Saudi Arabia's bloated budget means it's not really a low-cost producer. That's why any race to the bottom will be difficult to win. In a war of attrition, the winner isn’t the force with overwhelming power, but the one with the greatest capacity to sustain damage.
The current price war in the oil market is little different. Brent crude fell the most since the 1991 Gulf War Monday, dropping 31% in a matter of seconds, after Friday’s OPEC+ meeting broke up in disarray and Saudi Arabia slashed its crude prices and promised a surge in output.
That decision to open the spigots may seem contradictory from a country that just days ago was trying to coax Russia to join a 1.5 million barrels-a-day production cut. What’s happening, though, is really just a change of tactics. While previously Saudi Arabia hoped to maintain its position and revenues in the oil market by encouraging cooperation between major players, it’s now betting that its best prospect is to do the opposite: Engage in a game of chicken with Moscow and the U.S. independent oil industry, and count on being the last player standing.
If done right, this approach can be devastatingly effective. The current crisis looks like nothing so much as Saudi Arabia’s decision to flood the oil market in 1985 after years of restraint. That event, as we’ve written, ultimately helped precipitate the fall of the Soviet Union.
Each of the major players has advantages and disadvantages right now. No one can produce oil as cheaply as Saudi Arabia: It takes just $2.80 to get a barrel out of an existing Saudi Arabian Oil Co. field, compared with about $16 for Exxon Mobil Corp. and more than $20 for Rosneft PJSC.
Overheads in this industry can be significant, though. That’s particularly the case with Aramco, which isn’t just an oil company, but an institution almost indistinguishable from the Saudi state itself.
Once you consider the dependence of the Saudi economy on oil production, the best complete measure of Aramco’s overheads is probably the price at which the country’s budget breaks even — and that’s a whopping $83.60 a barrel, which we haven't seen in more than five years. Russia’s fiscal breakeven is around half that at $42 a barrel, and after sharp improvements in recent years, commercial producers in America’s Permian basin are around the same level.
Of course, at current prices everyone’s losing. Brent dropped as low as $31 a barrel Monday, and should a prolonged price war set in, it could go lower still. That’s where we have to start thinking about all three players’ ability to endure pain.
After all, running a budget deficit isn’t the end of the world — indeed, it’s the normal condition for most countries. Credit markets can easily see a solid business through a patch of low prices as long as lenders expect things to recover, and the general risk-averse backdrop means that governments in particular can borrow cheaply.
The yield on Saudi Arabian government bonds maturing in April 2030 is currently 2.38%, and in spite of U.S. sanctions Russian 10-year bond yields touched a record low of 2.56% last week. Thanks to the slump in Libor, investment-grade energy debt in the U.S. is also quite cheap, with option-adjusted spreads implying a rate of about 2.95% at present — but spreads for the junk debt that’s financed so much of America’s shale boom have surged, adding up to about 10.6%.
With everyone pumping below their breakeven costs, the winners and losers in this fight are likely to be decided by capital markets, rather than commodity markets.
That probably leaves U.S. producers most vulnerable in the near term. While oil-price hedges and investment-grade balance sheets can provide a cushion for low prices, shareholders have been falling out of love with crude producers for a while. In this environment, they’re unlikely to show much patience for the likes of Exxon Mobil and Chevron Corp. getting into trench warfare with the Russian and Saudi governments, and life will be even tougher for smaller producers with weaker balance sheets.
The bigger problem for Saudi Arabia is that even a withdrawal of shale production will leave the fragile truce it’s enjoyed with Russia in tatters, just as the prospect of a plateau and peak in oil demand looms ever closer.
Riyadh’s race-to-the-bottom strategy only worked in 1985 because it was the lowest-cost producer. Now, its bloated budget means that it’s one of the highest-cost and shakiest players. It remains embroiled in a costly and brutal military quagmire in Yemen, and on Friday arrested senior royals on the grounds they were plotting a coup.
More than four years after Prince Mohammed Bin Salman began the economic reforms that were intended to diversify the economy’s dependence on crude, the prospect of prices ever returning to fiscal breakeven levels looks even more remote. Even Saudi Aramco shares are now trading below their offer price.
Countries embarking on wars often expect they’ll be over in a few months, only to discover their opponents were stronger than they thought. Should this turn into a prolonged fight, Moscow is unlikely to be the first player to fold.
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