Understanding the Oil War between Russia and Saudi Arabia

Understanding the Oil War between Russia and Saudi Arabia, Oil WarOver the past six years, domestic crude oil has experienced a volatile ride. 2014 saw the emergence of American shale as producers were attracted to the $114 price levels. However, in 2016 the price for a barrel eventually fell to $27 as a global supply glut developed. 2016 also saw Russia and Saudi Arabia form an oil pact that drew together Russia and OPEC, leading to the so-called OPEC+ to navigate the global oil market. This agreement would eventually culminate into the current crude oil tensions that exist between Saudi Arabia and Russia.

Through the early 2000s – up until the financial crisis of 2008 – increasing global demand accounted for the rising price per barrel of oil. After reaching a high of $147.27 the week of July 7, 2008, the financial crisis’ effects brought the price of West Texas Intermediate Crude down to a low of $32.98 in December of 2008, according to the U.S. Energy Information Administration. However, with the economy recovering through 2009, the price of WTI crude oil rose to the high $70s and low $80s.

After the world emerged from the financial crisis, world oil markets were rocked by geopolitical tensions from the political revolution in Egypt during January 2011, spiking the price of crude oil to $100 a barrel. Prices stayed in the $90 to $100 per barrel range, until the end of 2014. With increased production in North America, reduced demand from emerging economies and increased storage of crude worldwide, the price per barrel of crude oil in 2016 traded in the low $30s per barrel. The price of oil fell because Saudi Arabia attempted to flood the world market with excess oil to lower the per-barrel price to bankrupt the emerging U.S. frackers.   

In reaction to the low oil prices, OPEC and its non-OPEC oil-producing countries agreed to reduce their total output by 1.8 million barrels in December 2016, taking effect in January 2017. After OPEC reversed itself and increased output in June 2018, it again cut output for 2019. The price of WTI rose to the mid-$70s by October 2018, which can also be attributed to a drop in Venezuela’s oil production, and the re-introduction and increase in severity of sanctions against Iran.

A November 2018 report by the U.S. Energy Information Administration (EIA) relayed that the U.S. produced 11.3 million barrels in August 2018. With the report’s news, additional Russian oil production and even some OPEC countries producing more, it brought WTI down to $51 per barrel. Fast forward to March 2020, with the coronavirus sending shockwaves and diminishing demand, oil prices fell.

This led to a meeting in Vienna on March 5 for OPEC and its (+) or other major oil-producing companies throughout the world to discuss production cuts in hopes of increasing the price of oil. During this meeting, OPEC and its (+) members discussed whether to reduce production by 1.5 million barrels a day through the end of June 2020. OPEC asked Russia and those (+) members to cooperate with the production cuts. However, on March 6, Russia did not agree to reduce oil production. This immediately dropped the price of oil by 10 percent.

With the coronavirus pandemic beginning at the end of 2019, manufacturing and transportation decreased, reducing the global thirst for oil. Based on these events, the International Energy Association (IEA) announced in the middle of February that global consumption would fall to 825,000 barrels per day.

Russia said that reducing production was premature because it was and still is uncertain of how the coronavirus will affect global oil prices. Additionally, they cited political instability in Libya, where approximately one million barrels per day were expected to be offline from production.

In light of the unknown extent of the coronavirus pandemic’s impact on oil demand, Russia and its oil producers reportedly offered to maintain the existing 1.7 million barrels per day cut for the next three months that OPEC+ already had in place. However, OPEC didn’t agree to this offer.

Beginning on March 8, Saudi Arabia gave crude oil buyers discounts of between $6 and $8 per barrel to European, Asian and American buyers. This set a downward cascade of the price of oil, lowering Brent Crude by 30 percent and West Texas Intermediate by 20 percent.

Starting March 9, the drop in oil prices coupled with the global coronavirus pandemic exerted a major impact on world markets. Russia’s ruble dropped by 7 percent shortly thereafter. While the price of oil recovered a little after the impact, it set off a production war between Russia and Saudi Arabia. Beginning March 10, Russia began pumping an additional 300,000 barrels per day, and Saudi Arabia ramped up its production to 12.3 million barrels per day, up from 9.7 million.

Impact on Markets

These two factors led the Dow Jones Industrial Average to drop more than 1,300 points in pre-market trading on March 9, with the DOW ultimately falling 2,000 points during intraday trading. Along with NASDAQ falling by nearly 7 percent and the S&P 500 dropping more than 7 percent, global markets fared worse. This was evidenced by the Italian FTSE MIB Index losing more than 11 percent. 

Producer Implications

When it comes to how the crude oil war is impacting shale producers in North America, it’s important to note that prices of $40 per barrel must be sustained to keep producers afloat, according to consultant Enverus. However, production cuts are imminent at the bottom of the $30 a barrel price point, and there’s certainly no expectations of new oilfield development.

Based upon forecasts from the U.S. Energy Information Administration, May 2020 U.S. production of crude oil is expected to drop from 13.2 million barrels per day to 12.8 million barrels per day by December, finally leveling off to 12.7 million barrels per day in 2021.   

Much like the volatility going on with the coronavirus pandemic, global markets are also expecting further volatility for the world’s energy market.

Coronavirus: Black Swan or Buying Opportunity?

According to the World Economic Forum (WEF), the spread of the coronavirus will impact the world’s economy. Whether it’s a Reuter’s poll from economic experts projecting growth in China slowing to 4.5 percent in Q1 of 2020, in contrast to China’s Q4 GDP of 6 percent; or the International Energy Agency (IEA) saying world desire for oil will be lower due to the coronavirus; or global companies reducing or temporarily closing their Chinese factories, change is on its way. Based on this data, what does the global economic outlook entail?

In order to understand how the coronavirus might impact global economies, it’s important to put this in context of other global events. Based on a February 2020 Monetary Policy Report from The Federal Reserve, there’s a mixed outlook for recent and projected economic activity. While the Fed notes that oil prices have increased over the past six months of 2019, in part due to OPEC members cutting production and brief tensions with Iran in January 2020, The Fed attributes more recent drops in oil prices to the coronavirus and associated lowered global demand.

Due to China’s already slowing economy, the IEA is projecting 435,000 fewer barrels of oil on an annual basis during Q1 of 2020, the worst in a decade. Looking at statistics from the United Nation’s International Civil Aviation Organization (ICAO), airlines are expected to see revenue losses of between $4 billion and $5 billion in the first three months of 2020. With the coronavirus impacting China, thereby reducing outbound travel to Japan and Thailand, losses could be as big as $1.29 billion and $1.15 billion for each respective country.  

The Fed explains that in 2019, manufacturing has been challenged both globally and domestically. Citing the industrial production (IP) index, the first six months of 2019 saw declines in both domestic and global activity. For 2019, U.S. production dropped by 1.3 percent for durable and non-durable goods. This is attributed to trade issues with China, soft economic growth worldwide, less than aggressive investment from businesses, declining oil prices that lower continued production by crude producers and production issues with Boeing’s 737 Max airplanes.

However, despite the manufacturing slowdown in China, the United States’ manufacturing base shouldn’t see the same impact from the coronavirus. The Fed says that factoring in purchasing materials for production on the input end, and transporting, wholesaling and retailing products post production, the drop of 1.3 percent on the industrial production index equates to a 0.5 percent drop in U.S. GDP. For context, compared to the U.S. manufacturing employing 30 percent of workers 70 years ago, it presently employs 9 percent of workers.     

One way to see how the coronavirus might play out is to look at how SARS impacted China in 2003. Based on data from the National Bureau of Statistics in China, it took three months, during Q1 of 2003, where China’s economic growth dropped to 9.1 percent, from 11.1 percent. While a much smaller economy, on a global scale, in future quarters China was able to grow at an annualized rate of 10 percent, per Refinitiv. However, economists note that if SARS didn’t impact China, there could have been another 0.5 percent to 1 percent increase in annual growth.   

Another comparison with SARS is China’s retail sales. Refinitiv shows that May 2003 retail sales dropped to 4.3 percent. This is compared to between 8 percent and 10 percent for retail sales figures in March 2003 and July 2003, showing how serious the impact SARS made, but also China’s resiliency.

While the Chinese economy impacts the global economy today more than when SARS hit, it also has a more responsive economy and a larger middle class. Only time will tell as to the coronavirus’ impact, but based on past experience, it should only be a matter of time before China’s (and the global) economy bounces back to greater economic output. 

How Will 20-Year Treasury Bonds Impact the Economy?

According to a Jan. 16 press release from the U.S. Department of the Treasury, within the first six months of 2020, the federal department will begin issuing a 20-year Treasury bond. This is the U.S. government’s attempt to maintain and support the federal government’s ability to borrow into the future. This action will also have an impact on the markets going forward, especially when it comes to the Federal Reserve and its monetary policy.  

The Federal Reserve’s many purposes include promoting stability and growth in the economy by keeping prices stable and healthy employment levels. The ways The Fed does this is by influencing short-term interest rates, being active in Open Market Operations (OMO) and impacting reserve requirements.

The Federal Reserve Bank of St. Louis details that along with providing banks with loans from the federal funds market to support adequate reserves and liquidity, it’s important to understand how Open Market Operations function.

Much like individuals and institutions can buy or sell securities, The Fed can buy or sell securities, including U.S. Treasury bonds. The buying and selling are the operations portion. The open market refers to the fact that The Fed doesn’t transact directly with the U.S. Treasury, but works on the open market via auctions through the Trading Desk of the New York Fed.

Assuming there’s a modification to the federal funds rate’s target range by the Federal Open Market Committee (FOMC), the directive starts the reaction to either purchase or sell government securities to meet the new target. The OMO is one way the Fed adjusts its two-pronged mandate of promoting employment and maintaining target inflation.       

If the Fed wants to stimulate the economy, it can do so through Treasury bond purchases. This occurs when the Fed makes a deposit into the seller’s bank account via the Trading Desk. This purchase increases the reserve balance of the bank offering the Treasury bond for sale, which increases the bank’s ability and willingness to lend.

In the opposite scenario, the Fed can reduce the amount of money available that banks can use for lending. This time the Fed sells government securities, prompting banks to remove money from their bank accounts, reducing the amount available for lending. As pressure on the federal funds rate increases, rates will go up, making loans cost more for borrowers and incentivizing savings.

During the financial crisis, the FOMC engaged in quantitative easing (QE) after it brought the federal funds rate to near zero. This approach consisted of buying longer-term U.S. Treasury securities and mortgage-backed securities (MBS) through open market operations. As the St. Louis Fed explains, in exchange for the Fed buying these securities, banks receive a credit that increases their reserve balances above reserve requirements. While this was far more prevalent during the financial crisis, the 20-year U.S. Treasury bonds will undoubtedly make QE easier to re-engage in.

While the government may benefit from the direct investment and its ability for the Fed to guide the economy, there are a few potential risks for those who invest in U.S. Treasury bonds. Compared to many other investments, Treasury bonds have lower yields, which are even lower when inflation runs high. Another risk is that when rates rise, the value of the Treasury bond goes down, creating less attractive debt if the owner wants to sell it.

The Jan. 16 press release noted that more details on the 20-year bond will be available in the U.S. Treasury’s quarterly refunding statement on Feb. 5. Only time will tell the level of interest among investors and how effective this instrument will be in creating further cash flow for the U.S. Treasury.

How Will Oil Prices Fare in 2020 With Global Events?

When it comes to 2020 and energy prices, the world’s energy market will face many known and unknown variables. How and what types of events that will ultimately play out are unknown but, according to industry and government experts, there are some variables that are projected to lead to lower global prices overall.

Based on a Dec. 10 short-term energy outlook publication from the U.S. Energy Information Administration (EIA), there will be a mix of pushes and pulls on the price of crude oil and associated refining products. Market prices in 2020 for Brent crude oil is expected to average around $61, compared to 2019’s $64 average price per barrel. Looking at West Texas Intermediate (WTI) quotes, the EIA sees this type of crude settling, on average, at about $5.50 per barrel lower than Brent crude oil in 2020. The EIA bases its lowered price forecast on greater supplies of oil globally, especially in the first half of 2020. 

The agency’s data shows that in September 2019, America exported more than 90,000 net barrels per day of products from and crude oil itself. This is coupled with domestic export projections of 570,000 net barrels per day in 2020, in contrast to average net imports of 490,000 barrels per day in 2019.

According to EIA’s projections, U.S. crude oil production will grow by 900,000 barrels per day in 2020, compared to 2019’s production, resulting in 13.2 million barrels of daily production in 2020. This growth is compared to 2019’s production gains of 1.3 million barrels per day, and 2018’s 1.6 million barrel per day growth. The decrease in production, attributed by the EIA, is due to increased rig efficiency and well level productivity, despite the number of rigs dropping.

The EIA believes that OPEC and its “+” oil producing states will go beyond announced oil production cuts on Dec. 6, further cutting production through March 2020. The original cuts of 1.2 million barrels per day, announced in December 2018, have been modified to reducing production to 1.7 million barrels per day. The EIA expects the major global producers to keep production curtailed through all of 2020, due to increasing global oil inventories.

Fuel Standard’s Impact on Oil Prices

Through implementation of the International Maritime Organization (IMO), Jan. 1, 2020, is ushering in new standards for allowable levels of sulfur in bunker fuel. This fuel will be required to contain no more than 0.5 percent sulfur content, compared to current allowable levels of 3.5 percent of the bunker oil’s weight. In reaction to the new standards, the EIA expects American refineries to increase operations by 3 percent in 2020 versus 2019’s production. It’s expected to increase wholesale margins in 2020 to 57 cents per gallon, on average, with it spiking to 61 cents per gallon. This is compared to 45 cents a gallon in 2019.

The Federal Reserve and Oil Prices

According to the Dec. 11, 2019, FOMC statement from The Federal Reserve, there was no modification to the federal funds rate. They based their decision on a yearly measure for inflation, excluding food and energy, along with signs of continued economic expansion, including healthy job creation and continued high rates of employment. However, the Fed indicated that if its goals of fostering a growing economy, maintaining a healthy job market and a 2 percent inflation target fall short, it will take appropriate action to keep supporting economic expansion. Depending on the Fed’s action to lower, increase or maintain its rates, the price of oil would feel the impacts.

While there’s no telling how fiscal policy and geopolitical events will play out in 2020, it looks like the price of oil will head south.