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Saudi Arabia’s pyrrhic oil war triumph

The kingdom may consider it has prevailed over Russia and US shale producers in the short-term, but its longer-term prospects are clouded in uncertainty

Riyadh has scored some impressive victories in the month-long oil price war it and Russia unleashed, and which has ended in a three-way truce of sorts, crucially also involving the US.

But analysts caution that any supply-side calm necessitated by the unprecedented global health and economic emergency—and oil demand destruction—posed by the Covid-19 pandemic may be fragile. It may be too early for Saudi Arabia to celebrate: continuing elbowing for market share, especially in Asia, is just one sign of ongoing challenges.

Outwardly, at least, Saudi Arabia appears triumphant. There are few more public ways to project an image than to buy a European football club, in its case a bid for England’s Newcastle United through the Saudi Public Investment Fund (PIF)—stealing a page from the playbook of both Russian oligarchs and some of its Mid-East Gulf neighbours.

“The Saudis can be said to have prevailed in this saga” Kalicki, Wilson Center

Perhaps more pertinently, Riyadh is also signalling its continued confidence in the oil markets by bargain-hunting for stakes in European oil majors. PIF has recently purchased as much as $1bn worth of shares in Shell, Total, Italy’s Eni and Norway’s Equinor, according to credible press reports.

“The Saudis can be said to have prevailed in this saga, because sharply reduced demand has forced the Russians to accept higher production cuts than what had been demanded previously, and will force the US shale patch to cut back considerably,” says Jan Kalicki, an energy security expert at the Wilson Center, a Washington-based thinktank. “Much lower production costs will always give the Kingdom greater leverage in this new triangular contest.”

Victory at a cost

The price impact, with its subsequent impact of Saudi state coffers, means it is a Pyrrhic victory at best. But the crash has brought Riyadh within sight of what it failed to do during the last price war it unleashed in 2014-2016: forcing the US shale industry to its knees.

Steep output cuts of at least about 2-3mn bl/d this year are already underway, according to US government figures, as producers are forced even to build make-shift storage tanks for unwanted oil they cannot evacuate. A significant chunk of even the largest US independents are threatened by bankruptcy, while the midstream, downstream and services sector are also braced for ongoing pain. 

“Saudi Arabia led the process, potentially establishing its leadership beyond the traditional ‘borders’ of Opec” Bianco, European Council on Foreign Relations

Recent Saudi output hikes and aggressive marketing have played a major role in the North American panic. Saudi exports totally c.40mn bl, or more than half the total capacity of the Cushing storage facility in Texas, is reportedly on its way to the US.

Victory over Russia has been more symbolic, but Russian producers—which could lose state subsidies in addition to having their profits slashed if crude prices stay low through next year—are also hurting. Moscow attempted to play hardball with Riyadh in early March by rejecting far more modest cuts, but in April was forced back to the table to agree to cut its output by c.20pc.

Russia’s concession, alongside the informal inclusion of smaller non-Opec producers such as Brazil and Norway within the pact, has allowed Saudi Arabia to reassert its global leadership in the geopolitics of energy, in one analyst’s view. “After almost two months of resistance, as many producers as ever joined the cuts and Saudi Arabia led the process, potentially establishing its leadership beyond the traditional ‘borders’ of Opec,” says Cinzia Bianco, Gulf research fellow at the European Council on Foreign Relations multinational thinktank. 

Covid challenges

Riyadh is not isolated from the epidemic: about 150 Saudi royals including the Riyadh governor are reportedly infected. The authorities are considering cancelling this summer’s Hajj, the annual Muslim pilgrimage to Mecca, a major non-oil source of income. The kingdom’s oil earnings projections are suffering just like those of all other producers: Saudi Aramco’s share price has in recent days declined by more than 20pc from its December 2019 highs. 

Weathering the crisis would require that Saudi Arabia lowers its spending: cuts of $13.3bn, or about 5pc of this year’s budget, have already been announced. Further tightening is widely expected and is likely to focus on some of its more ambitious projects related to its Vision 2030 programme. 

“Demand is unlikely to return to anything like previous levels” Stevens, Chatham House

The country needs to lower the fiscal, rather than commercial, breakeven price of its oil—that is, the price required for it to balance the state budget—which is currently north of $80/bl. As it stands, the Kingdom’s fiscal deficit is projected to more than double and borrowing is forecast to balloon. International bond markets are gearing up for a potentially unprecedented Saudi issue that could top the $50bn mark.

For now, though, Riyadh can afford to strut in the role of last man standing. It has a comfortable $500bn stash of foreign exchange reserves, slightly smaller than Russia’s, but with only a quarter of the population.

Whatever semblance of domestic opposition ever existed, mostly within the royal palace, has been neutralised with the arrests last month of two high-ranking princes who have been charged with treason. While the 84-year-old Saudi King Salman and the younger Crown Prince Mohammed bin Salman (MbS) may have retreated into seclusion on Covid-19 infection fears, there are few credible immediate threats to their rule, domestic or international.

Devil in the long-term details

Saudi Arabia is also positioned for a time when oil demand for oil picks up again, which could happen as early as in a few months based on the most optimistic view of how the pandemic plays out. It has an advantage over Russia in that it can stop and restart production far more easily and cheaply, and an advantage over US shale producers that its output costs are just a fraction of theirs.

According to the Fitch credit ratings agency, it will have spare capacity of more than 2mn bl/d over its newly agreed production level. “If and when demand rises, Riyadh has demonstrated between March and April that they can quickly ramp up production,” agrees Bianco.

2mn bl/d+; Fitch estimate of spare Saudi capacity

But the new so-called Opec++ production cut deal is at least publicly predicated on these most optimistic forecasts—committing to reduced volumes only for the rest of the first half of the year. Many analysts, both energy expert and more macro forecasters, point to the possibility of a prolonged economic downturn with a considerably slower recovery of oil demand.

In mid-April, the IMF estimated that the ‘Great Lockdown’ could result in the worst recession since the Great Depression in the 1920s and 1930s. “Certainly demand is unlikely to return to anything like previous levels given the world faces a long and deep economic recession,” says Paul Stevens at the UK’s Chatham House thinktank. Such an outcome would make Saudi Arabia look far less like a winner. 

Compliance, always compliance

And striking a deal is one thing, implementation quite another. Russia, for example, faces a technological disadvantage in its harsh production environments that all but forces it to cheat. Its older fields require higher investments to maintain—for some reservoirs, if production stops, it may never restart again. 

“Saudi Arabia will be forced to absorb Opec and Opec+ (especially Russian) cheating if the deal is to survive”, says Stevens. “This means their production will be falling.” 

Saudi Arabia also has geopolitical liabilities, too, and can only afford so much to test the nerves of both of the world’s former superpowers at once, particularly given its ongoing tensions with Iran. US president Donald Trump has already threatened to block or slap tariffs on Saudi oil imports, including ships that are currently on their way. The Saudis may have to be consider carefully possible ramifications of trying to flood the US with cheap oil.

“[Saudi Arabia’s] gains have two major costs,” says Bianco. “The first is that relations with Russia and with the US come out strained. The second is that price did not recover nearly as far as the Saudis would need, indicating that they [have still] massively miscalculated the impact of Covid-19.”

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