No End in Sight to the Oil Price War Between Russia and Saudi Arabia

Russia and Saudi Arabia, two of the world’s biggest oil producers, are each making a bet that they are better placed than the other to bear the pain of the oil price war that they set off over the past week—and that they can get what they want as a result.

That raises two big questions: Are they able to stand the pain? And what exactly do they want?

One week ago, as Saudi Arabia and other big OPEC countries and Russia gathered in Vienna to plan production cuts that could put a floor under falling prices due to the outbreak of coronavirus, crude was trading at more than $50 a barrel. That’s when Moscow decided to blow up a three-year-old pact to manage global oil supplies, refusing to sign on to Saudi Arabia’s proposed cuts, sending the price of oil sharply down.

Riyadh responded not with unilateral cuts of its own but in the opposite direction: It slashed selling prices for its oil and later announced plans to massively increase oil output, further driving down the price of oil that was already plunging due to the disease outbreak and its toll on the global economy. Oil trades today around $33 a barrel.

For Russia and Saudi Arabia, both more or less dependent on oil sales to fund their national budgets, it was—and still is—a dangerous game of chicken.

Russia figured that it could afford to walk away from its informal cooperation with Saudi Arabia and other OPEC countries, even if that meant crashing the price of oil, for a few simple reasons. First, it has tucked lots of money away in the years since the last oil-price crash, giving it a big financial cushion. Second, the biggest losers in any oil-price war, Russia figures, will be high-cost U.S. shale producers; driving the price down would both inflict economic harm on the United States and undermine its ability to wield its favorite tool of international coercion: sanctions.

“Russia is better positioned to survive this crisis,” said Sofya Donets, the chief Russia economist at Renaissance Capital and a former senior Russian central bank officer. “It will be tough, but they have enough resources to pull through.”

Russia has spent the last five years tightening its budget and building up $550 billion in reserves that officials say will let it cope with oil prices between $25 and $30 a barrel for up to a decade, if need be. On Monday, Russia’s finance ministry said that it would draw from its $150 billion national wealth fund in order to supplement the budget even if oil prices stay low. If crude sells for an average of $27 a barrel—it was in the low-$30s most of this week—Russia would need to draw $20 billion a year from the fund to balance the budget.

That war chest is the result of Moscow’s decision to restructure its economy after it was pushed into recession in 2015—following the last big one-two punch of Western sanctions over the annexation of Crimea and OPEC’s decision to open the spigots the year before. While efforts to diversify away from hydrocarbons have largely fallen flat, Moscow has emphasized stability over growth in recent years, and in many ways it is now in a better position to weather the current shock than it was the last time around.

There is one problem, though: Russian President Vladimir Putin needs to spend more. Putin rode the oil boom of the early 2000s to a strong economy and huge popularity—but that’s a harder act to maintain when oil prices plummet. With economic growth a focal point of Putin’s current presidential term—and with his time in office now possibly extending until 2036—big increases in infrastructure investment and social spending are central to his future and key to promises to help turn around long-stagnant living standards. Lowered incomes and austerity have been the source of his falling popularity and a key factor behind a January government reshuffle that saw Dmitry Medvedev pushed out as prime minister.

Before oil prices collapsed, the government planned to tap the wealth fund to help drive a slew of projects central to its growth agenda. But a prolonged oil price war could force them to go back to the drawing board.

“If there is not another [OPEC+] agreement by the middle of the summer and oil stabilizes around $30 a barrel, then Russia will have to adjust,” said Natalia Orlova, the chief economist at Alfa-Bank in Moscow.

A weaker ruble will offset some of the budgetary support lost due to low oil prices, but if oil prices stay low, the Russian government will need to cut spending or raise taxes, possibly both—neither of which is politically appealing.

“The national wealth fund is for use in emergency cases. If things look bad, they will have to tighten the budget or increase tax collection,” Orlova said. “In a way, this would be paid by Russian consumers.”

What Russia wanted when it made this gamble was to kill off U.S. shale oil production once and for all. Igor Sechin, the head of Russia’s state-controlled oil giant Rosneft and a close confidant of Putin, has argued that efforts to keep oil prices high by limiting output only boosted shale oil production in the United States; clawing back that market share was the Kremlin’s main objective by pulling out of the Saudi deal.

With the shale patch facing high production costs and loads of debt, Russia figures cheap oil will push many U.S. firms into bankruptcy or restructuring. The added benefit of reducing U.S. oil output could also limit America’s ability to levy sanctions, such as the ones it slapped on a unit of Rosneft for doing business with Venezuela.

In one way, Russia’s right—the shale producers, loaded with high-yielding debt, are a fuse that could blow up the whole U.S. corporate debt market. If Russia wants to push buttons to cause chaos in the United States, that’s a good one. That’s why some experts are calling for a very targeted government intervention—not to save the billionaire oil executives, but to forestall a wider credit collapse.

“If you want to limit bankruptcies and keep shale from destabilizing credit markets, you’d want to see the U.S. Treasury look at term lending options to forestall defaults,” said Amy Myers Jaffe, an energy expert at the Council on Foreign Relations, suggesting ideas like asset-backed loan facilities that would prevent defaults. “I don’t think we should be worried about the oilmen per se, but we should be worried about the credit markets.”

But the U.S. shale industry has proved resilient in the past, as when OPEC tried to smother it in 2014 and 2015 with a flood of cheap oil. When prices fall, U.S. production falls, just enough to get prices up, and then rigs start pumping again—a self-regulating mechanism. While the U.S. oil industry may have less cushion now than before, it could still absorb a few body blows. That’s why some puzzle over the latest Russian effort to kill shale dead.

“It’s all really strange. If you look at the numbers and data, it makes no sense,” said Sergei Guriev, a professor of economics at Sciences Po in Paris and the former chief economist of the European Bank for Reconstruction and Development. “The only explanation is that it’s a miscalculation by people who don’t have a comprehensive analysis of the markets and don’t grasp how the American oil industry works.”

Many are equally puzzled by the Saudi decision not only to forgo production cuts but also to slash prices and boost production to drive prices even further down. If Russia threw the first punch, Riyadh, like U.S. baseball legend Billy Martin, threw the second four.

It seemed a risky move by a young and inexperienced Saudi crown prince, Mohammed bin Salman, who has overseen bold yet catastrophic moves since taking de facto control of the kingdom, from the disastrous war in Yemen to a bonesaw approach to dealing with dissidents like Washington Post columnist Jamal Khashoggi. On paper, Saudi Arabia—which needs oil to be roughly twice as expensive as Russia does in order to balance its budget—is playing with fire by pushing prices down to force Russia to rejoin the informal OPEC+ grouping.

“It is reckless in some ways—he is trying to do a ‘shock and awe’ attack, telling the Russians, ‘We mean business, and if we lose our shirt, you will too, so you better get back in line,’” said Jean-François Seznec, an expert on oil and Saudi Arabia at the Atlantic Council.

Saudi Arabia has cash reserves to withstand lower prices, though less than it did in 2014—and less than Russia does today, given its budget imperatives. Saudi Arabia was already on track for a fiscal deficit of about $50 billion, and lower oil revenues will boost that by another $70 billion, for a $120 billion annual hit. The Saudi financial war chest could take that for about four years at best—but Riyadh is clearly hoping for a short and sharp oil war.

“They knew that going in, and they figured the Russians would give in quickly, thinking a 30-day war,” Seznec said. “But the Russians think the Saudis will also give up quickly.”

The stakes for Saudi Arabia go beyond short-term survival and touch on transformation. Mohammed bin Salman has a hugely ambitious plan—Saudi Vision 2030—to spend billions to turn the Saudi economy from an oil-rentier state into something resembling a modern economy. But that requires ready cash, which will be in short supply the longer the oil-price war lasts.

“I think he is killing his own Saudi Vision plan,” Seznec said.

Others see method in the madness. Though prices have collapsed and Saudi Arabia is ramping up production and exports dramatically, that may not be a net loss for the kingdom, said Anas Alhajji, an expert on the Saudi oil sector. Oil prices were already cratering due to the virus and Russian intransigence. By raising exports from 7-plus million barrels a day to 9-plus million barrels a day, or even more, Saudi Arabia can make the same amount of money as it would have in a world without Russian cooperation, but snatching more market share, Alhajji noted.

In the end, both Russia and Saudi Arabia are gambling that the other will blink first. Both have reasons to think they’re right. There are reasons both, or either, could be wrong. Both are planning for short-term pain to compel the other to submit on their terms.

“It reminds me of the First World War, when France and Germany went to war thinking they’d be home by Christmas, and spent four years in the trenches,” Seznec said. “That’s why this is so dangerous—it’s a mirror image.”