Disastrous Saudi miscalculation exacerbates oil crisis

Commentary by Donald Gasper*

As if the unexpected novel coronavirus crisis was not enough, this month another black swan hit ‘black gold’ – a term referring to the high value of petroleum – as a sharp fall in global oil prices took the world’s markets by surprise and sent the oil industry reeling.

According to Investopedia, a black swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Such events are characterised by their extreme rarity and their severe impact.

The term was popularised by the 2007 book with this title by former options trader Nassim Nicholas Taleb, which deals with the impact of the highly improbable .

Now, since the beginning of March oil prices have tumbled to roughly half their previous level. The industry is confronted by what the financial press is calling its biggest crisis in the past 100 years, as demand for petroleum shrinks.

The fall came as Saudi Arabia on March 8 unilaterally tore up the agreement it had made with the Russian Federation in September 2016 to cooperate in managing the price of oil. This agreement, which was due to be renegotiated in April anyway, had created an informal alliance of the Organisation of Petroleum Exporting Countries (OPEC) and non-OPEC producers that was called “OPEC+”. As of January this year this alliance had reduced oil production by 2.1 million barrels per day (bpd). 

Riyadh and Moscow fell out over the best strategy with which to respond to the huge fall in demand created by the novel coronavirus pandemic, as airlines were grounded and millions of motorists stopped using their cars to commute to and from work.

The Saudis had demanded that Russia agree to a sharp cut in prices. Perhaps still remembering how outside pressure had engineered the plunge in the price of oil in the 1980s, crippling the Soviet economy, Moscow said ‘nyet’ and a price war ensued, with the Saudis cutting prices and flooding the market with their surplus oil. 

The collapse has hit the United States, which now ranks among the world’s leading oil exporters. As a result of the novel coronavirus crisis stocks of all US oil firms, not just those involved in the shale business, have plummeted. Some of these firms are heavily in debt and threatened with bankruptcy and they have been lobbying the government for help. The latest reports are that as a result, the Trump administration is trying to apply diplomatic pressure on Riyadh to get it to cut production. It is also threatening to increase its sanctions against the Russian Federation with a view to stabilising prices, according to The Wall Street Journal. 

In addition, Texas regulators are considering whether the US itself should curtail crude oil production for the first time in decades. 

What is evident is that the present situation is unsustainable. Although the oil is cheaper, there is currently no demand for it from the importers. For example, China, which would normally have been eager to purchase, is not interested due to the slowdown in its economy. As for the oil producers, countries like Indonesia, Malaysia and the Philippines are suffering from the fall in prices. Outside Asia, other major producers like Iraq and Nigeria have also been hit heavily by the price collapse.

The Saudis took a huge risk, thinking that Russia would be the first to back down in this game of chicken. However, the Russian Federation now has no foreign debt burden. Like China, it has been buying gold heavily with its surpluses. So it can afford to ride out this standoff.

The Saudi economy, on the other hand, is heavily indebted, due among other reasons to the country’s ruinous intervention in neighbouring Yemen.

As detailed in the just published book ‘MBS, The Rise to Power of Mohammed bin Salman’ by Ben Hubbard, the Beirut bureau chief of The New York Times, in 2015 the Saudi heir apparent ordered the Saudi Air Force to start bombing neighbouring Yemen, hoping to tip the balance in that country’s civil war in Riyadh’s favour. The fighting continues to this day, leading to a grim record of civilian casualties, many killed by bombs supplied to Saudi Arabia by the United States. Disease has added to the misery of the Yemenis in what the United Nations has described as the world’s worst humanitarian disaster.

It was the need to finance this military adventure, among other things, that is believed to have pushed MBS to initiate the oil price cuts in an attempt to increase the Saudi market share. The price cuts have resulted in a free-for-all which is beyond Saudi control and a loss of income that the kingdom cannot afford in the long run. 

Given their budgetary constraints, the Saudis really need a price of US$80 per barrel to balance their budget and certainly cannot cope with a price of only between US$40 and US$50 per barrel for long.