Adding fuel to the fire is a very well-known idiom, and not without reason; as is evident in the current global oil scenario, adding, or rather, producing more oil has ignited a fire in the form of an oil price war, which is likely to engulf and char all those involved in it. Following on the heels of the corona pandemic, nations have declared lockdowns, thus putting a near full-stop to industrial activity and transportation and causing a steep decline in the demand for crude oil. The resultant disequilibrium in the oil market has naturally pushed oil prices to a new low, an anomaly further aggravated by a conflict of interest between Saudi Arabia and Russia, two of the biggest oil-producers, thus leading to a Saudi-Russia Oil Price War.
Providing a little background, the Organisation of Petroleum Exporting Countries (OPEC) is a cartel formed by 13 oil-rich nations, the most prominent among them being Saudi Arabia, who collude to regulate oil supply and prices in order to ensure maximum profit for all members. OPEC controls approximately 75% of the world’s crude oil reserves and 42% of the world’s production (2019). OPEC+ is an extended version, additionally comprising high oil-exporting nations like Russia and Kazakhstan, and controls about 90% of the world’s oil reserves and over 50% of its production. All was peaceful in this oil landscape until the entry of the US with its shale oil. A high price of oil in the vicinity of $90 per barrel in 2014 made shale exploration and extraction profitable, thus making the US the world’s largest crude oil producer.
Hostilities crept up as the new entrant started to capture a greater share and threatening the hold of OPEC over oil prices. However, one advantage that Saudi Arabia’s ARAMCO held over the new adversary was its $2.8 per barrel production cost, the lowest in the world, as compared to the latter’s $40 per barrel direct cost.
Now highlighting the facts of the Saudi-Russia oil price war, the coronavirus-induced oil demand plunge created an excess supply market, and prices started to fall (oil prices opened this year at $61.18, but within a matter of 4 months, it fell to $19.87 on 15th April). At an OPEC summit in Vienna on 5th March this year, the organization decided to slash production by 1.5 million barrels per day through the second quarter of 2020; furthermore, they called on OPEC+ members to do the same. On 6th March, Russia rejected the demand, thereby breaking the partnership with OPEC, a move that saw oil prices drop by $4.5 per barrel on the same day. On 8th March, Saudi Arabia offered price discounts to its customers, initiating a freefall in prices to $31.18 the next day. Consequent moves by both players only added to the downward spiral, and soon enough stock markets reported major losses, the Russian Ruble depreciated. As if this weren’t enough, Saudi Arabia announced that it would increase its oil production by almost 3 million barrels per day (BPD), and Russia announced an increase of 300,000 BPD. Anyone with a vague knowledge of market mechanism would clearly see this as a suicide mission. Why would Saudi and Russia knowingly sabotage their oil revenues, outbid each other’s production levels, and put a strain on world storage capacity during a demand crunch? Their leaders are clearly smarter than that, and there might be a slightly more convoluted, yet logical, reason behind this.
Fields medal laureate Pierre-Louis Lions and finance-theoretician Jean-Michel Lasry have presented this scenario in the light of mean-field game theory, an extension of this study of strategic interaction, and lauded this Saudi Russia oil price war as a game-theory masterstroke. For those unfamiliar with the concept, game theory is the theoretical study of strategic interaction among rational decision-makers, and it has wide application in all kinds of real-world situations. The most famous example of the theory is the Prisoner’s Dilemma, which is concerned with 2 accomplices to a crime deciding on whether they should plead guilty, keep silent, or rat the other player out, depending on which course of action will give them maximum utility. While classic game theory mostly consists of 2 player games and struggles with more than 2 players, mean-field game theory smoothens the effect of large numbers by restating game theory as an interaction of an individual player with a mass of others. In other words, each player does not care about the actions of each of its adversaries but rather cares about how all the other players, as a mass, act.
Reconciling this theory into reality, Saudi Arabia, as the “dominant monopoly” in the oil market, has to choose between profit (producing less to keep prices and, thus margin, high) and market-share (producing more to gain wider share) aspirations. With the 2nd largest share of the world crude oil market, Saudi was just behind the US, and in this period of tumbling prices, it chose to strike against its adversary by attacking its profitability. Why Russia chose to ignore restoration of market balance, nobody knows, but we can assume running US shale companies to the ground to be a plausible reason. With their low production costs and vast financial reserves, both Saudi and Russia can survive the price free-fall, but we cannot say the same about other nations. Shale-oil drilling companies in the US have started filing for bankruptcy, leaving millions unemployed and worsening the burden on the already pressured economy.
Global efforts to put an end to this Saudi-Russia oil price war finally proved fruitful, when over weekend-long video conferences, negotiations, and discussions, all members of OPEC+ unanimously agreed to cut oil production by 9.7 million barrels per day. Donald Trump was a major advocate in these discussions, and he even got out of it without having to slash domestic shale-oil production. On plain sight, the US appears to have got out of this brawl unscathed, but on deeper investigation, Saudi and Russian ministers have far outplayed everyone else in what appears to be a game theory masterstroke.
Despite the agreement to cut down oil supply, on 20th April the West Texas Intermediate (WTI) crude oil futures contract (a benchmark for US crude oil prices) fell to a negative $37.63 per barrel for the first time in the history of oil prices, reflecting the extent of the damage done by the coronavirus pandemic and the Saudi-Russia oil price war. A point of clarification, this plunge was in the price of futures contracts, and not spot prices of crude. That is, with oil storage capacities almost saturated, those buyers who had entered into contracts to take delivery of oil in May started canceling their orders, and with the dumping of futures orders, their prices fell to negative. This is an alarming situation, created by the powerful oil suppliers who had initially refused to cut production in tandem with the fall in demand. With the easing of lockdowns in recent days, oil futures have turned re-entered the positive double-digit range, but the damage is already done.
Drilling and extraction of oil is a lengthy procedure, and increasing oil production takes anywhere from one to three months. Naturally, when Saudi Arabia announced increasing its daily production, one would expect its crude oil inventories to go down; but surprisingly, its stocks have been rising steadily. This might suggest that energy ministers walked into the fateful meeting with OPEC+ nations in March knowing fully what Russia was likely to do. The Saudi-Russia oil price war may have ended, but it was Saudi Arabia that cast the deadly checkmate. World oil storage capacity was filled 63% last year, and the remaining storage is predicted to run out by May, even with the proposed cuts in supply. This, coupled with an estimated 20 million barrels per day fall in oil demand over the next 2 months is enough to ensure that there is little scope of oil prices to rise above the $25 mark, let alone rise to over $40 (the break-even price for US producers). The US may not be obligated to cut down its oil production, but at the prevailing rates, producers will be unable to continue producing without suffering massive losses. With the impending global recession and demand slump, the oil landscape is likely to see a major recasting of its players, and it is pretty safe to assume, that when the markets come back on balance, months later or years later, Saudi Arabia and Russia will emerge as the two superpowers in the oil market, pushing all other players into the backseat.
Of course, this is all conjecture, and we have to wait and see how the scene unfolds in the near future, but undoubtedly, the game-theory version of the Saudi-Russia oil price war is slightly more believable than Arabian and Russian ministers’ lack of understanding of market mechanics.