Oil Update – Saudi Arabia and Russia: Who will blink first?

by ObservationalHumor

Both countries are currently planning on burning through reserves or borrowing money to actually sustain price levels below $40/bbl for any prolonged amount of time. The whole reason Russia was bold enough to do this is because they moved their budget breakeven to around $42/bbl and established around $400 worth of reserve funding and another $150B or so in a special energy fund that can be tapped. They basically spit out a 6 year figure if oil remained in the $30-40 range and that’s basically gone out the window with oil being lower than that. Russian lifting costs aren’t that high but the big problem is most of their production(literally >50%) comes out of Western Siberia at this point and is quite far from ports and lacks major pipelines to good export targets like China and India. Saudi Arabia doesn’t have that problem as they can pipe oil out to tanks on the ocean or refineries near it pretty cheaply based on where their fields are. Shale formations in Texas have a similar benefit and some of them literally just pump oil 50-60 miles to inland refineries and maybe another 150-200 after that if they’re looking to export. Well head costs are significantly higher though (a big part of that is exactly capital costs though).

Another big issue the Russians have is that they flat out can’t increase their production capacity that much more, they’ve literally got maybe 3% production headroom in the near term and closer to 5% a few months out. Their conventional oil production is also expected to peak in 2023 which makes the question of any kind of long term strategy pretty questionable here.

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The big issue the Saudis have is their budget is balanced around $78/bbl and their economy is not well diversified. On top of that there’s more practical problems emerging with their plan to actually float another 3M barrels on the market (4M if you count their close allies in the UAE increasing production by another 1M too). Refineries are actually scaling back production rates to around 75-80% of normal capacity since they don’t want to bear the expense of storing refined products as end consumer demand contracts due to the virus. There’s literally not many people out there willing to buy the existing supply of oil let alone more of it and the recent turmoil in the markets and risk off attitude has likely put a lot of parties willing to physically store and speculate on the price of oil on the sidelines as well.

The fact of the matter is both countries will burning through an enormous amount of reserves in the current standoff, especially a Coronavirus outbreak happens in their country and demands additional fiscal spending (happening in Russia currently but being denied). On top of that they’re also essentially losing a valuable asset by selling oil at prices that are literally 1/2 to 1/3rd potentially of what they could otherwise get with a production decrease. You’re talking about over a trillion dollars worth of money and value being flushed down the toilet over this spat if goes on for a few years here. The fact of the matter is there’s no scenario where extending this spat makes any economic sense. Both stand to lose massively and really can’t make any money off of doing this. Even from the perspective that this is some kind of coordinated effort to bankrupt shale the fact of the matter is that US capital markets are much much deeper than anything Russia or Saudi Arabia could dream of having and the fact that the underlying assets never really vanish and have very low per well investment costs and production lifetimes which blunts a lot of the price risk. If oil prices get above $55/bbl again it won’t be difficult for a speculator or creditor sitting on previously uneconomic shale assets to pull together a few million dollars to get them producing again in a few months.

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People keep on trying to look for some kind of strategic masterstroke in all this but there isn’t one, it’s a pissing contest based off of a misunderstanding of how shale economics work within the Russian oil industry and government and a terrible decision on the Saudi’s part to try to strong arm the Russians into further cuts which history will tell you is a terrible reason as the Russians historically chose to send millions of people to their deaths over being forced into submission.

Both parties are likely just looking for an excuse to get back to the table and that’ll probably be data indicating a significant drop in shale production or a commitment from the US government or Texas RR commission to make that happen in order to stabilize prices.