International Policy Digest

Miramax
World News /06 Apr 2020
04.06.20

Russia-Saudi Oil War had the Worst Timing

Vladimir Putin has declared war against the U.S. shale oil industry. Shunning an alliance with Saudi Arabia in limiting the production of oil on the world market, Russia has embarked on a course of action that may mean the end of Vladimir Putin’s reign and bring Russia to the point of economic collapse.

With the collapse of the agreement between Saudi Arabia and Russia to limit oil production at the March 5th OPEC+ meeting in Vienna, an oil war has begun initiated by Russia, which is being exacerbated by the worldwide outbreak of COVID-19. The Russian objective is clear, the destruction of the U.S. shale oil industry. Russia feels that the agreement with Saudi Arabia and OPEC limiting oil production has allowed the shale oil industry in the United States to thrive, and capture market share at the expense of the Russian oil industry. Buoyed by its sovereign wealth fund, with an estimated value of $150 billion, Russia feels that it has the financial reserves to survive an oil war with Saudi Arabia.

The shale oil revolution in the United States

The shale oil revolution in the United States was aided by the unique characteristics of the U.S. economy. One of these characteristics is that the owner of any piece of land where there are minerals, the rights to these minerals belong to the individual, or corporation, that owns the land. In the rest of the world, governments own the mineral rights and so the development of mineral wealth is done by government rules and regulations which normally slow the development of mineral rights and slow the creation of wealth. The United States actively promotes the development of mineral wealth through the use of favorable laws and regulations that provide a stable and orderly development process.

Shale oil production in the United States has a long history of starts and stops in its commercial history. It was not until 2011 that the current shale oil boom led to increased efficiencies in extracting oil from shale and made it profitable enough to lead the United States to energy independence. When oil prices rose to $90 a barrel in 2011, combined with historically low-interest rates, independent oil companies bet big on shale oil, and won. When Saudi Arabia and Russia realized that U.S. shale oil was a threat to their business model, they opened up their production of oil to drive the U.S. shale producers out of business beginning in 2014 to 2016. U.S. shale producers responded by investing in new drilling processes, became ruthlessly efficient and increased output which allowed them to achieve economies of scale that sharply cut business costs. While U.S. shale producers experienced a drop in profits, they were able to survive. Since both Saudi Arabia and Russia depend on oil revenue, in September of 2016 OPEC+ changed tactics and began to cut production in order to increase the price of oil. Because of this change, U.S. oil shale producers expanded production and in late 2019 the United States achieved energy independence.

Russia’s power play in oil and the economic consequences

In early March 2020, Vladimir Putin, egged on by the head of Rosneft’s Igor Sechin, whose nickname is “Darth Vader” refused to continue cutbacks in the production of oil with the goal of destroying American oil shale production capabilities. Riyadh angered by Russia’s refusal to support prices by oil production limitations the next day announced its intentions of bringing Russia back to the agreement by flooding the world market with Saudi light sweet crude. The Saudi maneuver immediately had an effect on the Russian ruble causing a drop of 20% and bringing the Russian ruble to an exchange rate of 80 rubles to 1 American dollar.

Russia’s finance minister, Anton Siluanov, is confident that Russia, with its National Welfare Fund with an estimated value of $150 billion, at the beginning of the “oil war,” would allow Russia to weather the loss of revenue for a maximum of 4 years. In addition, Russia has some $551 billion in currency reserves. However, with the advent of COVID-19, and the subsequent meltdown of equity markets worldwide, the amount of wealth in Russia’s sovereign wealth fund is unknown. However, with Russia’s estimated GDP of $4.2 trillion in 2017, even by using its sovereign wealth fund reserves and foreign currency reserves in the oil war, which has been complicated by the worldwide slackening demand for oil due to COVID-19, it is doubtful that Russia will be able to forgo the revenue it depends on for the funding of its government expenditures.

With oil revenues making up 52% of the Russian budget (with the current cost of Urals oil $18.30 a barrel, down from a high of $52 a barrel), this would mean a much larger drain of wealth from Russia’s sovereign wealth fund. Accounts Chamber of Russia head Alexei Kudrin has said that Russia may need to ramp up spending with an additional 5% of its GDP, roughly $70 billion a year to combat the effects of COVID-19 in Russia. Presumably, this would come from Russia’s foreign currency reserves. In addition, especially with the meltdown of equity wealth worldwide, the amount of money available from the Russian sovereign wealth fund will be much less than planned for.

With the average Russia citizen already unhappy with the state of Russia’s economy, and with the economic costs associated with the dramatic drop in the profitability of its oil revenues, it is highly probable that Russia will experience significant civil unrest as the standard of living of the Russian people continues to decrease.

The American response

Faced with the loss of support from the oil industry in an American presidential election year, it is hard to imagine President Trump not moving to mitigate the damage being done to the U.S. shale oil industry. President Trump has already announced plans to purchase oil from the U.S. domestic shale oil industry to fill up the U.S. Strategic Oil Reserve which would amount to 77 million barrels. In addition, the domestic U.S. oil industry is pressuring President Trump to impose a tariff on Saudi Arabian oil to protect the U.S. domestic market. Given that the ultimate objective of both Russian and Saudi Arabian oil producers to crush domestic shale oil producers in the U.S., it would seem that this would be a logical response to the deliberate flood of oil onto the world’s market in order to maintain U.S. energy independence with minimal damage to the U.S. economy.

Additionally, the increased use of natural gas for electricity generation will support the price of shale oil in the U.S. A byproduct of fracking is the release of millions of cubic feet of natural gas. When oil shale is released as a result of fracking, natural gas is released as well. Because the natural gas released is a by-product of fracking, the cost of drilling for natural gas is essentially free. Since it is difficult to store natural gas, much of the natural gas freed during the fracking process is flared (burnt off) at the site of the fracking well. Even with flaring, over 300 electrical generation plants have been closed and replaced with electrical generation plants using natural gas as a power source. Not only is natural gas cheaper than coal, it is also much more environmentally friendly than coal. So instead of drilling for oil, energy producers will make natural gas their moneymaker, making shale oil a by-product which unlike natural gas can be easily stored and later resold when prices are higher.

The political consequences for Russia and Saudi Arabia

With both Russia and Saudi Arabia depending on the sale of oil to finance their respective governments, the consequences for each country could mean the end of their respective forms of government.

For Russia, with an economy still suffering from sanctions related to its seizure of Crimea in 2014, further economic stagnation has the danger of igniting a further wave of resistance from the Russian people already angry over the reductions of social benefits and a raising of the retirement age from 60 to 65 for men and from 53 to 60 for women.

Part of Putin’s popularity has rested on his pledge of raising the standards of living of the Russian people and restoring Russian prestige worldwide. With plunging oil prices and Russia’s expensive foreign adventurism in the Middle East, the current regime in Russia will face domestic pressure on maintaining the current standard of living in Russia already in decline. Russian history is replete with historical lessons on what happens when the people of Russia lose patience with their leaders during times of economic decline and unrest.

For Saudi Arabia, the consequences for the House of Saud could be more devastating. Saudi Arabia depends 100% on the profits from its oil sales to fund its government and the welfare state it has created with the proceeds from oil sales. For Saudi Arabia to meet this need, and to balance its budget, Saudi Arabia needs oil to be at $80 a barrel. With Brent crude prices at $34.11 a barrel as of April 3, 2020, the Saudi regime faces a shortfall of $47.89 a barrel. This is having a devastating effect on the Saudi economy, and eventually, the economic crisis will bleed into the political scene.

Unless the Russians and the Saudis find some means of ending this insane oil war, both countries political systems may implode, leaving the United States as the largest oil and natural gas producer in the world.