Crude oil benchmarks Brent and West Texas Intermediate, opened this morning at $33.5 and $27.3 respectively.

Since the fall in prices last month, last week marked a slight recovery in oil prices. This was perhaps a consequence of some hectic intervention efforts by US President Donald Trump, who has spoken with Russian President Vladimir Putin and with Saudi Arabia’s Crown Prince Mohammed bin Salman (aka MBS).

Tweeting in his signature farcical manner, Trump declared that he had brokered a deal between Russia and Kingdom of Saudi Arabia (KSA) to cut output by 10 to 15 million barrels per day (bpd).

-He followed this with another puerile tweet: “Could be as high as 15 Million Barrels. Good (GREAT) news for everyone!”

The Kremlin denied that President Putin spoke to MBS and the Organization of the Petroleum Exporting Countries (OPEC) meeting called by KSA, which was to be held via video conference today has now been postponed.  

The oil sector is in for some massive variations attributable to the ongoing global refractions. Three months into 2020 and the economy has been hit by a COVID 19 induced recession and a 66% fall in crude oil prices. In January 2020 ,oil was trading at $61-63 per barrel and within weeks fell to $20.9 per barrel. Beyond the coronavirus demand slump this current steep fall in oil prices is a result of a bitter price war between the KSA and Russia. 

The sight recovery in oil prices is a short-term phenomenon. The low demand for oil, will offset any reason for the KSA to back out in its price war with Russia. And it would be credulous to accept that Trump commands that kind of influence over either Russia or MBS to pressure them into a rollback of production. 

OPEC Plus’s deal collapse  

Since 2016, the Russians and Saudis were coordinating their production to keep prices elevated at around $50-$60 per barrel. As long as oil traded at these high figures, US shale oil producers were taking a free ride on OPEC plus’s cuts in production. Then on March 6, 2020 the three-year deal collapsed when Russia refused oil production cuts despite the coronavirus induced reduction in global demand.

Also read: Do Saudi Arabia, Russia Target US Shale Industry?

The very next day, KSA decided to cut its selling price and increase oil production to above 10 million b/d, with output in April likely to be near 11 million, up from 9.7 million in recent months. As OPEC crude oil production surges to 29.1 million b/d in the next quarter of 2020 the hardest it will be US domestic shale oil manufacturers.

Twilight for American Shale oil 

While a price war isn’t good for either KSA or Russia, it is calamitous for American shale producers. When American companies pioneered ‘Hydraulic fracturing,’ also called fracking it was believed that the US is now more capable of taking its energy future into its own hands. Fracking allowed American extraction companies to recover a staggering amount of oil from deposits that were formerly unworkable. In shale oil extraction the wells go thousands of feet down, and then also run thousands of feet horizontally to reach the target deposit.  After the drilling, millions of gallons of water, proppants and chemicals are pumped down into the well to literally ‘fracture’ the formation and allow the oil to flow back into the pipe to be pumped out. 

US shale oil production has grown from about 0.4 million b/d day in 2007 to a record 12.86 million b/d, the most monthly crude oil production in U.S. history in late 2019. But as a developing fuel source, the production and processing costs for shale oil are very high. Shale oil production remains profitable as long as the price of oil exceeds marginal cost. Most shale oil companies have a break-even point of $40 a barrel, but for some this break-even point rises above $60. Conventional oil production typically costs between $30 to $40 a barrel, but varies a lot.  At $2.8 per barrel Saudi state oil giant Aramco has the lowest production costs in the world. Up until OPEC and Russia were cutting supply to support global energy prices, US shale producers were free riding by boosting production and capturing the market share. 

Notwithstanding the massive production, the fall in oil prices combined with high fracking costs, have meant that American oil companies have struggled to make enough money to satisfy investors. Rampant bankruptcies among American shale production companies raise substantial doubts about the ability of these shale production companies to continue functioning. 

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Current market turmoil aside, the death of many shale companies was going to be inevitable. Even as the Trump administration was considering some type of financial help for the failing U.S. shale oil and gas industry there was opposition from the American Petroleum Institute (API) and the Texas Oil and Gas Association (TXOGA) the energy industry's most powerful lobbying groups controlled by Exxon, which prefers independents to go bankrupt, so that they can be easily acquired.

As one of the most capital-intensive businesses in the world financing problems for the shale oil and gas sector will only grow. And given that estimates of the stock of shale oil that can be recovered using current technology are subject to considerable error, sustained ongoing investment is subject to much speculation.

Furthermore, in the long run, demand for oil itself is uncertain as electrical generation gradually begins to fade out fossil fuels. Despite America’s optimism surrounding shale production its quest of energy independence is yet to be realised and it is far from being immune to foreign oil price shocks.

KSA will not cut back oil production 

As long as prices held up the US was not interested in cutting down production, because of the dividends it brought in terms of jobs,  low-cost energy for manufacturers and nearly $1 trillion in investment, mostly across shale regions which also happen to be major electoral battlegrounds. OPEC's higher output and reduced global demand means the call on US shale will fall 2-3 million bpd. The benefits US shale industry going belly up accrue directly to Riyadh and Moscow, so the notion of a US negotiation with OPEC and Russia on some sort of a global production cut faces enormous obstacles. 

Trump is under tremendous pressure to persuade KSA to cut back on production and bring some stability to oil prices. But this may be wishful thinking. With such low prices It might appear that MBS is risking draining Saudi coffers, but given the structural features of the oil market and the world’s inevitable transition to renewables, he probably sees no other alternative. Even before the ongoing price war, MBS has been signalling a change in strategy when in December 2019 KSA proceeded with the initial public offering of 1.5% of Aramco, which represents one way of monetising the upfront value of its oil reserves, while also signalling the shift toward maximising profit. 

Saudis have also reached an agreement with Kuwait, after years of dispute, over oil production in the Neutral Zone, which will allow production to increase by up to 500,000 b/d.

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In fact, with MBS in the driving seat indications are that KSA may also start running Aramco more like a profit-maximising international company, producing as much as possible. With a climate change fuelled a global push toward de-carbonisation and renewable energy the next couple of decades may be the only window to extract maximum value from oil. Saudi Arabia has no intention of making its reserves a stranded asset. None of this suggests that the KSA will slow down production soon.

US desperation to rope in Russia as an ally in the oil price war became evident when it announced that it would lift sanctions it placed on Rosneft earlier this year for trading with Venezuelan state oil company.  Russia has said that it is comfortable with oil prices in the range of $25 to $30 per barrel and estimates are that it can hold out at these levels for 6-10 years. It is less vulnerable to external shocks and turbulence in energy markets than most oil-exporting nations due to its massive forex reserves as well as a flexible exchange rate. The flexible exchange rate that allows its oil companies to collect revenues in dollars but pay their own expenses in rubles. Russia’s largest oil producer, Rosneft’s average lifting cost, which has fallen to just $2.50 per barrel of oil, which is cheaper than Saudi Aramco. 

Last week’s videoconference summit of G20 leaders did not include discussions about oil supplies and prices, despite US pressure on Saudi Arabia. Meanwhile the world’s free storage capacity is already running low in the environment of severely depressed demand. A growing number of refineries around the world are either curtailing operations or shutting down entirely as the oil market collapses. Indian Oil Corporation (IOC) slashed refinery runs and declared a force majeure on imports from key Middle Eastern suppliers including Saudi Arabia. While the coronavirus pandemic has ensured that there’s no demand for its oil right now, regardless of how cheap it is, the price war will actually pinch the US after the virus recedes and demands surge. 

For India, a strategic opportunity 

For every dollar the price of oil drops, India saves approximately $1.5 billion, but that is offset by the weakening Rupee.

Experts believe that domestic oil prices could potentially become cheaper and declining margin pressures on non-oil businesses may translate into some relief for the low demand weighing on the economy. For India the real benefit of low oil prices will come once the currency stabilises and the impact of the Coronavirus subsides. India must try to maximise benefit from the price war and top up its Strategic Petroleum Reserves (SPR).

There are plans to spend about $ 670 million to buy oil at around $30 a barrel, for its strategic reserves, drawn from Saudi Arabia and the United Arab Emirates. Without any suspension, the endeavour should be to fill the oil coffers for 30 days in the first phase, in the ultimate aim of building 90 days’ worth strategic reserves. 

Vaishali Basu has worked as a consultant with the National Security Council Secretariat (NSCS) for several years. She is presently associated with the think tank Policy Perspectives Foundation.

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