MACRO ADVISORY: Going Cold Turkey, Russia wants an end to OPEC production cuts

MACRO ADVISORY: Going Cold Turkey, Russia wants an end to OPEC production cuts
Russian president Vladimir Putin and King of Saudi Arabia Salman bin Abdulaziz al-Saud. Russia wants an end to the OPEC production cut deal as it doesn't want high prices
By Chris Weafer of Macro-Advisory May 30, 2018

Moscow, rather than a US Presidential tweet, is the initiator of the expected revised Russia-OPEC production deal. The Kremlin has made it clear for some time that it is a lot less happy with high, and rising, oil prices of late than it used be. The ruble is no longer a volatile petro-currency and the economy is being weaned off its previous addiction to annually rising oil wealth. The government learned the lesson of oil dependency the hard way, twice, and does not want a third lesson.

It would, however, be wrong to say that Russia’s stance has nothing to do with the White House. The 2014 sanctions regime is directly responsible for putting the Kremlin in a position where it had no choice but to deal with oil dependency, and vulnerability, and with greater determination to avoid slipping back to into its previous addiction.

But while Moscow had been warning of the danger of creating another oil spike, the government in Riyadh had a different view: the higher oil prices are, the better.

That position also appears now to have changed and while, on June 14 Russia and Saudi Arabia will meet in Moscow’s Luzhniki Stadium at the opening game of World Cup 2018, a little over one week later, on June 22, the two countries are expected to leave competition behind and jointly present a new production deal to OPEC Ministers at their scheduled meeting in Vienna.

Both countries want to change the existing deal and raise respective average daily oil production, although for different reasons. Russia is not comfortable with oil at $80 per barrel that looks like it might go higher.

Saudi Arabia needs a higher average oil price than Russia to balance itse budget, but sees an opportunity to boost output because of the steep decline from fellow OPEC member Venezuela. Boosting average daily output would allow Riyadh to reduce its budget breakeven price from the $88 per barrel, assuming current production, which the IMF estimates it needs today.

Moscow wants a stable oil market, with an indicated price range in the low to mid $70s per barrel, while Saudi appears ready to compromise on its previous higher price ambition because of the opportunity created by Venezuela and the price supporting backdrop resulting from the US withdrawal from the Iran nuclear deal. That raises the prospect that Iran may not be able to sell as much oil in 2019 as it does today. The regular firing of missiles from Iranian backed groups in Yemen into Saudi also adds a useful degree of risk and price support.

The other reason why it appears Moscow and Riyadh are ready to announce a new deal is because the producers now benefiting most from the existing deal, and the resulting high oil price, are those in the US, who are not only starting to invest again in shale projects but are boosting crude exports to take advantage of the $10 per barrel premium they can get outside of the US.

According to the methodology used by the International Energy Agency, the US produced an average of 13.17mn barrels per day in 2017 but in the fourth quarter of this year that may rise to 15.28mn, an increase of over 2mn barrels and almost all of that competing in global markets. Neither Moscow nor Riyadh, not to mention the Russian oil majors, are willing to continue supporting the US oil industry and helping it gain market share.

At first glance it may appear counter-intuitive that Russia, the world’s biggest oil exporter, when refined products are added to crude, would not only be willing to participate in some action that will bring the oil price lower, but actually push for it. After all, every additional $1 per barrel over a full year is worth approximately $2.5bn for the country and with the bulk of that going into the federal budget via taxes.

But there are very good reasons why the Kremlin was unhappy with oil looking set to breach the $80 per barrel level and is relatively more relaxed in the low to mid $70s range;

  • Two oil-based slumps are enough. In 2008-09, Russia was shocked when the price of oil fell from almost $140 per barrel to $40 and pulled the economy into recession. GDP contracted by 7.8% in 2009. But that slump, although nasty, was short-lived and a rapid oil price recovery helped the economy return to 4.5% growth in 2010. In mid-2014 the oil price again fell and although the imposition of sanctions from August that year added some strains, the recession of 2015-16 was mostly due to the oil price slide. The government was able to ride that slump by blaming economic warfare waged by western nations. A third oil induced recession may be harder to explain, or forgiven, by a less tolerant public. The view in the Kremlin appears to be “let’s not test it” by risking another price again spike to $100.
  • Oil had stopped driving growth. Another reason for not wanting to see oil higher is because it had stopped working as an effective driver of economic growth from late 2012. In 2013, GDP grew by 1.3% or one-third of two years earlier and despite the fact that the price of crude traded near $110 per barrel all year. That was the year when the government was forced to accept that the oil driven boom had become exhausted and the economy needs to move in a different direction, a fact acknowledged by President Putin in his Federal Assembly Address in December that year.
  • Budget rule is working. The reason why Russia is much better placed to live with a more modest oil price than is the case with all of the OPEC nations is because it was forced to make policy adjustments as a result of sanctions. The Finance Ministry could not comfortably borrow on international markets and the banks were also effectively locked out. It meant that there was no choice but to maintain tight spending discipline and to let the ruble devalue and free-float. The legacy of that period is that the budget assumes $42 oil, and a modest deficit, for this year the aim is for a balanced budget with $44 oil through to 2021. All oil taxes above this price are diverted to financial reserves, which have grown by over $80bn since January last year.
  • Russia does not need the money as much as it used to. The budget needed $115 per barrel to balance in 2013. This year it will balance at $54 per barrel, assuming the current ruble-dollar exchange rate. At $75 per barrel the budget will run a surplus of $30bn. Of course, a higher price would generate a larger surplus but, now that financial stability has been achieved, there are greater priorities.
  • Higher oil revenue creates internal instability. It used be said that if you asked a liberal reformer what Russia most needed to change the economy the answer would be “ten years of low oil”. Whatever the merits of that statement, the fact is that higher oil wealth does reduce the momentum for change and causes division amongst the elites between those who want to spend on elaborate state projects and others calling for restraint. Much easier to keep the peace with an oil price high enough to maintain comfort but not so high as to create spending demands.
  • Higher oil boosts alternatives. One of Moscow’s main points is that a high oil price leads to bigger budgets for the development of competing energy sources and especially in the transport sector, which is the biggest consumer of oil each day. As far as Russia is concerned $100+ oil only hastens the day when Ford or Toyota or another mass producer starts to roll out vehicles requiring much less oil to run.

Finally, the new-found relationship with the Saudi leadership is very important for the Kremlin. Although Moscow was becoming less comfortable with oil approaching $80 per barrel, there was never any prospect of it walking away from the current deal or not wanting to replace it with a new deal. Maintaining a close relationship with OPEC, with Saudi Arabia in particular, is a key geopolitical priority for the Kremlin. It represents the ideal combination of good business and very good politics. Whether that is a new set of production targets from January 2019 or a staged increase in the current quotas, or some other agreed intervention mechanism, the main point is that Moscow will continue to work with Saudi to try and extend the age of oil, and with less volatility for as long as possible, and to protect respective market shares from the resurgent Americans.

 

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