Frenemies

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The oil narrative is not as it seems. We think there will be a superficial deal between Russia and the Saudis sometime this week – just as we wrote last week. However, the narrative is not as one-dimensional as president Trump has been suggesting in his press briefings. Trump’s narrative has been that low oil prices are bad for both the Saudis and Russians. Therefore, he concludes, they have incentive to do a deal. Sure they are ‘bad’ right now – but long-term gain (for them) comes from short term pain if US E&P is permanently impaired. In our opinion, the popular oil narrative is generally ill-premised, as it assumes the Saudis and Russians to be at odds. Don’t be so sure. Their interests are aligned around disabling U.S. production. Period.

The President’s recent tweet (last week) made me wince, and I’m guessing it may have made Vladimir Putin laugh – you know, one of those evil genius laughs. President Trump tweeted:

I pray that the President does not have a sincere belief in this friendship or outcome. Brinkmanship combined with narcissism make him a hard read, and that’s probably a good thing. Does he really believe he’s going to drive a deal here? It would certainly be ironic if the Saudis and Russians actually gave him an illusory win and do cut some – allowing him to think he’s actually a real ‘influencer’ in a game that is ultimately of their design. Is a cut in the amount he cites completely unprecedented? No, there were large cuts in the early to mid-1980s.[2] But if the cuts were 10 to 15 million barrels per day, that would amount to between roughly 25% and 38% of current output for OPEC+. Interestingly, the tweet was countered by immediate denials from Russia that any conversation between MBS and Putin had yet occurred – which means it probably has occurred – but not for the purpose of easing production. A high five perhaps?

For anybody naïve enough to think that the current production ramp-up is not a coordinated effort between the Saudi’s and Russia, I have two words: wake up. This artful play will likely have may acts. Putin and MBS are ‘frenemies.’ They will at times emphasize their friendship and at other times their adversarial relationship. That dichotomy is helpful to their narrative. Feigned compromise on production cuts should make the nefarious collaboration more believable within the context of the long-game they are playing. Whatever cuts occur will make a for a great headline, but they will be short-lived. Their goal is most likely to eliminate the high-cost U.S. producers that have survived only because of access to capital markets. Few are cash flow positive below $45/bbl, so oil probably does not have to be this low anyway. A small superficial cut will make little difference at prices this low and with demand so weak.

On March 9th, my team and I wrote in our Morning Read:

“Does anyone remember the infamous high-five between Putin and MBS (pictured)? One theory is that the Saudis are playing a game of chicken with the Russians. Unfortunately for the Saudis, the Russians have positioned away from the U.S. dollar, and ruble depreciation cushions the blow of lower oil prices for Russian producers. The Russians also have an estimated $100 billion in gold reserves after dumping most of their USTs. They have little external debt. In short, Russia has staying power. Alternatively, the Saudi’s actions could be yet another high five veiled as a slap in the face. Now that Aramco IPO done, something else could be going on here.

Perhaps this is not a game of chicken at all and instead a far more coordinated effort with Russia to finally crush US E&P. Given lack of access to credit markets E&P defaults will begin to spike. Breakevens are in the low to mid 40s, so cash burn already underway (given steep decline rates and continuous capex) will accelerate. Both the Russians and MBS seem to value instability, and this could be their moment to disable debt laden U.S. E&P companies.”

OPEC+ has seized the opportunity for which they have been waiting. Oil demand by EIA estimates was already slated to fall in the first quarter even before coronavirus hit. That said, the impact on demand from the virus is unarguably severe. Like the meme that low rates justify high equity valuations, we disagree that lower oil prices will act as a tax cut to the consumer. Rates are low for a reason; oil prices are low for a reason. In fact, low rates for far too long led to massive overcapacity in U.S. E&P. Capital markets remained open to companies because of the ‘Fed put.’ This is at the root of what catalyzed the price war we now have. OPEC+ had simply had enough. Perhaps most importantly, we suggest the oil price war is between OPEC+ and the U.S. – not between Russia and the Saudis.


[1] The inflation-adjusted real 2004-dollar value of oil fell from an average of $78.2 in 1981 to an average of $26.8 per barrel in 1986.

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Landvermesser
9 months ago

Once US E&P is crushed, is the next step the end of the petrodollar arrangement synchronized with Russia replacing the US as the bodyguards of the Saudi royal family? Then Iran has to hook up with China. US-Israel is probably pretty durable.

ike
ike
9 months ago

The narrative is not only not what it seems, it’s much ado about nothing. OPEC is a paper tiger that has been at the mercy of market forces for several decades now. Prior to price falling out of bed on March 9, OPEC+ was discussing cuts on the order of 1.5 million barrels per day, hardly sufficient to dent 20-30 million barrels per day of COVID-19 demand destruction. I suspect had they come to agreement price would have done something similar and the headline would have read ‘OPEC cuts not enough’.

Shale oil has been one of myriad malinvestments of this Fed easing cycle. (As cartels go, the central banking one has been much more effective). US shale producers have sported significant negative net cash flow in aggregate over the past decade, yet seemingly are always able to get access to credit to keep increasing production. US production has grown by 4 million barrels per day the past 3 years while Saudi and Russian production has been relatively flat. It’s not that Saudi and Russia don’t want to hurt US shale producers, it’s that US shale producers have already severely impaired Saudi and Russian finances (and their own in the process). But, man, can you think of two characters whose cartoons make better villains?

Thomas Coleman
9 months ago
Reply to  ike

CBC (Central Banking Cartel) has a nice ring to it. Temporarily displaced by the CDC in this forum perhaps, but the spotlight will be theirs again. CDC might even help by encouraging a cashless economy for health reasons.

E&P boom and bust is a 100 year plus Do Loop. Nothing new but the face of the stressor. Underlying cause same as always.

Pete_Cecchini
9 months ago
Reply to  ike

We are clearly of the same mind here. The one aspect I did not bake into my piece was U.S. reticence to do anything game changing in retaliation for the Iranian attack on the Aramco facility. That attack was really against the U.S., and our lack of a more visible and impactful response must have maddened the Saudis. (https://www.reuters.com/article/us-saudi-aramco-attacks-iran-special-rep/special-reporttime-to-take-out-our-swords-inside-irans-plot-to-attack-saudi-arabia-idUSKBN1XZ16H). Yes, there were reports about a cyber attack on Iran in retaliation, but who cares. Nobody cared about Soleimani either. It failed to make a point to the world that we had the Saudi’s back.

ike
ike
9 months ago
Reply to  Pete_Cecchini

My main points were twofold. First, whether the narrative of Saudi-Russia price war or Saudi-Russia collusion to destroy US shale is closer to the truth is meaningless. OPEC+ has little or no influence on price in the face of 20-30 million barrels per day of demand destruction. Second, the primary source of oversupply in the market is US shale due to malinvestment encouraged by Fed policy. The Saudi-Russia cartoon villains make for perfect scapegoats rather than US producers and policy makers looking in the mirror (especially if the narrative of foreign meddling can be advanced in service of receiving federal assistance).

MJR
MJR
9 months ago

I agree there is a long game being played. Unfortunately for Russia and Saudi bankrupting the US E&P companies does not solve their problem! It is not like the oil in the ground disappears. The point being once oil prices rebound – if that is part of their game – the assets will be dusted off, risk takers, both equity and debt markets with short term memories will be all to happy to fund the dusting off wells and ramping up production again! Is this really just a supply and demand issue – and the games just a merry-go-round, lots of spinning but going no where?

DaHoj
9 months ago
Reply to  MJR

With the Whiting Petroleum BK, the assets didn’t even need to be dusted off: debt holders get the new equity, old equity owners get nothing, and the new company continues producing, uninterrupted.

MJR
MJR
9 months ago
Reply to  DaHoj

If i’m not mistaken this is the second time around the merry-go-round for them!

Roy Blanchard
9 months ago

“We suggest the oil price war is between OPEC+ and the U.S.” Precisely. I’m in the RR business and frac sad shipments to Texas are waaaay down. I’m hearing breakeven at $50 and many low-end producers are north of $60. The Saudis and Russians have to agree that profitable or subsidized producers in the US eat into their share of the world market. Frenemies is about right. Thanks.

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