The end of the oil war gives hope for the devastated global economy

The oil war between Saudi Arabia and Russia is over, giving hope for the global economy ravaged by the coronavirus pandemic , yet do not expect the return of long-term stability to markets, for this truce is only temporary.

A week of bilateral negotiations and four days of video conferences were needed to reach on Sunday the agreement to cut world production in 9.7 million barrels per day ( mbd ) in order to encourage oil price recovery , after the unexpected leading role assumed by Mexico within the Organization of Petroleum Exporting Countries and independent producers ( OPEC+ ).

The largest slash in production in OPEC history starting May 1, just below the initial plan to cut 10 mbd , was made possible due to the pact between United States President Donald Trump and his Mexican peer Andrés Manuel López Obrador ( AMLO ), whose government was reluctant to contribute with a cut of 350,000- 400,000 barrels per day ( bpd ) as demanded by the Saudis.

Instead, Mexico will reduce its production to only 100,000 bpd between May and July thanks to the “ generosity ” shown by Trump curbing its own output in 250,000 bpd; the U.S. president declared that his country would “pick up the slack,” so Mexico would not have to scale back too deeply. “We’d make up the difference. Now, the U.S. production has already been cut.”

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However, several analysts have questioned the feasibility and real impact of the agreement, since there is now nearly 35 mbd less oil demand worldwide ; while Trump , with no legal basis to curb U.S. output, has even mentioned a reduction of 20 mbd , Moscow and Riyadh were looking to enlist other nations outside OPEC+ such as Canada and Brazil to bring the total cuts to 15 mbd .

On Friday, U.S. Energy Secretary Dan Brouillete said during a meeting of the G-20 that U.S. production would decline by between 2 and 3 mbd by the end of this year. “Everything would suggest that Trump’s ‘promise’ to cut oil production for Mexico is a lot of hot air. He has done nothing to indicate he supports taking direct action to rein in U.S. production,” Gregory Brew , a historian of the industry told The Washington Post .

In Moscow , Alexander Novak , Russian Energy Minister , pointed out that the arrangement would in theory last for two years, yet given that the U.S. contribution depends on market forces, “we will need to monitor the situation. It will inevitably change. And if necessary, either additional measures will be taken or output for countries will be restored faster.”

According to Nigeria’s Energy Minister Sale Mamman , oil prices would be boosted at least in USD $15 per barrel , after Russia suspended its collaboration with OPEC+ in March, plunging oil prices to its lowest level since the 1991 Gulf War .

Nevertheless, it is expected that the prices will move below USD $20 per barrel until demand comes back from its current 75 mbd to above 90 mbd , when the COVID-19 pandemic has ebbed and consumption resumes at a sufficient rate, probably two years from now.

Winners and losers

If it is possible to talk about winners and losers in this scenario, Mexico should be included among the first ones, although its victory can be considered Pyrrhic.

On Wednesday, AMLO , who has given priority to the recovery of state-run oil company Pemex building a new oil refinery and ramping up production which has fallen in the last decade, affirmed the OPEC+ deal managed at a minimum to avoid the “ complete collapse ” of prices (the Mexican oil basket fall to USD $15.30 on Tuesday, its lowest level in two weeks, after the International Monetary Fund announced that the “ Great Lockdown ” provoked by coronavirus will plunge the world into its worst depression since the 1930s.)

The oil sector generated about 17% of Mexico ’s government revenue in January; the country is the 12th world oil producer and Pemex is the second largest company by annual revenue in Latin America , yet corruption and poor management have saddled the firm with USD $100 billion of debt.

During the OPEC+ negotiations, however, Mexico resorted to its “ secret weapon ,” a massive hedge shielding it from low oil prices . For the last 20 years, explained Oilprice.com and Bloomberg , the nation has bought some 50 “Asian style put options” from a small group of investment banks, oil companies, and trading houses in what is seen as Wall Street’s largest-and most closely guarded-annual oil deal .

The options, with a cost of nearly USD $1 billion this year, give Mexico the right to sell its oil at a predetermined price—calculated in USD $49 a barrel —working as an insurance policy: the country banks all gain from higher prices yet enjoy the security of a minimum floor. So if oil prices remain weak and average above USD $20 a barrel , the hedge would pay out close to USD $6 billion .

Pemex

has its own separate, smaller oil hedge and the company hedged 234,000 bpd in 2020; the success of the Mexican strategy has not gone unnoticed. Dai Jiaquan , head of market research department of China’s largest state-owned oil company CNPC , said that Chinese firms could mitigate risks by using derivatives in order to ensure more stable returns.

China

is a major oil importer and its refineries seized the opportunity to stock up on cheap crude last month, yet its drillers saw their upstream revenue evaporate, forcing them to cut capital expenditure and postpone or cancel new projects.

In the political context, AMLO has insisted that he did not agree to anything in return for Trump’s help to avoid a 23% cut in Mexico’s oil production . Nevertheless, analysts commented that the country could “ reimburse ” the U.S. on migration and security.

Under U.S. pressure, Mexico has spent additional funds on border policing , looking after Central American undocumented workers and asylum seekers . Since March 21, Washington has used an obscure statute allowing the suspension of entry from designated places to prevent the spread of coronavirus and deport 30,000 people back to Mexico , whose immigration claims have been denied without any due process.

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The United States is also in the winners field; as Dmitry Peskov , spokesman of the Kremlin stressed, “with layoffs looming for the U.S. oil industry and shale oil companies on the brink of bankruptcy, the nosedive in prices acquires political significance as U.S. elections approach.”

In any case, shale oil companies are already eliminating thousands of jobs for the worst downturn in more than a generation. Oil-producing states as Texas , Oklahoma and North Dakota are expecting deep losses in jobs and tax revenue.

Banks are preparing to start seizing the assets of ailing shale oil and gas firms to avoid losses on the loans—totaling more than USD $200 billion —they extended to the industry during the boom, in a situation aggravated by the fact that new wells are falling short of expectations concerning yields.

“There will be some companies that will not survive,” accepted Trent Latshaw , Latshaw Drilling president, an oil service company active in Texas and Oklahoma .

However, “the industry in general will survive and come out of this stronger,” he underscored, recalling that this scenario is similar to 2014, when Saudi Arabia also flooded the market in an effort to undercut U.S. shale producers who were taking market share away from it.

In its latest short-term energy outlook, the U.S. Energy Information Administration stated that the country will return to being a net importer of crude and petroleum products in 2020-2021, as a result of higher net imports and lower net exports.

As for the losers field, Riyadh is abandoning its dreams of global primacy again, victim of miscalculations and even the U.S. Congress political pressure. At a projected average price of USD $34 a barrel this year, the kingdom’s revenues would be 50% lower than in 2019, a loss of USD $105 billion .

Saudi Arabia

still has foreign reserves of USD $500 billion , yet that has shrunk from USD $700 billion in 2013. Several years of depressed oil prices and the disastrous military intervention in Yemen forced Riyadh to borrow money and reduce energy subsidies for its subjects, now counting only on its reserves to help diversify the Saudi economy for the future.

Russia

is in better shape financially, with a flexible exchange rate and a much lower fiscal deficit than Saudi Arabia , as well as USD $550 billion in foreign reserves. Yet it has limited processing capacity, and its refineries have insufficient storage facilities.

Thousands of Soviet-era oil and gas wells are located in Siberia , where Russia is facing the prospect of shutting down and later turning back on facilities, an expensive proposition called “a financial disaster” by Mikhail Krutikhin , a partner at RusEnergy , a Moscow-based consultancy .

On a more positive note, LukOil Vice President Leonid Fedun told the Russian press that if the new deal had not been made, global oil storage would have been full up in 40-45 days. The agreement is expected to keep prices within the range of USD $30-USD $40 per barrel and bring Moscow USD $70 to USD $80 million per day , which makes the deal a reasonable choice, Fedun added.

Editing by Sofía Danis

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