HOTTER ON METALS: Panic as Saudi Arabia flexes its oil muscles

If global financial markets had been operating under a pervading sense of uncertainty due to the impact of the novel coronavirus (2019-nCoV), they now appear to be veering on panic.

Oil prices have suffered their biggest one-day collapse since the 1991 Gulf War following Saudi Arabia’s declaration of a price war on Russia through a shock move to hike oil production.

S&P Dow Jones Indices was forced to trigger a 15-minute trading halt to major United States markets this morning after an initial 7% decline, following a 5% fall in Japan's Nikkei and the move of many of Europe's indices, including the FTSE 100, into bear territory. Beneficiaries have been gold, the Japanese yen and Treasuries while the flight to safe assets kicked in.

The rout began last week, during the annual meeting of the Organization of the Petroleum Exporting Countries (OPEC). Saudi Arabia, a leading OPEC member, had been trying to get non-OPEC ally Russia to fall in line with a proposal to cut production by an extra 1.5 million barrels per day (bpd) from April through to year-end.

Russia rejected this on Friday March 6, leaving Saudi Arabia to flex its muscles and announce an increase in production that should push output above 10 million bpd from around 9.7 million bpd currently, with room to go as high as 12.5 million bpd. Saudi Arabia also said it would offer its crude at a discount to customers from April.

Riyadh’s goal: bring Russia in line with OPEC’s desires and highlight Saudi Arabia's position as the world’s largest oil exporter.

OPEC has meanwhile given no directive as to what will happen when current production quotas expire at month end, meaning the cartel’s nations will have free reign to pump as much or as little oil as they like.

The oil price response in an already coronavirus-hit market has been swift. Oil prices dropped over 30% from $41 per barrel (bbl) on Friday March 6 to a four-year low of $27.34 per bbl on Monday March 9, although have since recovered slightly. Brent crude and West Texas Intermediate are now trading at around $34 per bbl.

Who blinks first
With market expectations that oil prices will drop to the $20s per bbl range - and possibly even lower - the question now is who will blink first and how long will it take.

The oil price collapse was, ironically, the result of an attempt to shore up the market that went horribly wrong. Facing a demand shock concurrent with airlines, transportation and industrial activity slowing while the coronavirus spread, Saudi Arabia had been looking to lead OPEC to take out excess supply.

Russia’s argument was that the effects of the virus have not been fully played out, and that a production cut would have handed yet another lifeline to the US shale industry, whose break-even price is somewhere between $45 per bbl and $54 per bbl, analysts estimate.

There is also the imposition of US sanctions on Russian oil companies in February. Most recently on Rosneft Trading, a unit of Russia’s state-owned Rosneft Oil Company, along with the subsidiary’s president and board chairman Didier Casimiro, who continued to attract the country's ire.

Even more ironic is that Saudi Arabia's planned increase in oil production could potentially create a supply shock that will benefit the consumer, particularly China, whose economy could do with all the help it can get to shake off the negative effects of the coronavirus.

Breakeven oil
Of course, there’s only a limited length of time that low prices can continue before starting to seriously bite producers.

Saudi Arabia has a fiscal break-even oil price of $83.60 per bbl, meaning the minimum price per barrel that the country needs to meet its expected spending needs while balancing its budget is over 145% higher than current levels. In 1985, when the country dramatically slashed oil output and pushed prices down 67% to just above $10 per bbl in the space of a few months, it was a much lower cost producer and could afford to weather the financial effects.

The Kingdom’s OPEC allies are also suffering and likely to push to for the situation to be resolved. Iran, whose economy has been smashed under sanctions and is now struggling under the weight of the coronavirus, has, for example, a fiscal break-even oil price in 2020 of $194 per bbl, according to International Monetary Fund and other estimates.

Russia meanwhile has a much lower fiscal oil break-even price of around $42 per bbl, but that’s still above current oil price levels, suggesting the country’s ability to remain steadfast may be stronger than it appears.

Barring an emergency meeting, the next OPEC meeting is scheduled for Saturday June 9. In the meantime, the rout in financial markets looks set to continue with the knock-on effects being felt across the board. With coronavirus infection cases yet to peak outside of China and its effects on global economies still unclear, some much-needed confidence is in relatively short supply.

Andrea Hotter

ahotter@fastmarkets.com

Published

Andrea Hotter

March 09, 2020

16:30 GMT

New York