CFE Analysis

The Saudis, the Russians, the Chinese…and the Greens, Four Dimensional Chess in the Time of Corona

Crude oil prices plunged on Monday, as Saudi Arabia has announced that they will ramp up production to punish recalcitrant OPEC members, including and especially Russia. Rising supply alongside a virus driven swoon for global demand is a prescription for collapse, and that is what is unfolding. We would argue, however, that the Saudi move is not a short-run tactic, but instead, a part of their new found long-term strategy. As we see it, one should expect a sustained rise for Saudi production, reflecting newfound understanding of climate change. Russian oil dependent oligarchs, unnerved pols in China and developed world heads of state fearful of climate change will all need to contemplate the Saudi gambit and decide upon their own responses. To be sure, the coronavirus, for the moment, owns the airwaves. From our vantage point, the current pyrotechnics in the oil market reflect epochal developments.

We wrote, a bit more than two years ago, that Saudi Arabia had
finally gotten the joke about their long-term prospects for selling oil. Our thesis was simple. The Saudis recognized that climate change was real, that fossil fuel use in the coming decades would shrink dramatically, and that they needed to engineer a two-part strategy to maximally monetize their oil holdings. Part one involved duping investors into buying a share of Saudi oil reserves. The centerpiece of part two would be a big ramp up of production.

We posited that the Saudi Aramco initial public offering (IPO) was a ‘tell’—signaling Saudi’s newfound desperate desire to sell oil at current prices. We offered that a key Saudi tactic to preserve interest in the deal would involve cutting production, to keep spot market oil prices artificially inflated. On the other side of this sale of oil reserves to chumps scheme, the Saudis would soon reverse course and ramp up production. This sharp reversal would reflect Saudi willingness to accept a sharply lower oil price, in order to dramatically increase market share and ensure that, at least at some price, they would sell most of their oil.

The Aramco deal is history. The plan was to sell 5% of the company—3.5 years’ of production, at its 10mb/day rate. The Saudi issuance was less than a third of that size. They took the money and ran. Now, as the coronavirus threatens global demand, the Saudis are taking their second big step. They have announced to the world that they refuse to be the sole price stabilizer in a world awash in oil. Instead, they intend to dramatically increase production, accept a period of much lower prices, ostensibly in order to punish those unwilling to temper production. The last time the Saudis did this? Check out Saudi oil production in 1999. Their open the floodgates move in that episode took oil prices down by over 50%, with the low price a bit less than $10/bbl.

Current commentary about the oil market accepts the Saudi narrative. In their telling, this is a short- term event, virus driven and meant to re-instill discipline among OPEC members—including and especially Russia. We would point out that their actions also fit with our storyline about a long-term strategic shift. The Saudis have 265 billion barrels of oil, and they know they will need the world to want to buy oil for 70 more years, if they leave their 10mb/day production rate in place. Greta Thunberg has convinced them that is highly unlikely. Thus, they brute forced an IPO, and sold as much oil as they could, engineering inflated expectations for future prices during the process. Soon thereafter, they ramped up production, in order to sell more oil now, when the selling is relatively good. Importantly, our story line views the Saudi production increase, not as a short-term tactic, but as a portent of things to come. Look for rising production rates from the Saudis, as they attempt to both temper the climate driven move away from petroleum and to capture a growing share of the shrinking demand for crude. If our take is correct, then as the rest of the world comes to appreciate their strategy, key players will be compelled to respond.

Russia, China, USA, Europe; Your Moves

Russian finances go red with oil below $40/bbl., and they are armed and dangerous. Will Putin take collapsing revenues lying down? U.S. frackers are largely responsible for doubling U.S. production over the past several years. Most of them are awash in high yield, short-term debt. Absent a major step from some other player, they are sure to go bankrupt in droves [see the Floyd Norris article]. Indeed, Putin might choose to weather the Saudi surge, content that his staying power was much larger than the financially strapped U.S. fracking industry. Wipe out the frackers and the Saudis and Russia are both in better stead.

On the demand side, however, a plunge in prices throws a major monkey wrench into plans to quickly move away from crude. Though many U.S. citizens pledge allegiance to Greta, car buyers will surely tilt away from electric vehicles (EVs), if gas prices fall back below $2/gallon. Similarly, China will be hard pressed to ignore the allure of a newfound super cheap energy source. The coronavirus will most drastically depress their economy, and saddled with enormous government debt, access to very cheap oil will almost certainly tilt them back toward infrastructure based on a fossil fuel future.

The profound question: How will the U.S. and Europe respond?

What might the U.S. do? If the Dems are in charge, imagine a tame version of the Green New Deal. Gas prices at the pump, via a tax hike, return to $3.50/gallon and, going forward, are automated. Each year gasoline taxes rise, if necessary, to ensure a floor for prices, of $3.50/gallon plus a bit more than the yearly rise for the CPI. Amid a rapidly pumping Saudi strategy, this could generate close to $300 billion in tax revenues—all of which could be used to cut payroll taxes for those in low/middle income brackets. Simultaneously, taking a page from President Eisenhower, the interstate highway system, could be modernized so that all rest stops sport many dozen electric charging platforms. Thus the move to EVs from ICE driven vehicles would continue. And the bonus? A part of it will be financed by Russia and the Saudis.

What can the U.S. and Europe do about China’s possible desire to dive back into oil? China is the manufacturer to the world. The U.S. and Europe could strike an agreement on a carbon tax. This tax would calculate the CO2 content of manufactured goods. If China decides to press ahead with coal and backslide on oil inputs to their production processes, their products would have large taxes associated with them. In theory, their potential market share losses would squelch their enthusiasm for cheap fossil fuels.

All of this suggests to us that we are at an elemental crossroads. To be sure, the effects of the coronavirus on the global economy will be temporary. Moreover, it is also true that temporary frights don’t require long lasting fixes. Nonetheless, epochal changes, in many cases, are catalyzed by temporary fissures. Fasten your seatbelts. Our bet is that enormous change is afoot in the energy markets.