The Russian invasion of Ukraine has reshuffled the cards of the alliances on the global energy market. Moscow and Riyadh are now playing a dangerous game on the long run. But let’s take a look in the mirror to understand how we got here.
A background to the New Oil Order
In December 2018, during the COP24 meeting in Katowice, Poland, clear fault lines emerged between potential winners and losers of the low-carbon energy transition.
While a coalition of major fossil fuel producers including Russia, Saudi Arabia, the United Sates and Kuwait, refused to toe a motion to ‘welcome’ the IPCC’s report on Global Warming of 1.5 °C and since its approval required unanimity among members, the motion was only noted. It however caused some angst among members with Saudi Arabia’s Minister of Energy, Industry and Mineral Resources Khalid Al-Falih criticizing the tone of the meeting.
In reference to the intent of the landmark 2015 Paris Agreement, Khalid Al-Falih said “The basis of the Agreement was an intent to strengthen global action on climate change without sacrificing sustainable development and poverty eradication. That was to be achieved through a focus on reducing emissions rather than banning or restricting energy sources, such as fossil fuels… we are seeing undue emphasis on energy and particularly oil.”
Those in opposition to the motion were some of the word’s biggest fossil fuel producers and it was dawning on them that effective climate change mitigation could threaten their current prosperity and global influence. The reality of the situation is that divesting from fossil fuels to a low carbon economy will take time and this transition phase could be a source of geopolitical instability.
In the global energy mix, two of the world’s biggest fossil fuel exporters, Russia and Saudi Arabia have adjusted their economic models in response to the recent turmoil in the global energy market.
Russian Invasion of Ukraine
In the midst of this transition to a low carbon economy, the Russian invasion of Ukraine has had a profound impact on global energy markets, including its governance and policy, which is without precedent since Iraq’s invasion of Kuwait in 1990.
In addition to the humanitarian crisis, loss of lives and the destruction of Ukraine, the war, which Russia describes as a ‘Special Operation’, has disrupted energy markets resulting in higher prices, heightened volatility and sustained period of uncertainty which is threatening the global order and the world economy.
Sanctions on Russian Energy
In response to the invasion, several major economies imposed economic sanctions on Russia and revised their policies on energy security. Since years Moscow has taken steps to fortify itself and has created a fortress economy which is largely self-sufficient. This has not only reduced the impact of sanctions on Russia’s energy exports and has instead fueled inflation on countries which have imposed sanctions.
This has also resulted in Moscow’s biggest customers for oil, gas and coal initiating drastic measures to reduce their reliance on Russian energy in the short as well as in the long term.
Case in point: on March 8, the European Commission proposed “an outline of a plan to make Europe independent from Russian fossil fuels well before 2030, starting with gas, in light of Russia’s invasion of Ukraine.” This new policy could potentially reduce the EU’s demand for Russia energy before the end of this year.
To date, the EU has imposed five tranches of economic sanctions on Russia including a ban on Russian coal.
Impact of sanctions bite
Although Russian energy exports to the European Union (EU) have fallen, the bloc continues to buy more than a million barrels of oil per day. In Asia, countries such as India and China, have ramped up the purchase of discounted Russian oil, midst high prices in the global energy market.
New Delhi’s purchase of Russian oil, known as Urals which is a blend typically exported to Europe, increased sharply earlier this year. India’s imports of another Russian crude blend, called East Siberia Pacific Ocean (ESPO), has also spiked according to data from shipping sources.
Since March, China has been buying larger quantities of both ESPO and Urals and in July Russian energy exports to China rose sharply to record amounts for the second month in a row.
India and China have emerged as big buyers of Russian energy and account for more than 50% of all Russia’s seaborne oil exports.
At one-point, Russian crude was more than $30 a barrel cheaper than the global benchmark Brent crude. While the pricing of Russian crude to India has not been publicly disclosed, the discount for Russian crude has narrowed to around $20 per barrel.
Sri Lanka, which is currently grappling with a severe economic crisis, is also taking advantage of the discounts in Russian crude and has increased its purchase.
Myanmar has also said it would also start importing crude from Russia.
In contrast, Japan has made it clear that it will phase out Russian oil imports; Russian crude imports into South Korea have also fallen.
Although crude oil prices remain attractive, many large Indian refining companies faced a challenge of financing large volumes of crude oil purchases since large Russian banks were sanctioned. The problem was bi-directional. As a potential way out, India started transacting using local currencies with Indian exporters to Russia getting paid in roubles rather than US dollars while importers get paid in Indian rupees.
Russia has reportedly also asked for payments from India to be made in Dinars, although trading firms involved did not confirm the report.
Chinese state-owned oil companies have also begun using the Chinese Renminbi to finance oil purchases rather than the greenback.
Towards the end of 2021, India’s import of crude oil from the US had risen sharply but dropped before picking up slightly. In contrast India’s oil imports from Russia have risen with New Delhi also purchasing oil from Middle East Countries, including Saudi Arabia. Similarly, while China continues to buy oil from the Middle East, in July Russia continued to remain as its top oil supplier for the third month in a row.
Price dynamics in the Asian oil market
In financial terms, no other country in the world stands to benefit from the Russia-Ukraine war as much as Saudi Arabia. Its vast oil reserves make it one of the world’s cheapest producers of crude oil. For every $10 rise in crude oil prices, Saudi Arabia stands to gain by $40 billion a year, according to a report from the Institute of International Finance.
This is a significant considering that just 2 years back, in April 2020, oil prices had turned negative midst COVID-19 lockdowns. Since then the price of benchmark Brent crude stands at $105 a barrel – prices that are unseen since 2014.
Following Western sanctions on Russia, Moscow has increased its dependence on oil exports and has offered deep discounts leading to growing rivalries among oil producers. In fact, a fierce price war is brewing over oil pricing with Moscow undercutting OPEC+ rivals as well as its ally Saudi Arabia in order to expand its market share in India, one of the world’s biggest importers of crude oil.
During April through June this year, Russian crude was cheaper than its Saudi alternative with discounts widening to almost $19 a barrel in May. In June 2022, Moscow overtook Saudi Arabia as the second-biggest supplier to India, and was just behind Iraq.
Both India and China have become willing consumers of Russian crude with the former importing 85% of its oil requirements from Russia as a means to mitigate inflationary pressures midst a global turmoil.
In the second quarter of this year, India’s crude import bill swelled to a whopping $47.5 billion following a surge in global prices which coincided with rebounding demand from oil. In comparison, this figure stood at $25.1 billion during the same period last year, when prices and volumes were significantly lower.
“Indian refiners are going to try and get their hands on the cheapest crude possible that works with their refinery and product configurations,” said Vandana Hari, founder of Vanda Insights in Singapore. “Russian crude fits that bill for now. The Saudis and Iraqis are not entirely losing out because they are directing more supply to Europe.”
Although the discount of Russian crude with that of Saudi Arabia narrowed in June, Russian oil was still nearly $13 cheaper, averaging to around $102. This compares with a premium of just over $13 in March, although most of India’s monthly oil supply would have been fixed much before the Russian invasion of Ukraine in late February. In 2021, Saudi Arabia was India’s second-biggest supplier of oil, in comparison Russia was the 9th.
Deceptive oil rivalry
The price differential between Russian and Saudi crude oil supplies and the grab for Asian market share by Moscow has led to increased rivalry between them with both countries appearing to pit against each other. Analysts however have opined that both, Moscow and Riyadh are waging a war on the U.S. oil industry.
Regardless of whether the deception is intentional or not, the open price war had dealt a massive blow to the U.S. oil industry, resulting in significant decline in oil prices. This downturn of events is likely to not only damage the U.S. economy but also shrink the size of the US energy industry and knock off Washington from the top spot of being the world’s largest oil producer, according to analysts.
Moscow’s failure to agree on deepening a production cut of 1.8M barrels a day in response to weakening demands caused by the coronavirus pandemic, has led to rising tensions between the two countries.
The rift appeared to widen after Russia ended a meeting between them, with a break in the more than 3-year-old agreement on production cooperation between OPEC and non-OPEC oil producers.
Riyadh’s response was swift: it offered steep price discounts and announced a boost in production – moves which helped trigger the steep price decline. On the other hand, Moscow said, it oil industry can weather the price downturn and that it will maintain its market share.
“While OPEC leadership retains hope that the price collapse will be a catalyst for a reconciliation between the two oil heavyweights, President Putin may not quickly capitulate,” said Helima Croft, head of global commodities strategy at RBC. “We fear that it could be a [protracted] struggle, as Russia’s strategy seems to be targeting not simply US shale companies — but the coercive sanctions policy that American energy abundance has enabled.”
She went on to note, Russian President Vladimir Putin may have been influenced by Igor Sechin, chairman of Russia’s biggest oil company Rosneft. Since long Sechin has opposed OPEC’s production deal and he was also annoyed by U.S. sanctions on Rosneft’s trading.
Further, Russia was also not happy with US sanctions aimed at stalling the completion of its Nord Stream 2 pipeline which would take LNG to Europe.
“There is no question this was a huge humiliation for the Russians to have the Nord Stream 2 pipeline construction stopped just short of completion,” said Daniel Yergin, vice chairman of IHS Markit. Washington was opposed to the deal since it would take Russia closer to Europe and increase its dominance over the European energy market.
“For now, it seems that Sechin is not seeking to eliminate simply the market share of US shale producers, but the aggressive US sanctions policy that American energy abundance has enabled,” opined Croft. “Trump administration officials have repeatedly bragged about the ability of the US to punish its foreign policy adversaries by sharply reducing their oil exports, and to be shielded from the price impact because of abundant domestic energy supplies.”
Croft has also noted that like Putin, Sechin is also the intelligence services and is seen as a strong nationalist.
“Undercutting American energy dominance therefore most likely appeals not only to his bottom line but also to his ideological [affinity],” notes Croft.
In a statement the U.S. Department of Energy said, the U.S. will continue to be the world’s biggest producer of energy because of its pro-growth policies.
“These attempts by state actors to manipulate and shock oil markets reinforce the importance of the role of the United States as a reliable energy supplier to partners and allies around the world. The United States, as the world’s largest producer of oil and gas, can and will withstand this volatility,” said the Department of Energy in a statement.
A price war for increasing the market share in the global oil market is likely to result in a further 10% decline in prices, opine analysts. This is likely to further deal a big blow to the US oil industry, and could lead to sharper cutbacks, potential bankruptcies and forced mergers for US cash strapped companies.
Price War
The distrust among investors of the industry for overspending has resulted in a lack of funds for the oil industry; capital expenditures are likely to become even more limited.
“The market expected the Saudis to act as they always do, which is to basically curtail production to balance the market, but they went out and did the exact opposite,” said Francisco Blanch, head of global commodities and derivatives at BofA Securities. “They could have just stayed where they were and then the question is, is this something the Saudis are doing because they wanted to teach the Russians a lesson and bring them into the fold, or is this alternatively something the Saudis are doing because they believe the Russian theme in this is the right way to deal with the virus? The question is are Russia and Saudi joining forces to hurt U.S. shale or are they fighting against each other.”
While there is a lack of clarity of what is behind the rift between Russia and Saudi Arabia, the motive could potential emerge as markets move into the second half of the year. If the squabble is only on strategy, it could be short lived and could potentially lead to a new deal between the two.
“The real political fact is that the U.S. is a lot less involved in the Middle East than it used to be, and that Russia has deepened its presence in the region pretty dramatically in recent years, and this is both political and economic. So, Russia, in other words, carries more weight than it used to. Its influence is being felt alto more than in the past,” said Blanch.
According to Yergin, Moscow’s strategy could be driven by desire to take a hit at the U.S. shale industry, which is seen as being a wild card in the global energy market over the last decade.
“It’s Saudi Arabia against Russia and Russia against the United States. I think that’s what it is. The Russians can’t increase production much and the Saudis can,” said Yergin.
John Kilduff of Again Capital offered another point of view. Moscow may have taken Riyadh’s commitment to steady the global oil market for granted, he opined.
“They may have gone a step too far and the Saudis basically said: ‘This is what pump-whatever-you-want looks like,’” said Kilduff while adding, Russia’s energy minister Alexander Novak had said, all oil producers have the right to pump whatever they wanted as of April 1, 2022.
“The first quarter estimate is that the global oil market is 3.9 million barrels a day lower than it was in the first quarter of last year. The overarching issue here is what to do in a market that is contracting on a very large scale as the global economy freezes up,” said Yergin.
She expects Brent crude, which touched a low of $31 per barrel earlier this year, could fall to levels below $20s per barrel before steadying. According to his assessment, Saudi Arabia intends to increase oil production and flood an already oversupplied market.
“During our 36 hours in Riyadh, it was made clear to us that the central banker of oil was preparing for a swift and substantial production increase that could retest the 2018 highs of just over 11mb/d,” wrote Yergin.
She went on to add, “Despite the huge fiscal costs that such a policy entails, Saudi Arabia seems determined to keep the spigot open until Russia agrees to rejoin the 23 other OPEC+ producers and participate in a massive collective production cut (which could balloon out to even 2 mb/d) to try to address the demand impact of Coronavirus”.
The volatility in the oil prices have already hit U.S. oil companies hard. While earlier they were under pressure from a limited access to financial markets, low oil prices are eating up their bottom lines. Such downturns have however not stopped U.S. oil producers from pumping a record 13.1 million barrels a day with U.S. oil exports touching a record 4.15 million barrels a day.
With Saudi Arabia poised to add to the glut in the global oil pool, analysts expect the global demand for oil to decline even further; this could lead to the first contraction of the oil market since the financial crisis.
The economies of oil producing U.S. states including that of North Dakota and Texas, could be hardest hit by this energy slowdown.
“This whole energy industry picture is going to be abruptly driving in reverse,” said Yergin. “The supply chains of the oil and gas reach deeply across the industrial Midwest so this hits the steelworker, this hurts the people who build machines in the U.S. so it’s not just a crisis in the oil patch. … U.S. oil production is going to go down and that would be bad for the trade balance. …The U.S. is number one now in both oil and gas, but at these price levels that’s not going to last very long.”
According to Blanch, oil prices could bounce back after a steep decline; while this will have a negative impact on the U.S. economy, consumers will benefit from cheaper fuel prices.
Of note is the fact even as Russia and Saudi Arabia appeared to break their oil deal, the chumminess between the two countries, as seen in increased investment deals, continues unabated. Russian President Vladimir Putin and Saudi Crown Prince Mohamed bin Salman have moved closer together over the past several years with oil being a common bond.
