Why Russia Will Ultimately Agree to OPEC+ Cuts
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Why Russia Will Ultimately Agree to OPEC+ Cuts

by | published March 4th, 2020

OPEC+, that is, OPEC plus main non-organization oil producers led by Russia, has its next two-day meeting beginning tomorrow. Crude oil prices have plummeted following the now global emergence of the COVID-19 (coronavirus) scare, and that meeting is widely expected to result in another production cut.

Before posting a modest two-day recovery, primary international benchmarks Brent (set in London daily) and WTI (West Texas Intermediate, used as the pricing yardstick for futures contracts written in New York) oil had declined 13% and 14.2%, respectively, for the most recent rolling month (adding most recent daily close, deducting oldest).

Put another way, it was the worst crude pricing performance since the 2008 financial crisis, a grim milestone that hasn’t gone unnoticed in Riyadh and Moscow…

There’s a Lot of Daylight Between Russia and Saudi Arabia

Saudi Arabia, OPEC’s driving force, had been pushing for a further 1 million barrels a day in a move designed to curtail any further pricing declines in the face of COVID-19 uncertainty. An OPEC technical committee subsequently recommended a cut of 600,000 barrels.

The lower level reflected a rising concern among members that oil-dependent domestic budgets would feel an additional pressure from lowered exports, even at a higher price per barrel. All OPEC parties have been running budget deficits for some time, exacerbated by the accelerating revenue losses over the past month.

But Moscow has expressed reluctance about another decline in production.

The push back was in evidence over the weekend. Russian President Vladimir Putin stated that he found current prices “acceptable” for the Russian economy. But Russia’s large financial reserves don’t “eliminate the need for action, including in cooperation with our foreign partners,” he added.

Now the reluctance has been in the air for some months. My Russian contacts, especially at Minenergo (the Russian Ministry of Energy), have been sounding the concern. The matrix of problems attending upon OPEC+ cuts has been intensifying in Moscow. But most energy folks I know believe Russia will once again enter into an agreement with OPEC, albeit not without some drama.

On Monday, Russian Energy Minister Alexander Novak said Moscow is evaluating the smaller oil production cut proposal vs. Saudi Arabia’s plan to cut by 1 million. That would come after OPEC+, which includes OPEC and partners like Russia, earlier trimmed output by 1.7 million barrels.

Any cut decided upon this month will certainly last at least until the next full OPEC meeting scheduled for June 9 -10, 2020.

My read is that the communique issued after completion of the OPEC+ session on Friday will have a 1 million barrel cut, but also indicate this is a temporary measure designed to offset the current demand crunch until the global virus scenario stabilizes.

However, there are significant limitations to a protracted Russian opposition.

Russia Must Move Above, Out, Into, and Below

As I observed in Oil and Energy Investor last month, the Russian central budget is dependent upon the proceeds from oil exports. Last summer it was set based on a price of $49 a barrel for Urals Export Blend Crude, the primary Russian benchmark rate for sales. That is the lowest pricing level used in a decade. Currently, with Brent at slightly more than $54 and Urals Export selling lower (as much as 5%), there is no budgetary flexibility and local deficits are expanding.

In addition, the Kremlin runs some operations “off the books,” relying on proceeds from oil and natural gas sales (having an ongoing and pronounced pricing decline of its own) without including those activities in the official budget. That makes the need to sell more crude even more acute.

Second – and even more important from the standpoint of the main Russian oil companies – Russia is experiencing an accelerating and acute problem in arresting production declines from its traditional Western Siberian basins. The vast majority of Russian oil comes from these mature locations.

To offset this approaching crisis, which some analysis indicates could reach an 8% annual decline by 2022, Moscow must move in four directions: above the Arctic Circle, out onto the continental shelf, into Eastern Siberia (where there are known reserves but a pronounced lack of expensive infrastructure and support systems), and below the current mainstay production locations in Western Siberia.

This last category comprises large resources of heavy oil more expensive to produce and needing production approaches not available in Russia. The usual steam-assisted approach used elsewhere succeeds only in collapsing the Siberian tundra.

All of these require vast amounts of capital expenditure and access to sophisticated equipment and techniques. Russia is limited in acquiring the latter from the West due to U.S. sanctions, which are also putting a heavy damper on possible Western investment.

Thus Russian oil companies need to rely on working capital derived from sales. The government agreeing to a further cut in exports makes that even more difficult.

One Russian contact put it to me this way: “An additional cut in oil may help the global price a bit. But it runs the risk of an economic downturn [in Russia]. And that is without a single case of coronavirus appearing here.”

Putin may be able to jawbone the companies into line, but it is not going to be easy. Even if he succeeds, the Russian budget and company needs will oblige a heavier reliance on exports.

And that is setting the stage for a renewed Russian-Saudi competition to provide product for the Asian market is likely. As I said last month that competition might become the biggest threat to OPEC+ moving forward.

When in November of 2014 the Saudis pushed through an OPEC defense of market share rather than price, most pundits saw the move as an attack on U.S. shale production. However, there was a second, equally important rationale in Riyadh.

Russia has completed the East Siberia Pacific Ocean pipeline designed to move additional oil volume to the expanding Asian market. A new export grade is emerging, also called ESPO. This oil is of significantly higher quality than Urals Export Blend, having lower sulfur content than the so-called Arab Light coming from Saudi Arabia. Moscow was also prepared to sell the oil at a discount to market virtually eliminating the “Asian premium” (the additional Asian importers pay over what it costs to receive oil in Western Europe or the Gulf Coast of the U.S.).

The collapse in crude prices throughout 2015 and 2016 put oil at below the level Russia needs to make exports to Asia make sense. That, in turn, saved the main expanding foreign market for Saudi exports.

Expect any price benefit from another OPEC+ cut to rekindle the Russian-Saudi fight over the Asian market.

Kent Moors
Kent

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