.

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Source: US Energy Information Administration

Saudi Arabia

Strengths

  • The biggest oil reserves in the world give a comparably unlimited capacity to increase the oil output unlike any other country (note: formally, Venezuela has the highest reported oil reserves, but given the current situation in the country such as sanctions and other socio-economical aspects these reserves are likely to stay in the ground in the nearest future).
  • Military and strategic alliance with the US inherited from the British Empire ensures that at any high-level opposition threatening the country’s strategic integrity the US will try to support the KSA as long as it doesn’t cross the American national interests

Weaknesses

  • 100% oil dependency – the country’s almost only source of revenue and self-sustainment is oil exports, hence the destiny of Saudi Arabia goes hand-in-hand with oil price.
  • Relatively high break-even oil price is required to have a balanced state budget.

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Source: JPMorgan

Russia

Strengths

  • Nuclear state, developed intelligence, counterintelligence, cyber-security, and spec-ops capacities; as unrelated as it seems, these very much define how far one can go to cross the interests of this country – including those in the economic field; given the fact that all of the listed elements are of a similar level to those of the US, any direct conflict escalation against Russia will be considered twice by the US.
  • Substantial strategic fund reserves accumulated during higher oil prices – these enable the country to potentially absorb any damage by the price war in the long-term.
  • Exports oil and gas, which is a prime energy source demanded across the globe, specifically by Europe and China, both of which depend on the supplies from Russia and have their own reasons not to side with the US.

Weaknesses

  • Oil dependency, low internal economic diversity and capacity, making this country vulnerable in the long-term against any serious economic threat.

Now, as we cross-weighed the strategic pros and cons for each country's positioning, let's see their mutual relasionships.

Three countries - three points of view

How the conflict started

Now, the March 5 meeting was the OPEC+ meeting, which means mainly Saudi Arabia and Russia. As long as the two disagreed on the oil cut, the opposition is said to be between those two countries. But in reality, there is a triangle: Saudi Arabia, the US, and Russia. And going deeper, there is a Russia-US opposition conditioning these happenings.

Formally, here is the sequence of events. The virus comes, hits China, hits the global economy, reduces expected global oil demand, presses the oil price down – all suffer. Specifically, OPEC (headed by the oil-dependent Saudi Arabia) and Russia suffer because of lower oil-export profits. So the KSA comes up with an urgent proposition to lower the output across all OPEC members and Russia to balance out the lowered demand and prevent the oil price from slumping on the mismatch between the demand and supply.

Russia

Russia, in general, has no problem with a cut as such. And it has a little problem with Saudi Arabia itself, all “small” issues aside. But it does have a problem with the US and its shale production, which already gained momentum and its share in the global oil market.

Russia’s starting point is that the OPEC+ with its collective initiative to reduce the total oil output across all countries including Russia only resulted in an increased share of the US shale. Hence, the argument of the Russian side is: yes, the oil price is now more stable, but it came at the cost of giving more room for the US oil producers. And the latter undermines the strategic strength of Russia as an oil exporter. So now Russia doesn’t want to continue giving in to this output cutting spree, because it doesn’t want the US to grow stronger in shale oil production. In fact, Russia wants to push the US shale out of the game in this specific sphere.

Saudi Arabia

In the meantime, Saudi Arabia is tired of facilitating most of the output cuts on its own and bearing the responsibility of OPEC’s destinies almost alone, while other OPEC members and non-OPEC partners (such as Russia) act as they please. In view of the huge untapped capacity to increase the oil output, Saudi Arabia is more than happy to do that. And by doing that, it will not only compensate for the lower oil price to keep the same profit level incoming but (supposedly) force Russia to get back to the negotiating table, because Russia, being unable to increase the exports at a similar pace, will suffer from lower oil price and hence lower profits.

The US

Now, the US stays somewhat behind the scene here, but it is, in fact, a primary protagonist. The impact of the price war, which makes the oil price low and unstable at the same time, primarily hits small and medium-sized shale oil producers in the US. These will surely go out of business in the short-term as long as the situation follows the same direction for a couple of months. However, the question is how harmful that may be to the core of the American shale oil industry, presented by the giants like Exxon or Chevron – those most probably have prepared to situations like that and hedged the risks. Very likely, their preparations will be tested in the long run if the conflict goes according to the pessimistic scenarios.

Conflict's inner working

That’s why Saudi Arabia, although a primary actor in this theater of war, is, in fact, a hostage of the situation presented by the opposition between the US and Russia. The US wants to grow its global oil supply market share reducing the dependency of global powers on Russian oil and increasing their dependency on the US. Russia wants to keep its market share and keep other global powers being dependent on its supplies not letting the US take this part of the pie. And Saudi Arabia is just trying to survive being caught between two fires and trying to exploit its only two aces: the biggest oil reserves and strategic interest of the US to have the KSA on its side.

Conclusion

Human evolution

We are witnessing amazing changes in the ways we live. The XXI century is an incredible era. But electric autos, nanotechnologies, cryptocurrencies, augmented reality or any other never-believed-before marks of the “era of the future” cannot change what lies at the foundation of the human civilization – humans. And until the human brain evolves into something naturally different from what it was 5000 years ago, no technological advancements will change human’s ways. That means, you can kill by a stone, a stick, a sword, a bullet or a laser gun – the action is the same; only the method changes. Applied to our question, oil as a global energy resource stepped into the scene only roughly a century ago; before, it was coal, water, forests, croplands, etc. But it doesn’t change the underlying process – the old good rivalry of global powers over spheres of influence and resources, and survival of smaller powers in between. In other words, essentially, what we are witnessing between the US and Russia with Saudi Arabia in the middle, is little different from what was happening between Russia and British Empire, Britain and Spanish Empire, Ottomans and Byzantine Empire, the Umayyad Caliphate and Frankish Empire, Carthage and Roman Empire, Greece and Persian Empire, and numerous other powers, which emerged and left the stage. Neither this will ever end.

Trader's resolution

For the oil market, although that’s not the first time it goes into turbulence, where the current situation will lead – nobody knows. As Warren Buffet said, if knowing the past guaranteed expected outcomes, Forbes 500 would consist of librarians.

For trading, however, nothing changes: sell at the highest highs, buy at the lowest lows. And currently, oil price seems to be very close to the rock bottom – however, don’t fall for this “seems”. Observers already voiced out fears that $3 per barrel (yes, the number is correct: its “three”) may be a possible outcome. And that makes sense: Saudi Arabia and Russia just stared their competition, and there is no indication that it is going to end soon – hence, there is little reason to expect the oil price to make any significant upswing other than in the course of correction. That’s why, until there is a peaceful resolution to the oil price war, there will be constant pressure down on the price, given the fact that the strongest weapon both countries have is to flood the markets with more oil.

Therefore, the current situation presents a choice for you as a trader. Either you play short-term/correction, or you play long-term/downswing, and the latter will be prevailing in the market as long as the war goes on.

The safest step, for now, is to hold and wait until the oil price indeed reaches its lowest levels, and then buy. When it is going to be – we are yet to see. But given the “normal” levels at $55-60 where the price has been balanced during recent years, it is worth waiting.

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