Main takeaways of this piece:
- A temporary production reduction agreement under current conditions is not necessarily in the interest of all stakeholders in the global oil industry
- This deal will not solve the huge oversupply that is currently still building-up
- The oil war is not due to misunderstandings or ego plays but to the intrinsically different strategies and motives of the key players at hand.
- For all these reasons, an OPEC ++ coalition cannot not be sustained over time and its impact on oil prices is likely to be marginal.
Speculation is rife about the upcoming conclusion of an “OPEC ++ agreement” to reduce oil production, involving OPEC countries, led by Saudi Arabia, Russia, and shale oil producers American, whose official spokesperson became the Railroad Commission of Texas (RRC). Such an agreement will not be based on strategic considerations linked to the regulation of supply in the medium and long term, unlike the 2017 agreement concluded between OPEC and Russia. It will be a temporary truce aimed at achieving tactical objectives, involving above all the maintenance of production capacities which, in the absence of such an agreement, would have to be decommissioned, translating into operational bottlenecks and additional financial costs for drillers.
Beyond a temporary convergence of interests, there are structural divergences between the protagonists of this “House of Cards” with global outreach (OPEC / Saudi Arabia, Russia / Norway, and United States / Canada). It is important to grasp these divergences in order to understand the short-term tactics and the long term strategies of all these players. As a matter of fact, there are three structural factors that need to be taken into accounts.
The first fundamental factor is the degree of state intervention and coercion vis-à-vis the oil industry. Alongside this axis, we can distinguish three groups of countries:
- Countries where the petroleum industry is subject to an almost complete state monopoly. In these countries, the oil sector is monopolised by NOCs (National Oil Companies) – that is to say by the State – which extract these resources in partnership (or not) with foreign companies. These are mainly the OPEC countries.
- Countries where the oil industry is half-privatised, in which NOCs coexist with private players. We find in this group Russia, Norway and countries like Indonesia, Mexico and Brazil, where the NOCs have been “corporatised” and where private national and foreign players can get long-term oil concessions and can even possess oil reserves associated with a particular oil deposit, unlike the situation prevailing in the first grou, where oil reserves are the exclusive property of the State and where production sharing contracts are preferred to concessions.
- Countries where the oil industry is dominated by private players, and where the state intervenes only at the fringes, as an industry regulator in order to ensure safety, fair competition and to prevent a sudden disruption of supply, through the building of strategic stocks. This group includes the United States, Canada, Australia, as well as most European countries, with the exception of Norway.
It is easy to understand that the balance of power is not the same between the state and the private actors in each of these three groups of countries. Even in Russia, where the political and economic system is akin to a “vertical of power” tightly controlled by Vladimir Putin, there is a complex game of negotiations, compromises and balances between different interest groups. “Like an octopus, the Kremlin has several tentacles and these tentacles fight among themselves to catch the same prey,” said one of the characters in Pavel Loungine’s 2002 film, Tycoon: A New Russian.
In addition, although it is possible to transition from one group to another, the transition from the first to the second group is not straightforward, as evidenced by the byzantine process that led to the IPO of a minimal share (1.5%) of Saudi Aramco, or the protest raised by the new Hydrocarbons Law in Algeria. These examples showcase the difficulty of countries with monopolistic oil sectors to open up to competitive forces, due to the heavy dependence of the State in these countries on oil revenues, and to an entrenched rent-based governance system, which is fundamentally opposed to an advanced liberalisation of the economy.
In contrast, in the United States and Canada, the oil industry has always been dominated by self-starting entrepreneurs and private companies. Major oil companies emerged by the end of the XIX century and have gone through successive waves of market consolidation following crises that made the survivors stronger while shunning the most vulnerable players. Of course, this does not preclude the need for these players to develop privileged relationships with the political establishment. It is widely known that the petroleum industry has developed one of the largest political lobbying apparatus of any sector in the United States, to the point that it is difficult to be elected President or to stay in power without the industry’s support.
The second fundamental factor that must be taken into account is the life cycle of the oil exploitation for the various players, which is correlated with the expected ROI. As a matter of fact, there are three distinct groups in this regard:
- State-owned corporations with planning cycles spreading over 10 to 20 years. These are of course the NOCs such as Saudi Aramco – 2222.SR -, whose contractual obligations vis-à-vis the States oblige them to align themselves with the long-term economic development strategies developed by these last. These State-owned enterprises are the most vulnerable to a faster than expected historic peak in world oil demand (“Peak Oil Demand”). In this case, the assets of these companies are in danger of being irreparably impaired – or stranded. The Norwegian State–owned oil company Equinor – EQNR – is probably the only exception to this rule.
- Diversified Player whose planning cycles are comprised between 5 to 10 years made up of IOCs (International Oil Companies) – the Majors such as Exxon Mobil – XOM – and smaller albeit still large companies such as Marathon Oil – MRO – for example. Unlike most NOCs – perhaps with the exception of Equinor, and perhaps with the exception of Saudi Aramco since its acquisition of SABIC – these corporations have diversified their sources of revenues by developing downstream capabilities and by engaging long-ranging transformations and overhauls of their business models to survive in the post-oil era.
- Opportunistic Players with very short planning cycles (less than 3 years), that we might call the SMOCs (Small and Micro Oil Companies). Only a few years ago, there still were thousands of these entrepreneurial ventures in the US shale oil industry, or in the Canadian tar sands industry. The 2014-2015 crisis led to a consolidation of these players and the current crisis – which is arguably even more violent – will undoubtedly intensify this consolidation process with the like of Whiting Petroleum – WLL – and other former shale oil stars filling for bankruptcy. But the opportunistic nature of this “Business model” remains the same. The lifespan of a shale oil deposit being only a few years, as opposed to several decades for conventional oil deposits, it is tantamount for these companies to demonstrate great financial and operational agility in order to survive in such a Darwinian environment.
We can therefore understand that the way decisions are made is very different from one group of actors to another. Up to a certain point, IOCs share strategic interests with NOCs, with which they are involved in numerous joint exploration and production projects. These two groups can tolerate temporarily lower ROIs, provided that the situation does not continue indefinitely, especially for the NOCs whose revenues are chiefly derived from the upstream segment. The last group consisting of SMOCs needs a high ROI, which alone can allow these companies to repay the huge debt they had to contract in order to set in motion their operations. However, these companies can also go under the protection of the US bankruptcy laws. In addition, they have arguably lower “sunken costs”, insofar as the costs of closing their installations are lower and the foregone income from a well shutdown is less severe due to the rapid depletion of the deposits, as opposed to the large conventional oil deposits which require extremely complex and costly procedures to get them running again once they have been shut down.
Finally, the third structural factor is the properly geopolitical dimension of oil. This dimension is fundamental in the present case, and to neglect it would lead to a misunderstanding of the State players true intentions. Indeed, throughout its history, oil has been considered as a diplomatic instrument and as a key bargaining chip to extract concessions from other States. In other words, it has been – and it still is to a great extent – an essential “soft power” tool. In situations of tight supply – such as the ones that prevailed in the 1970s or in the late 2000s -, producer countries were able to take advantage of this lever. In situations of falling demand, such as the one we are witnessing today, the large consuming countries should be in good position to use this lever. However, the coronavirus crisis and its unprecedented shutdown of global demand have upset all the pre-established patterns.
President Donald Trump, who, as usual, surprised the whole world with a tweet that raised the price of oil by 30%, is in an uncomfortable position on this issue. On one hand, the majority of Americans would welcome the prolonged maintenance of the price of gasoline and diesel at very low levels, but on the other hand, this situation has already significant negative repercussions on some constituencies (Texas, Louisiana, California,…) which does not bode well, politically speaking, a few months before a presidential election. This crisis has also exhibited critical inter-sector linkages between the energy sector and the financial sector. Some US banks and asset managers are particularly exposed to the junk bonds of oil companies, which represented one tenth of the total outstanding amount of high-yield bonds in the United States at the onset of the crisis. Overall, the oil collapse combined with the other Covid-19 direct and indrect effects led to a sharp repricing of corporate default risk.
Due to strong production growth and stagnant US demand for oil for several years, the US market is unattractive for large state-owned oil exporters like Saudi Arabia. The latter exports less than 1 million barrels per day to this market. Sufficiently high customs duties temporarily imposed on oil imports from other countries would increase the price of oil in the United States and, to a lesser extent, in the rest of the world. Indeed, these customs duties would redirect to the domestic market a substantial part of the American production of crude oil and refined petroleum products which is now exported The later represented almost 9 million barrels of petroleum per day in early 2020. In any case, the contraction in domestic demand – around 4 to 5 million barrels per day in the United States due to the coronavirus crisis in H1 20202 has already led to an record high inventories of gasoline which will significantly reduce oil imports over the coming months. Depending on the response of the world prices, Saudi Arabia and Russia might actually be net winners in a “no deal + US tariffs” scenario. Conversely, Mexico, which exports much more oil to the United States would be much heavily impacted by tariffs if it were concerned by such measures.
Alternatively, Saudi Arabia and Russia could pretend to side with President Trump to show their desire to stabilise the oil market, while taking advantage of whatever concessions they can extract on other matters. Do these states have any interest in significantly reducing their oil production? This is a classic situation of uncooperative game. Every player prefers to wait and expects that the other players will make the first move in order to free-ride at their expense. If it were enough to achieve market stabilisation that OPEC reduces its oil production by 6-7 million bpd, that non-OPEC Group 2 countries also decrease by 2-3 million bpd their production – and that this is paired by a similar drop of 2-3 million bpd in oil production in the US and Canada – which in the later case will inevitably happen in any case due to domestic demand destruction – we would not witness such a game of fools. In normal times, this cuts would certainly represent a colossal effort, but in the current situation it would represent less than half what is needed to balance global supply and demand. It is difficult to see under these conditions how such an agreement could cause prices to start rising again, beyond a certain threshold allowing for the continuation of oil drilling activity – albeit in a diminished way – , at a level which would obviously be much lower than the 60 dollars a barrel routinely observed before the crisis.
More fundamentally, recent analyses of the oil market industry using game theory show that long-cycle players have no interest in concluding pacts with short-cycle players. The latter introduce a significant disruption in the game of supply and demand, but without necessarily modifying the underlying trend in the medium and long term. In this regard, they are more of a noise than a signal, like the number of shale oil wells in operation which is a poor indicator of this industry’s actual production capacity. The Railroad Commission of Texas has been endorsed on a global stage as the representative of the US shale industry. However, its role is above all to ensure the optimal storage and delivery of oil, not to enforce permanent restrictions on oil supply. The Majors, on the other hand, are playing a more subtle game, by trying to leverage their influence over the American political establishment while keeping good relations with their partners in the rest of the world. Due to the segmentation established above, it is difficult to see the formation of a lasting coalition associating the SMOCs, the IOCs and the NOCs, or the three groups of countries mentioned above.
Therefore, beyond the attempt to limit the damage done to the oil facilities, and beyond the political and geopolitical calculations or mis-calculations, e believe that the global oil industry will remain subjected to intense competitive pressures over the coming months and quarters. The primary objective of this war is the preservation and increase of market shares in Asia, particularly in India and China. These two countries which have accounted for the lion’s share of global oil growth over the last two decades, are the ultimate winners in this war, as they are now in a position to negotiate stable oil supplies at ultra-low prices for a prolonged period.
In retrospect, the agreement concluded in 2017 between OPEC and Russia exhibited a certain consistency. It paved the way for a gradual evolution of the monopolistic industries to evolve toward more competitive frameworks, while insuring a certain stability and relative predictability of income streams for Group 1 NOCs, by forging an alliance with Group 2 NOCs while developing their partnership with Group 3 IOCs. The corporatisation and IPO of Saudi Aramco finally achieved in December 2019, as well as the corporate overhaul and projected IPO of Abu Dhabi’s ADNOC were early signs of these structural transformation that started in 2016-2017. However, in a time of collapsing demand and diverging geopolitical goals, these projects are considered incidental to more pressing national objectives, which we had already noted in our analysis on Aramco’s IPO. Based on these elements, a new coalition involving three groups of players with such conflicting interests is likely to explode, even faster than the OPEC + agreement signed in 2017.