On April 20, for a brief period road side tea in India at Rs 10 a cup was priced way above crude oil. With the benchmark US West Texas Intermediate (WTI) trading at USD – 37 for the May ’20 contract, a pricing scenario not witnessed since WW II,which was as incredulous a scenario as it was unprecedented!
To get to the bottom of this we simply need to round up the usual suspects in the pot potpourri of global energy dynamics– Saudi Arabia (OPEC), Russia & the US. And yes, for a change there is no China hand in this one.
Post the oil price slump of 2014 -16 and the production cut of 2.1 million barrels per day effected by OPEC+ (OPEC & Russia) International Benchmark Brent Oil prices were stable up to February ’20 in a spread of USD 55 to 67 per barrel. For the same period the WTI too was trading stably while peaking at USD 59 in Dec ’19. Demand, though, had begun to slump since Sep ’19 and then in January & February ’20 it nosedived by 325,000 barrels per day (bpd) due to the impact of the novel coronavirus on China.
To stabilise prices,Saudi Arabia and OPEC proposed an additional production cut of 1.5 million bpd.However this time around Russia refused to play ball and sought more time to assess the situation.This immediately triggered a 10% drop in oil prices.
A rebuffed Saudi Arabia, construed Russia’s intransigence as a ploy to attack the former’s interests , defying all rationality, retaliated on March 08 with a steep discount and massive increase in production from 9.7 million to 12 .3 million bpd.
Russia now retaliated with a 3,00,000 bpd increase in production and the net result was an oil glut which inundated the market and plunged prices. A full-fledged price war was underway and OPEC countries such as Iraq and Kuwait too announced discounts. Crude oil was soon trading at a 17-year low with Brent at $24.72 and WTI at $20.48 a barrel. This game of charades continued for the whole of March ’20 and early part of April, resulting in severe self-inflicted as well as oblique hits on various players.
Analysts attempted to explain this as market being in Contango, implying that the forward price of a futures contract (long term) is higher than the spot price (daily price).Also called forwardation, it is a bullish indicator. But the incongruous bit was that to support bullish trends demand wasn’t going to rebound in the medium term. Something was amiss and it was about to hit home too.
US Shale Oil industry, which needs crude oil to trend between USD 55 to 65, rapidly became unviable and companies fell like pheasants in a shoot. Alarmed and under considerable strain in an election year, the US President Donald Trump ‘leaned on’ Saudi Crown Prince Mohammad Bin Salman (MBS) and threatened to withdraw US military support if OPEC did not make immediate cuts in oil production to put an end to the price war with Russia. He also dialed Vladimir Putin and soon enough on April 09, OPEC and Russia agreed to make a 10 million bpd production cut.
But the denouement was yet to play out.
This rallied the crude oil prices to about USD 30 per barrel but with the novel coronavirus impeding global economic activity, demand continued to slump by 35 million bpd and the proposed cuts were just not enough to stem the tide. So while everybody from Moscow to Riyadh was ostensibly over reacting and causing this havoc the US didn’t seem to get the joke about to be played out at its expense.
With production cuts yet to kick in and previously inked contracts being executed the oil glut was exacerbated.And for the first time ever the issue wasn’t demand or supply but – storage space.The main distribution point for US shale oil,Cushing,is landlocked and with no spare storage the WTI went into a tailspin and on April 20, the WTI traded at an unprecedented and insanely low figure of USD -37 per barrel for May delivery (expiring on 21 April).Effectively implying that producers were paying buyers to carry away excess inventory! And now this was Contango in reverse or backwardation in play, when the futures contracts are lower than the spot prices.
Through this carnage Brent traded at around USD 20 a barrel causing extreme short term losses to petro economies like the OPEC & Russia. Since commodity markets take a cue from oil prices this saw a domino effect on the prices of Natural Gas, Coal and Sugar. Havoc reigned supreme and no one seemed to be in control of the situation. As Roosevelt had said “We have always known that heedless self-interest was bad morals, we now know that it is bad economics.”
Contango was now truly unchained and it was running amok in the global oil market.
This Amul Topical shows the Amul Girl ,dressed as a Roustabout or a Roughneck on an oil rig, and sitting atop an oil barrel. In the background is a graph showing the downward slide ofcrude oil prices.The lowest signifying the run on the WTI on April 21.She has a brick of butter placed on a barrel alongside and a bemused expression at the oil price crash shown on the graph.
The Tag Line – Oil Kam, Butter Zyada – is a play on the oil price situation and its falling rates while endorsing the use of Amul Butter more than oil during culinary pursuits of the readers.
The Punch Line – Its Good, Not Crude – is underscoring the heartburn that crude oil prices were causing for the industry and its stakeholders and cheekily pegs the consistency of Amul Butter against the prized commodity.
We, the consumers in energy deficient and oil starved India, were getting a good feel about the whole thing without really knowing what was happening. After all crude oil had tanked!
And we Indians, who have gone on to protest every single paisa worth of hike had a genuine reason to rejoice and rush to the kerbside pumps, didn’t matter whether we needed to go there at all or not!
People harboured visions of getting their fuel tanks refilled over and over again (of course with nowhere to go during the Pandemic) and some people I knew were even planning to get additional tanks fitted.
Cant blame them when our own Bollywood flicks glorify Pavlovian tendencies towards oil by churning out dialogues such as “Is desh mein Petrol ki kami hai, khoon ki nahin” (This country has a dearth of petrol not blood)!
A few enterprising ones called up retailers and enquired about when they would be paid for the fuel they were storing in their fuel tanks. Choicest of the swear words, in chaste possible language wouldn’t have dissuaded these aspiring oil tycoons. And for some reality stung like a bee on the backside, when they made a dash for the fuel stations and were greeted by a price tag which was a notch higher (not lower) and by a beaming Narendra Modi smiling down from huge Government sponsored billboard – after having just uttered – “Bhaiyyo aur behnon”
And this is where the simple aspects about this merry muddle came to an end.
All the metaphors and economic jargon aside this was pure old fashioned economics and geo-politics at play and a throwback to the Tournament of Shadows of the 1830s -only that it now had three instead of two contenders. Remarkably, Russia was still one amongst them, just as it was in the Tournament’s original avatar.
Saudi Arabia has the world’s largest reserves of crude oil and also produces it at the cheapest cost. It has created spare production capacity which allows it ease of trimming or ramping production.So in that sense Saudi Arabia is well placed to withstand mid to long term low oil prices hovering at around USD 40 to 50 but anything lower than this price band renders it very vulnerable indeed as the Saudi budgetary break even (cost of crude oil to balance its books) is USD 80 per barrel.
When the US (19%) over took Saudi Arabia (12%) in terms of global share of oil production it was an obvious heartburn for the sheikhs.While they were prepared to supply all of the US oil needs for the security cover they got in return, they weren’t really prepared to see US shale oil establish itself at the expense of their global share and revenues. So in 2014 they triggered the first ever run against shale oil by increasing production in the face of plummeting prices.This was aimed at crippling the US shale oil industry since it could not support itself at prices lower than USD 80 to 90 per barrel.
But this ploy backfired spectacularly as American ingenuity soon reduced the input costs and provided viability to US companies at prices hovering between USD 55 to 65 per barrel, some even secured profits at USD 26! In the years since the US has constantly increased its production by 1 to 1.5 million bpd, effectively shutting out Saudi oil share in a big way. And leaving some grumpy sheikhs fuming and twiddling their thumbs.
Russia has been in the oil game for long and at 11 million barrels of crude oil per day,its the third largest producer.The US had recently stoked Russian anger and jeopardised it’s strategic and commercial push in Europe by imposing sanctions on Russia’s Nord Stream 2 & Turkstream pipelines.It also imposed sanctions on the trading arm of Russian oil and gas giant Rosneft , over funneling of Venezuelan Oil.Petro dollars are central to the longevity of Vladimir Putin and the Russian Federation and a pot shot taken at the oil revenues is taken as a very plausibile threat to Russia itself.
So now we have an angry set of Sheikhs and an equally ruffled up Russian Alpha Male glaring down at the US and biding time to strike back.
Since 2010 the growth of US Shale Oil has been one of the most far reaching developments in the complex world of energy power play. The exponential growth of US domestic oil production has reduced US import dependency from 60% in 2005 to 19% in 2019.And on a global stage it has contributed to price stabilisation of crude oil over the long term (much to the chagrin of the petro economies) and negated the desultory impact of the much expected ‘oil peak’.
Perennially stuck with FOMO, the Saudis tend to deal with an oil price race by ramping up production and drowning out other producers by announcing discounts, notwithstanding the loss in revenues. They did this in 1985 & in 2014 as well.So is it a surprise that the Saudis didn’t cut production?
It’s not that the Saudis do not cut production, they do but only to support short rallies or long term interests like in 2016 when they intended to restore OPEC’s diminished ability to regulate prices.
The combined Russian and Saudi run on US Shale Oil has resulted in US production highs of 13 million bpd being slashed by 30% over the mid to long term, 4 million bpd at risk of permanent loss, idling of 50% oil rigs, 40% insolvency rate and over 2,00,000 lay offs – in the US mid West (and in an election year!).And the vacant oil slots will be readily filled up by whom?
Through the price war Saudi Arabia did get some of its own back for Russia refusing to toe its line on production cuts It jolted Russian revenues when its premium brand Russian Urals traded at USD 8 per barrel! For all its show of independence Russia eventually went along with the agreement on production cuts proposed in Mar ’20 .
But this agreement is bound to fail.
Firstly with global demand falling by almost 35 million bpd, what would an agreement on a 10 million bpd cut amount to? Under normal circumstances I would have snapped my fingers and said “toilet paper”, but on April 20 even toilet paper was way more expensive than crude oil!
Next the production cuts. What production cuts?
They are supposed to be imposed on a base figure of 11 million bpd but the Saudis have never ever reached that production level. All the talk about 12 million bpd threshold being crossed was nothing more than some authentic Arabian version of (not belly dancing) but jumlabaazi (sloganeering) as all that the Saudis did was to add their spare inventory to the produced volume and announce the figure that they did. Their long term average has been 8.5 million bpd only. As for the Russians they were producing 11 million bpd and are known not to fall in line with any quotas or mandated cuts and will not do so even now. So in their case too there is no production cut really. So in effect where is the production cut? Its done a Houdini.
Lastly, the OPEC has decided to review the production cuts in June ’20 and its likely they will ease up on the same and that will ensure that the supply glut will remain in play for a long time to come. Only that the US has been successfully taken off the equation, for now.
While Putin & MBS got back at the US in good measure but in the bargain have given themselves black eyes too.
The immediate impact of the price drop was that Saudi Aramco cut its capital expenditure plan by USD 10 billion. Saudi Arabia announced its intention to dig into USD 32 billion of its reserve and to shore up loans worth USD 52 billion and acknowledged that its budget deficit will balloon to 9% and long term economic reforms agenda Saudi Vision 2030 would be considerably set back. And the Kingdom stared at really low revenues for at least the foreseeable future (remember the budgetary breakeven?).
The Russians who were expecting a USD 11 billion surplus are now staring at a significant deficit and the Rouble lost 30% of its value in March ’20.
And the dynamics get even more dramatic for other major producers such as UAE, Iran, Iraq & Kuwait where crude oil comprises 65 to 100% of exporting merchandise and their respective budgetary breakeven are estimated at USD 70,389,60 & 61.
Some analyst feel that while for Russia the gains are in the realm of strategy it’s a win-win situation for Saudi Arabia as it will get to fill in the void left by the other oil producers, ingratiate itself with the US over its willingness to align OPEC with US interests and,showcase its ability to ride out a storm as rough as this one and that it has restored the OPEC at the center of global oil pricing.
But there’s a dampener here. Was all this worth the price that Saudi Arabia paid? And it has paid the same price twice before in its history.
While it tends to ramp up production to gain larger market share albeit at extremely low payouts its elementary to visualise the disastrous effect that the strategy has on Saudi economy, stability and prospects, especially with crude oil ranging between USD 20 to 35. It is likely that it would be at least a decade before the global demand picks up to pre 2014 till then Saudi Arabia will continue selling its inventory cheap and bleed white. That is if the turmoil does not lead to the end of the Kingdom.
MBS is a novice in the world of power play and has a penchant for committing hara kiri at the global scale and is blessed with uniquely bad sense of timing,as typified by the Saudi’s disastrous war against Yemen, killing of Khashoggi and the grounding of the USD 100 billion dollar listing dream for Saudi Aramco which eventually ended up with an offering of USD 25 billion. He also has a sense of timing akin to a sputtering 1910s Model T.The Khashoggi imbroglio hit when the war in Yemen was being escalated under increased global scrutiny. And now the oil price war in the time of coronavirus? A demand and supply double whammy isn’t really the right kind of legacy that a Crown Prince would like to be stuck with.
Despite all the assessed gains that the Saudis may accrue they do not have the Kremlin’s capacity to fall back on alternative revenue sources and in any case the Russian budgetary break even of USD 40 per barrel allows it a little more leeway despite having put its foot in the mouth over the price war. And nor can the Saudis guarantee that US shale oil industry would not rebound with greater innovations. For now MBS has to contend with a budgetary hole and the US peering in through it, which is sure to strike back at the Saudis in one or the other form.
I am not surprised that MBS hasn’t learnt from the history of the Cold War, after all he was a 4 year old toddler when the USSR collapsed.
But somewhere the Contango having gone unchained has to be reined in.
How does this madness end?
Some analysts have relied upon Game Theory to predict how order can be restored. In Scenario 1, while the US will be forced to impose cuts due to the running aground of the shale oil industry and if the Russian and Saudi oil glut continues, oil will plunge to USD 10 to 15 per barrel and be the end of Putin and MBS along with the petro economies.
Scenario 2 presents the choice while US production remains depressed ,both Russia and Saudi Arabia can impose real production cuts, to ensure that oil hovers at around USD 50 per barrel in the medium term.Once prices stabilise the US will need to shun the urge to ramp up production as that would force prices to crash again between USD 33 to 25!
In Game Theory when the players have no incentive to divert from their initial rationale choices we have the classical Nash Equilibrium. And in this oily conundrum the equilibrium can only be arrived at with the Scenario 2 presented above.
Game Theory is based on the premise that players would behave rationally but when you have someone who wants disinfectants injected into covid19 patients and another who lures journalists and then suffocates them using plastic bags and dismember their corpses it’s difficult to kind of bet on rationality!
So who won and who lost?
The initial rounds have certainly gone to the two friends cutting the branch that they are sitting on. But they scored a few self goals by insisting on an ill though out price war.As for the US, it can kiss goodbye to any hopes of regaining its market share in the long run.Its best bet is to ride out the storm following the Russian and Saudi lead and also to peg realistic aims for its shale oil ambitions.
As for us Indians, low oil price means a rosy balance of payment scenario and lower Capital Account Deficit along with brimming strategic reserves. But “bhaiyyon aur behnon” don’t expect prices to come down anytime soon (not before 2024). Low global oil prices yield high tax returns for the government. And this is what the Government of India did when it raised excise duty to shore up taxes in the time of novel coronavirus, other than smiling smile back at you from billboards.
Contango cannot be allowed to run unchained for more than what has already transpired. If we do risk that,then we risk widespread collapses & descent into chaos for global economies and not to discount the possibility of the downfall of a few strongmen.
MBS & Putin included.