While global equity markets have bounced from lows over the last two weeks oil prices have not followed suit, instead continuing their fall to levels last seen in November 2002 . Lower oil demand as the world economy slows in reaction to COVID-19 has been compounded by a significant increase in supply as Saudi Arabia attempts to regain market share from US and especially Russian producers. The Smith & Williamson Energy team holds the view that current oil prices will not see a short-term recovery to pre-corona levels without a combination of significant geopolitical actions and a calming of the global pandemic.
The Saudi-Russian Oil feud began on March 8th after The Organization of the Petroleum Exporting Countries (OPEC)/Russian talks halted with Russia refusing to cut production in-line with reduced demand due to COVID-19. While not formally an OPEC member, in recent years Russia has acted with the international cartel to keep prices at levels satisfactory to the major oil-producing nations. In response, Saudi Arabia announced rapid production increases in an attempt to enforce Russian cooperation by reducing prices and profit margins.
Under normal circumstances, a lower oil price aids global growth as transportation, energy and industrial costs fall for the majority of companies and individuals. However, the COVID-19 lockdown means that those benefits cannot be maximised. While electricity generation, residential and agricultural demand are largely unaffected, these account for approximately 15.5% of oil usage in normal times (per OPEC 2020 estimates), meanwhile industrials (26.5% of oil demand) are slowing. The remaining 57.5% of demand is from transportation which has seen dramatic reductions in response to COVID-19. Cuneyt Kazokoglu, head of oil demand at energy consultancy FGE, said that the decreased US petrol usage alone was “like the entirety of Europe, Africa and the Middle East combined [stopping] driving” . Jet fuel demand (a higher-margin component of crude oil) has also dropped significantly with fleets of commercial planes grounded.
A resolution to the Saudi-Russian dispute may not come quickly as both are well equipped to hold out, with Russia potentially in a stronger position:
- Total production levels similar - last year Saudi Arabia was the world’s second largest producer of oil at 12m barrels per day and Russia was third with 10.8m - both after the US with 15m .
- Production costs similar – around $10 per barrel including capital expenditure and transport, ex-tax (per S&W Energy team’s estimates). Russia has benefitted by the recent Ruble’s devaluation and its flexible oil taxation, decreasing significantly as prices fall.
- Foreign exchange reserve levels similar, though Russia better off – Saudi’s $502bn vs. Russia’s $562bn including a $150bn national wealth fund sourced from surplus oil revenues since 2017 – war chests to draw on in the coming months or years .
- Fiscal break evens – Russia has the upper hand – Saudi Arabia requires an oil price of $83.6 to balance current spending while Russia would need $42 per barrel .
The real losers are smaller OPEC members with a combination of weaker economies, a heavier reliance on oil, and higher production costs (e.g. Algeria, Iran, Libya, Nigeria), and US shale. The US shale revolution has flooded the market in recent years leading to the US becoming the largest oil producer in mid-2018 – negatively impacting on OPEC’s and Russia’s previous dominance in the commodity. Costs of US shale production range between $25-90 per barrel  depending on the site, meaning that many shale operations are already uneconomical and are shutting down. That said, cash operating costs for existing inventory are much lower, leading companies to continue pumping in order to service high debt levels. This situation can persist for a year or two before well decline rates start to have a material impact.
Closer to home, oil & gas majors such as BP and Royal Dutch Shell have been battening down the hatches to weather out the storm. The focus of these companies has been to maintain their dividends as they appreciate that this is why the majority of their shareholders hold their shares. Plans include:
- Cutting capital expenditure plans and pushing back projects;
- Suspending share buybacks;
- Increasing credit facilities to safeguard dividends; and
- Paying scrip dividends in lieu of cash.
Royal Dutch Shell has been on the front foot in announcing various measures, with BP following suit, while also highlighting their extensive actions from a humanitarian perspective. Global peers are acting in a similar vein to varying degrees.
Looking forward, the Smith & Williamson Energy team does not expect a near-term sharp oil price recovery unless Russia and Saudi Arabia settle their dispute. The decline of US shale could, perhaps, be a catalyst for positive change as both parties would see a weakening of the market share of the US as a long-term victory, ultimately lowering global oil production. Otherwise it will likely be the longer-term forces of returning demand and depletion of the stockpiles that Saudi and Russia are releasing that will help prices revert back towards the marginal cost of production. Meanwhile, the Smith & Williamson Energy team is focussing on the strength of balance sheets of the oil majors, their ability to sustain their dividends, and the market valuations of their shares.
Finally, it is important to consider the effect these events will have on the ongoing “energy transition” from oil to renewables. With oil prices at these lows, renewables are less attractive and oil majors have shifted their focus to defensive action rather than evolution. However, this chapter is another reminder of the importance of the oil price and may encourage government investment into less-dramatic renewable energy, especially if US shale’s long-term viability is called into question.
 – Reuters 01/04/20
 - https://www.ft.com/content/e87d9f10-cb16-42af-a4dc-6f8ffc725048?accessToken=zwAAAXEq7PbokdPofZ8QyxZCr9Ok3G-P_HJQSA.MEUCIQD7tp5T30L4haL-ywCEAOJ0cUHTrS9hBu_Scjc5nQhmWQIgKkgM62U5TJKPLwlbhyleWIYCkuTJrS_cq6kNy2-ivNk&sharetype=gift?token=89942bcd-ba3e-4ac3-924a-ccf2ebd64095
 - https://www.eia.gov/international/data/world#/?pa=00000000000000000000000000000000002&c=ruvvvvvfvtvnvv1vrvvvvfvvvvvvfvvvou20evvvvvvvvvvvvuvo&ct=0&tl_id=5-A&vs=INTL.57-1-AFG-TBPD.A&vo=0&v=H&start=2019&end=2019
 - http://data.imf.org/regular.aspx?key=61280813
 - https://data.imf.org/regular.aspx?key=60214246
 - https://www.bloomberg.com/news/articles/2018-12-26/russia-s-oil-bosses-and-officials-brush-off-oil-price-drop
 – S&W Estimates, company data
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