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Mitchell McGeorge

Mitchell McGeorge

Mitchell is Executive Chairman and CEO of Berry Commodities, a vertically integrated global commodities group, with core services of Asset Management, Advisory, Technical, Trading &…

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Will Putin Risky Oil Gamble Pay Off?

Every gambler knows That the secret to survivin’

Is knowing what to throw away

And knowing what to keep

‘Cause every hand’s a winner

And every hand’s a loser

And the best you can hope for is to die

In your sleep.

Source: LyricFind Songwriters: Don Schlitz The Gambler lyrics © Sony/ATV Music Publishing LLC

After much rumour and speculation surrounding the OPEC+ meeting, the commencement of a global oil war was confirmed by Russia’s Energy Minister Alexander Novak when he said post meeting “Considering the decision taken today, from April 1 of this year onwards, neither we nor any OPEC or non-OPEC country is required to make (oil) output cuts.”

With this action, Russia signalled its intentions to take on OPEC, its leader Saudi Arabia and to attempt to deal a death blow to a US shale industry that is already on its knees.

Russia has long been negative towards OPEC+ production cuts. Whilst it has provided an environment of stable higher oil prices that have allowed it to become debt free and return to budget and trade surplus, the higher prices has also provided a free pass to the debt fuelled US shale industry to keep increasing production unfettered, to the point of overtaking Russia and Saudi Arabia and becoming the world’s largest oil producer.

Recent actions though have no doubt stoked Russia’s grievances to the point that it is willing to risk a protracted and all-out oil price war against two superior opponents.

On the Saudi side, Russia has long felt that artificially propping up oil prices by the Saudi led OPEC has given its old foe the US the ability to become an oil exporter for the first time in decades and thus become a serious competitor to traditional export markets. Secondly, rather than the mooted investment in Siberian gas projects, Saudi Arabia announced the Jafuria Shale Project – the biggest shale project outside the US, which would allow Saudi Arabia to become a net gas exporter whilst freeing up oil supplies for export that had previously been used for domestic power generation.

At the same time, Putin is pressuring Riyadh (and indirectly Abu Dhabi) to get more in-line with Russia’s operations in MENA, especially Syria and Libya. By “breaking OPEC+”, Putin has shown his willingness to take high risks to support his other strategic goals too.

On the US side, aside from the shale industry’s continued existence, Russia has felt aggrieved at the meddling of the US and the sanctions imposed by them on state-backed enterprises of Rosneft for trading with Venezuela and Nord Stream 2 to supply gas into Europe.

As most aggrieved parties do, Russia believes that it has ‘right’ on its side and views itself as being in a relatively strong position. Three years of stable oil prices has provided the Russians with a certain amount of firepower and the belief that it can withstand oil prices at between $25 to $30 per barrel for the next 6 to 10 years.

In taking this view, Putin is gambling on a couple of assumptions.

Related: WTI Rallies 24% In Panic Stricken Markets

Firstly, that Saudi Arabia, who is embarking on large and expensive structural changes to the country and its economy, lacks the ability to maintain a protracted price war when they need $80 per barrel to balance their budget and fund their expensive structural changes. With ‘perceived internal pressure’ on MBS continuing from inside the Royal Family, Putin may believe that the time is right.

Whilst true that the Saudi budget requires $80 per barrel to balance its budget, it is not a requirement that it does so. Saudi Arabia has deep cash reserves, a cashed up Sovereign Wealth Fund, the Public Investment Fund (‘PIF’), which is owner of SABIC and Aramco, and a far greater ability than Russia to borrow in the global financial markets. The Saudi Government has been gaming scenarios where oil drops to $12 to $20 per barrel and has been making its moves accordingly.

Secondly, Putin plays on Trump’s view that the key to his re-election is the performance of the US economy and the living standards of ‘his’ voters

Trump has always been very vocal fan of lower gasoline prices as a ‘free tax cut’ to the US economy. Trump, whilst being a vocal supporter of the US Energy Industry, also feels no pressure to immediately ride to their rescue, as he is safe in the knowledge that he will always have their support whilst a Democrat White House would mean industry Armageddon. 

And by some perverse circumstance, Putin has an accomplice in Saudi Arabia, who having tried and failed between 2014 and 2016, is not against piling on the US shale industry and having a free-kick whilst Russia shoulders the blame.

Remembering back in June/July 2018 we saw that Saudi Arabia was a victim of the ‘Trump two-step’ when encouraged to pump more oil by Trump to drive prices down and help out him domestically, as he placed sanctions on Iran. Saudi complied, only to see immediate and significant waivers granted to purchasers of Iranian oil and the oil price collapse from $75.

The Saudi response has been one of ‘shock and awe’ – with Saudi immediately offering barrels into the market with discounts of between $6 and $10 per barrel and Aramco’s  announcement yesterday to the Saudi Stock Exchange that from the 1st of April they will provide customers with 12.3 million barrels a day – and additional 2.6 million barrels per day (~27% increase) from current production levels.

As we know, Aramco has never been seen to be producing more than 12 million barrels per day. Increasing production by 2.6 million barrels per day requires some technical issues not yet solved. Whilst there is doubt as to whether these numbers can be achieved (and for how long), it is our expectation that they will dip into their reserves to meet these targets – a sign of the commitment to their ‘shock and awe’ tactics.

Whilst this ‘shock and awe’ tactic taken to be a direct response at the Russian oil industry, with the aim of bringing Russia quickly to heel, Russia may see this as somewhat of a tactical victory.

With Russia only able to increase their production modestly (between 200,000 and 500,000 barrels per day), they may see that Saudi’s 27% increase in barrels offered as being able to deal the fatal blow to the US shale industry that it can’t. They would certainly have been encouraged by the report by Lloyds overnight that Saudi state run shipping company Bahri has been active in procuring 10 VLCCs for late March loading (with a combined capacity of 20 million barrels), in addition to its own 41 tankers, on rates of up to $197,500 per day, to flood the US market.

Appreciating his best chances lie in a quick victory, Russia has kept the doors of communication open with high ranking officials on both sides are continuing discussions to find a solution. Former Saudi Minister of Energy Khalid Al Falih and his Russian counterpart Novak are still not intending a full-scale crash of oil in the end. But, as Putin hopes to turn the short-term tactical successes of destroying production curtailments, pressuring MBS and the Saudi budget and killing US shale into long-term strategic victories, significant risks abound for all players, especially Russia in a protracted war.

Whilst steady oil prices has seen Russia’s budget and trade surplus build up cash reserves in excess of $500 billion, combined with structural changes that has seen the budget break-even lowered to between $40 and $50 per barrel, Russia’s weak currency and still greater than 40% dependence on oil income, poses significant risks if this oil war is protracted. Since the oil price slide commenced, the Rouble has depreciated 23% against the US dollar. Related: U.S. Oil Industry Could End Up Losing More Than 200,000 Jobs

Far from being a coalition builder, Russia is a lone wolf on the world stage. No longer the super-power it once was, it has been reduced to being a big player on the sideline - meddling in the affairs of the world’s problem children such as Syria, Venezuela, Libya and Ukraine. Military is prohibitively expensive and with military intervention in multiple locations, Russia will soon realise that the cost of budget promises combined with military intervention hubris, will bring significant pressure quickly on the seemingly rosy budget position. The same can be said for Saudi Arabia’s Yemen excursion.

Russia’s lack of allies that have the capacity to trade with them, invest in them or provide financial assistance to them will be telling on Russia. Saudi Arabia has the much greater position of being able to rely on allies and to being able to borrow in the global financial markets at a much cheaper rate and with greater capacity. Russia’s dwindling reserves of hard currency, dwindling oil receipts and lack of financially viable allies that can assist will be telling as this crisis continues.

Russia’s greatest risk is that, in an attempt to kill the US shale industry, that the damage done in the short-term effects the overall economic narrative of Trump, and for the sake of his re-election prospects he is forced into intervening on behalf of the US shale industry.

In this, Trump has the flexibility of direct or indirect action, both of which would have a devastating effect on Russia.

Trump has the ability to intervene directly by providing direct subsidies, loans, assistance or even equity purchases to support the shale industry participants. Direct action such as this would signal to Russia (and Saudi Arabia) that the shale industry will survive and “perceived” energy independence is a cornerstone of his economic agenda. Russia (and Saudi Arabia) will then have to consider the position of going to war to kill an industry that has the support of the one player with deep and limitless pockets.

But, more devastating to Russia still, would be the indirect actions that Trump could take – which would completely take down Russia on a structural level.

Trump could begin with strategy right from his play-book and enforce a round of trade sanctions on imported oil. This would in the short-term shore up the local shale industry and curtail capacity dumping on the US.

But, the nightmare scenario for Russia would be that Trump imposes economic sanctions on Russia, similar to Iran and Venezuela, that would limit or completely stop its ability to sell oil and gas, trade, borrow and receive at both a country and a personal level.

This would be the smart play by Trump, which would use the least political capital, would provide a nationalistic argument to support and protect the Energy Industry and US sovereignty from attack and blunt any environmental flack for supporting the Energy Industry.

This is a tool that is being used in limited circumstances by Trump now, with sanctions on Rosneft’s trading arms, sanctions on Nord Stream 2 and the banning of US nationals from buying or dealing in Russian Sovereign Debt. We have seen the response of Russia to this limited action – one can only imagine a widescale imposition of economic sanctions.

Of course, Russia may choose to ignore these risks, as they have been doing, taking the view that the tactical considerations take precedence over the strategic ones as the effects of these sanctions have not been strongly felt whilst the oil price has been supported by OPEC+ and receipts have plentiful.

But that would be a grave error as we have seen the effects of total US economic sanctions on Venezuela and Iran – the incessant constriction of every facet of the country’s fabric of society. And, unlike Russia, the US is in the unique position to enforce its will on the global community – cutting Russia off – with no coalition supporters with the means or will to help break any sanctions imposed.

Russia will then realise that strategic errors cannot be overcome by tactical victories. Russia has a short-term window before The Gambler’s words ring true:

Son, I’ve made a life

Out of readin’ people’s faces

Knowing what the cards were

By the way they held their eyes

So if you don’t mind me sayin’

I can see you’re out of aces.

By Mitchell McGeorge for Oilprice.com

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