Supply, demand, domestic power struggles and geopolitics
The markets have been reacting violently to the sudden weakness in the oil price. West Texas International (WTI) is down 48% from the level of $61 per barrel, where it started the year. Brent’s fall has been very similar. The reason? Surprise. In an industry replete with insider discussion around the internal politics of OPEC, the fallout between Saudi and Russia, and Saudi Aramco’s announcements of increased production as well as discounts caught most market participants cold.
The confrontation is being billed as Saudi versus Russia, but they both want to knock out a common irritant: US shale oil producers, who they feel have had a free ride while the two heavyweights have taken the pain of price stabilisation.
Who is most affected?
There are three ways to look at that – who produces the most, whose economy is most dependent on oil, and who is most hurt by low oil prices.
Oil is important to all the countries on the above chart, but for Saudi Arabia, oil accounts for 77% of exports1, so it is absolutely crucial. Russia is a significantly more diversified economy, so although for Moscow oil is important, including refined product, it is 52% of exports2. This is a function of the sanctions regime that was tightened in 2016, when the number was 48%3.
Logically, it also matters who your biggest buyers are. For Saudi, it is China (17%), Japan (15%) and India (11%). For Russia it is the EU (52%), China (11%) and the US (4.5%). Arguably the havoc wreaked by COVID-19 could well be a factor in Chinese buying, although all buyers will naturally be opportunistic short term, taking the Saudi discounts to fill inventories.
In terms of each country’s breakeven price, Saudi still requires $88.6 per barrel4 in order to achieve a fiscal breakeven. Russia has spent a long time readying its sovereign financials and its fiscal breakeven point is commonly estimated at $42/bbl5.
Saudi Arabia – high stakes poker
The turbulence was precipitated by Mohammed Bin Salman, known widely as MBS, the anointed heir to King Salman bin Abdulaziz. Having failed to convince Russia to reduce production further, in order to support the oil price, he went off the established patterns of behaviour. Saudi Aramco announced increased production to 12.3 million barrels per day (an increase of 2.5mbpd, probably out of inventory) and offered discounts of $6 to $8 per barrel for April deliveries, thus causing a collapse in Brent to around $30 per barrel. It is a fight for market share, in the face of weakening global demand, not least because of COVID-19.
Saudi Aramco’s own disclosed cash flow sensitivities suggest that for every $1 move in the per barrel price of crude, there is a $1.5bn move in cash flow. In terms of production, every 100,000 barrels per day of additional production equals $1.1bn of cash flow. So, if we assume an average price of $45 per barrel and production going to 12 mbpd, that will only cover $10 of the per barrel price reduction.
Saudi is the dominant driver of OPEC, as the country with (we have long believed) the deepest reservoirs of crude oil and the biggest swing producer in the world. It accounts for around 13% of the world’s production6. However, the Kingdom’s budget statement for 20207 lays out the expectation of a budget deficit of $49bn or 6.4% of GDP, based on the assumption of a $55 per barrel oil price in this year.
All in all, this situation is coming at a difficult juncture for Saudi, which raises the stakes significantly.
As a rule of thumb, a $10 per barrel move in the oil price percolates through to a $20bn swing in the Kingdom’s revenues, so a $30 per barrel implies a deficit closer to 19% of GDP. The Saudi Arabian Monetary Authority has around $500bn8 so in the worst case, the Kingdom can hold out for three years. There is an added aggravation – the power struggle within the Saudi royal family. By anointing his son MBS, the King effectively broke with the long-established tradition of consensus, which would have passed the throne on to the next senior, in this case his nephew, the experienced, widely respected ex-Crown Prince Mohammed bin Nayef. This unilateral move, along with MBS’s actions to consolidate power have upset many in the ruling family, leading to speculation about the eventual succession. The international fallout over the war in Yemen and the murder of dissident Jamal Khashoggi in Istanbul have not been helpful.
This is relevant because at the same time as the change of tactics on oil was being implemented, authorities arrested Prince bin Nayef and the King’s younger brother, Prince Ahmed bin Abdulaziz on suspicion of working to block MBS’ accession to the throne. The key element here is that there remains a significant faction of wealthy, disenfranchised royals with their own support structures that need to be reconciled, potentially undermining the long-term sustainability of the leadership.
All in all, this situation is coming at a difficult juncture for Saudi, which raises the stakes significantly. Perhaps unsurprisingly, Saudi Aramco shares are below the IPO price for the first time.
Russia needs to win this one
Russia has consistently been one of the world’s largest producers of crude oil, accounting for 12% of the world’s production9 and historically has remained fiercely independent of OPEC, in spite of many invitations to join. In a context of sagging oil prices and a vacuum left in the Middle East by the withdrawal of the US, the Kremlin saw an opportunity and intervened in the Syrian civil war and drew closer to Riyadh, as both saw a common foe in the Islamic forces lining up against the Damascus government.
The Kremlin is well aware of its own vulnerability. Russia is a predominantly resource based economy constrained by sanctions, with a large working population that is educated, but not growing. That’s why it has built a robust macroeconomic moat around itself. The country has very low external debt (28% of GDP10) and its reserves are equal to 1,078%11 of short-term debt. For reference, the UK’s reserves are at 3.1% and the USA’s at 2.1%.
The country’s National Wealth Fund now stands at $125bn12 but the Bank of Russia’s reserves are $570bn13 All the indications are that the Kremlin is ready for the fight. The sovereign financials are strong, it is a diversified economy with a population which has earned a reputation of social resilience.
And the recently announced proposals to change the constitution in order to allow Putin to remain president until 2036 look to be a signal to MBS – I’m not going anywhere!
US Shale oil producers – in a tight spot
The revolution in the US oil industry driven by shale technology has propelled production to world leadership in a few years. The production boom has been enabled by the availability of cheap finance and benefitted from the OPEC/Russian production cuts over the last three years. So, it is only natural that they have become an irritant to both the Saudis and the Russians, although no one has explicitly said so yet.
The nature of shale oil production is very different from conventional oil production. Traditionally, fields take a long time to hit peak production and can be carefully managed, to last 30 or 40 years. Once a shale well has been ‘fracked’ (hydraulic fracturing, the technique employed to break the underground rock and enable access to the trapped reserve), the field hits peak production in months, but also depletes rapidly.
From a financial investor standpoint, this is good, because the upfront costs should be swiftly recovered as production soars and thereafter free cashflow drives dividends. That is one of the reasons for the sector’s popularity with investors in the early 2000s. However, CEOs and their management teams are typically incentivised to demonstrate growth, which can only be done by way of drilling more wells. The costs of a well can be $10-$12 million, so this is not a cheap exercise and the complexity of the local geology can imply the need for many fracking operations in a relatively reduced acreage.
So, in 2014-16, the weakness in the oil price forced many small shale operators out of business but the sector became more efficient. As an indicator, shale breakeven is now estimated between $48 and $54 per barrel, well below the $80+ of 2014. However, the easy availability of cheap finance has meant that companies have not generally chosen to manage their deposits for free cash flow – rather they have pursued growth. So many investors are unhappy, and it is now a sector with relatively few friends.
this time things look worse – many companies are more extended, with even Investment Grade companies exposed.
In the US corporate bond space, we have a precedent when default rates in High Yield energy names hit 20% in 2016; but this time things look worse – many companies are more extended, with even Investment Grade companies exposed.
The table below from Haynes and Boone’s Oil Patch Bankruptcy Monitor (Jan 2020) demonstrates the scale of ‘hit’ taken already by the sector. Nearly 200 bankruptcy filings in the four years to end 2019, still leaving a total of over $120bn of debt outstanding, of which nearly $60bn is unsecured. The three biggest states affected are Texas ($68bn), Delaware ($25bn) and New York ($20bn)14.
The rapid increase in debt levels shown below speaks to the focus on growth rather than returns in the context of cheap debt. If oil prices remain below $45 per barrel for a year, the rate of bankruptcies in the sector will rocket.
Source: Haynes and Boone, LLP Oil Patch Bankruptcy Monitor report
What is US shale breakeven?
In terms of fundamentals, each well in each shale region is different, but according to the US Energy Information Administration15, at $30 per barrel, 50% of the technically recoverable resource is uneconomical.
Maybe this is a report that was being read in Moscow and Riyadh, because it finds that until prices fall below $60 per barrel, the reserve elasticity is only 0.5, implying that for every 1% reduction in prices, only 0.5% of the reserves become uneconomical. Below $60, elasticity is greatly increased.
The conclusion is that prices must reach relatively low levels before the volume of reserves begins to shrink in a substantial way.
As can be seen in the chart above, borrowing costs were already going up for US shale companies – even before the price war was launched, generally over leveraged companies with minimal or even negative free cash flow are being offered 10% as a cost of financing. Russia is at 2.56% and Saudi at 2.38%. Even the big integrated oil companies with robust balance sheets will be pressured by this potentially ugly trench war.
The OPEC alliance with Russia was always going to be a temporary one and we seem to have reached the end of the road in a less elegant way than we are accustomed to. The rude awakening will probably be felt immediately in the US upstream sector, where the stressed balance sheets finally give out. Longer term, banks that are highly exposed to the sector will get marked down as will the municipal issuers in oil sensitive US states. On a global basis, this will clearly hurt the high cost producers like the UK (average lifting cost of $52.5 per barrel16).
In many ways, the rest of the world is now contemplating their good luck or their misfortune, as almost everyone will be impacted. Mexico is unfortunate, as the benefits of their oil price hedge and the mechanism which allows the government to delay implementation of the new lower prices at the pumps are completely swamped by the negative implications for Pemex. The company lost $18bn last year and loses around $2bn in free cashflow for every $10 move in the oil price. The starting point for Pemex is -$9bn of free cash flow in 2019. A downgrade of the company’s credit rating to high yield would raise the cost of financing and impact the sovereign as well, in spite of Mexico’s status as a net oil importer.
Elsewhere, Colombia is dependent on oil and suffers from weak sovereign financials as well as the weight of around 1.5 million Venezuelan refugees and the government’s attempts to integrate thousands of ex-Marxist guerrillas in accordance with the terms of the recent peace deal. The country is clearly in danger of a downgrade.
Medium term, China is the biggest beneficiary – as the country comes out of the COVID-19 induced downturn, it gets the gift of seriously cheap oil, helping speed the recovery. South Korea, another big importer sharing the economic pain of dealing with COVID-19 and Japan, potentially joining them very soon. For countries like Turkey and India, both struggling economically and with leaderships that are under pressure, this could be a tremendous boon. If these low oil prices are sustained for a year (and clearly there are many reasons to believe they are not), the world may well be the biggest beneficiary as economic growth falters in the coming months. Short term, refining companies will have a field day.
1World Bank database https://data.worldbank.org/indicator/TX.VAL.FUEL.ZS.UN?locations=SA
2World Bank database https://data.worldbank.org/indicator/TX.VAL.FUEL.ZS.UN?locations=RU
3World Bank database https://data.worldbank.org/indicator/TX.VAL.FUEL.ZS.UN?locations=RU
4IMF Statistics https://www.imf.org/en/Publications/REO/MECA/Issues/2019/10/19/reo-menap-cca-1019 Statistical Appendix
5IMF Article IV Consultation https://www.imf.org/en/Publications/CR/Issues/2019/08/01/Russian-Federation-2019-Article-IV-Consultation-Press-Release-Staff-Report-48549
6BP Statistical Review of World Energy 2019 https://www.bp.com/content/dam/bp/business-sites/en/global/corporate/pdfs/energy-economics/statistical-review/bp-stats-review-2019-full-report.pdf
7 KSA Ministry of Finance https://www.mof.gov.sa/en/financialreport/budget2020/Documents/Bud-Eng2020.pdf
8Saudi Monetary Authority annual report 2019 http://www.sama.gov.sa/en-US/EconomicReports/AnnualReport/Annual_Report_55th-EN.pdf
9BP Statistical Review of World Energy 2019 https://www.bp.com/content/dam/bp/business-sites/en/global/corporate/pdfs/energy-economics/statistical-review/bp-stats-review-2019-full-report.pdf
10Martin Currie proprietary country risk framework, World Bank and Central Bank of the Russian Federation 24/01/20
11Martin Currie proprietary country risk framework, World Bank and Central Bank of the Russian Federation 24/01/20
12Ministry of Finance https://www.minfin.ru/en/key/nationalwealthfund/statistics/?id_65=104686-volume_of_the_national_wealth_fund
13Central Bank of Russia https://www.cbr.ru/eng/
14Source: Haynes and Boone, LLP Oil Patch Bankruptcy Monitor report
15US Energy Information Administration, The Price Elasticity of U.S. Shale Oil Reserves https://www.eia.gov/workingpapers/pdf/elasticity_shale_oil.pdf
16Statista and Rystad Energy https://www.statista.com/statistics/597669/cost-breakdown-of-producing-one-barrel-of-oil-in-the-worlds-leading-oil-producing-countries/
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