The Russian Shale Roulette

Image source: VASILIS VERVERIDIS © 123RF.com

The crude oil price war between Russia and Saudi Arabia has evolved from a standstill in negotiations over production to a game of Russian roulette. The players are competing for more significant market shares, and the future of the crude oil industry is left on the table to be divided between the players.

In this game, the players use increased production output instead of a revolver, and the falling price of crude is the bullet. Just like in classic game theory, the players take turns in ‘firing the revolver’ and hoping not to get killed by the bullet – the one who survives this game the longest wins.

Unsurprisingly to some extent, the US has also been dragged in this game, and its role has now changed from an observer and a moderator to an active participant with a sizable stake in the game – the US shale industry.

The price war began at the 178th Meeting of OPEC in Vienna when the finance ministers of the Organization's member-states failed to reach an agreement regarding the appropriate reductions in crude oil production. At that time, investors and traders were expecting the announcement of cutbacks to stabilize the jolted energy market, which was undermined as the coronavirus fallout was beginning to distort the global economy and the international supply chains.

Instead, Russia refused to ‘play ball’ at the parallel OPEC+ meeting, and the Russian Energy Minister Alexander Novak stated that his country would not be implementing such measures. This prompted a U-turn change in Saudi Arabia’s policy as the world's top exporter of the precious commodity announced that it would be boosting its own production.

These actions started the game of chicken, which has since then escalated into a full-blown price war. In the three weeks since the negotiations in Vienna stalled, the price of crude oil has plummeted by 25 dollars to 20 dollars per barrels, which is the lowest level in 17 years. As the underlying conditions in the market have changed since then, so have the incentives for the involved parties, chiefly those of Russia.

For Russia, crude petroleum trade amounts to 28 per cent of the country's net exports, which amount to $341 billion yearly. Vladimir Putin's stake in all of this is a bigger market share for Russia's top producers – Rosneft, Lukoil and Gazprom Neft.

At present, the falling oil prices are undoubtedly exerting a massive toll on the Russian oil businesses; however, the Russians are not giving in yet, despite some analysts weighing in on a quick capitulation on their part. A case can even be made that the Russian oil industry can survive prices at $15 per barrel for several months. By this time, a lot of other producers are either going to go bankrupt or register tremendous losses causing them the loss of market share to Russia and Saudi Arabia.

The Saudis can continue carrying the brunt of the price war. The Kingdom is arguably better-fitted to withstand the accumulated pressures from the low prices in the energy sector and the coronavirus fallout for longer than Russia. The United States, on the other hand, is left exposed to the developing situation, and its fragile shale industry is at risk from succumbing to a prolonged crude price war. That is why Donald Trump is likely to join the side of the Saudis and attempt to force Putin to come to terms with OPEC by imposing new sanctions on Russia.

Some agencies have already reported actions undertaken by Russia in a bid to ease off the tensions between the involved parties. Kirill Dmitriev, Head of the Russian Direct Investment Fund (RDIF), commented on the situation by telling Thomson Reuters that:

“We are in contact with Saudi Arabia and a number of other countries. Based on these contacts we see that if the number of OPEC+ members will increase and other countries will join there is a possibility of a joint agreement to balance oil markets”

There is an underlying shift in tone in Russian rhetoric, which could be underscoring changed strategic goals. At the last OPEC+ conference in Vienna, Russia refused to agree to the proposal for production output cutbacks, which would have lessened the country’s market share, albeit benefiting Russian exporters by increased prices. Instead, the Russian Federation was able to preserve its market share, but the tumbling market prices hit the industry.

The statement above highlights an alternative course of action, which could signify an attempt by the Russian side to keep the cake and eat it too.

By advocating for the expansion of OPEC+ Russia would benefit indirectly by agreeing to cutbacks that are going to be shared by more producers. This, in turn, would lessen the Russian portion of the agreed-upon reductions noticeably. By sharing the burden of the necessary cuts in global production with more producers, Russia as well as other members of OPEC+ are going to keep their market share relatively intact while helping to stabilize the market.

A key takeaway is that due to their diversified industries, both Russia and Saudi Arabia can afford to keep on playing the game of Russian roulette for an extended period of time, albeit by having to deal with massive losses and enormous economic strain. The United States, however, are hardpressed in the short run and cannot risk the termination of their shale industry.

If Donald Trump does indeed decide to step up and attempt to break the negotiations impasse by imposing new rounds of sanctions on Russia, it would be anybody’s guess as to whether Putin would choose to comply. In light of the mounting impact of the COVID-19 fallout on the Russian economy, which is already projecting diminished capital flows for Q2 due to the decision to reduce its wheat exports, the Russian President might be forced to cooperate.

In such a scenario, however, the restoration of the economic balance in the energy market and its eventual normalization is going to come at a cost – heightened political tension between Russia, Saudi Arabia, and the US. Such actions are likely to have lasting and profound consequences even after the coronavirus crisis is resolved, just like any game of Russian roulette.