Saudi Arabia has escalated its oil market conflict with Russia in an attempt to force Russia back to negotiations or compel the United States to intervene and help broker a new agreement.
Saudi Aramco has said it will lift the volume of oil supplied to the market to 12.3 million barrels per day (bpd) next month, which is more than 2.0 million bpd above its current output and 0.3 million bpd above its sustainable capacity.
Increasing supply rapidly by withdrawing oil from inventories and announcing it publicly is intended to maximise downward pressure on prices and the pain felt by all oil producers.
It suggests Saudi Arabia is anxious to bring the conflict to a swift resolution and avoid a prolonged volume war that could cripple the country’s economy and jeopardise its economic modernisation programme.
The aim is to force Russia back to the negotiating table or compel the United States to intervene and push for negotiations to restart so it can protect vulnerable U.S. shale producers.
Nuclear war-fighting strategies in the late-20th century developed a similar theory about escalating-to-negotiate (“On Escalation: Metaphors and Scenarios”, Kahn, 1965).
Rather than a full-scale nuclear exchange, the idea was that the detonation of one or two warheads aimed at carefully selected targets could relieve tensions, enable both sides to demonstrate resolve, and shock them into restarting diplomacy.
Saudi Arabia’s decision to go for rapid escalation suggests the kingdom wants a quick resolution and a return to higher prices rather than a prolonged volume war with a long period of low prices.
The kingdom is unlikely to want the kind of drawn-out production battle it fought from mid-2014 to the end of 2016, which burned through the kingdom’s cash reserves and pushed its economy into recession. (“OPEC risks Pyrrhic victory with oil policy”, Reuters, Dec. 1, 2015).
But Riyadh’s bid to focus minds in Moscow and Washington also runs the risk that any of the three major players could misjudge the resolve of the others or their willingness to absorb short-term pain to pursue long-term objectives.
Saudi Arabia’s previous volume wars, such as those launched by oil ministers Zaki Yamani in 1985/86 and Ali Naimi from 2014 to 2016, have often lasted longer and proved more painful than expected.
Neither of those two standoffs brought a lasting peace with rival producers. Both ended with the scapegoating and dismissal of the sitting Saudi ministers (“Yamani legacy haunts the oil market”, Reuters, Dec. 9, 2015).
Critically, it is not clear what a new truce and market management agreement between Saudi Arabia and Russia, and implicitly also with U.S. shale producers, would look like.
There is no agreement on how to apportion market share between the world’s three largest oil producers or on the implied target for oil prices. U.S. producers are, by law, precluded from participating in any such pact.
The contradiction presented by the doubling of U.S. oil production since 2011, while Saudi Arabia’s and Russia’s output has stagnated remains unresolved.
For at least the last five years, U.S. shale producers have been the market’s marginal suppliers, providing a medium term anchor.
When prices are buoyant, U.S. shale production climbs rapidly until the market is oversupplied, pushing down prices and driving down output. This leads to slower U.S. production until prices start to recover and the cycle starts again.
Efforts by Saudi Arabia and Russia to lift prices have allowed U.S. shale to fill the gap and expand market share.
In most years since 2012, shale producers have captured all or almost all the increment in global oil consumption.
This was the case in 2012-2014 and 2018-2019, when Brent crude averaged $71 per barrel or more. Only when Brent averaged less than $56 per barrel in 2015-2017 did shale capture less than half of the incremental increase.
Brent prices at much below $55 are clearly unsustainable for shale producers, while Russia, Saudi Arabia and other members of OPEC+ cannot maintain prices much above $70 before shale production sends them lower. Prices plunged to almost $31 on Monday.
The $55 to $70 range is the long-term consensus expectation for prices over the next five years (“Oil prices expected to stay around $65-70 through 2024”, Reuters, Jan. 14).
In other words, the market expects the economics of U.S. shale to act as a long-term anchor for prices, with the business cycle and OPEC+ production policy providing short-term volatility around this level.
Top policymakers from Saudi Arabia and other members of the Organization of the Petroleum Exporting Countries (OPEC) usually insist they are not targeting oil prices.
They prefer to talk about stabilising inventories, balancing supply and demand, or eliminating harmful and unnecessary price fluctuations (“Statute of the Organization of the Petroleum Exporting Countries”, 1961).
But every target for inventories, balancing supply and demand, or reducing harmful volatility also contains an implicit target for an acceptable price, and by extension an implicit target for an acceptable market share.
Fundamental disagreements over prices and market share caused the three-year pact between Saudi Arabia and Russia to break down last week (“Russia’s ‘nyet’ is best outcome for OPEC”, Reuters, March 6, 2020).
Russia was willing to accept a lower price to protect market share. Saudi Arabia wanted a higher price and was ready to cede more market share to obtain it.
Saudi Arabia and Russia now have a choice: they can allow market forces to play out or they can put together a new supply accord, in which they must agree on an implicit price target and how to share output between each other and with U.S. shale.
The history of the modern petroleum industry is mostly a chronology of failed price and market share accords (“Crude volatility: the history and the future of boom-bust oil prices”, McNally, 2017).
For once, it might be better to leave aside the game theory and attempts to control the market and let prices do the work of aligning production with consumption.
For policymakers, however, the temptation to intervene has usually been too strong to resist.