11 October 2015

Russian Intervention In Syria Could Drive Crude Prices Deep Into The $30s


Amid worries that Russia’s armed intervention in Syria signals a new Cold War between Russia and the West, another and related rematch appears in the offing. If Russia and Iran are Syrian President Assad’s strongest foreign backers, Saudi Arabia and its Gulf Arab allies surely number among his and Iran’s most implacable foes. The implications of a potential Russo-Saudi proxy war for international oil markets are significant.

There is little doubt that such a conflict is brewing. Speaking with journalists on the sidelines of a U.N. General Assembly meeting last week, the Saudi Minister of Foreign Affairs, Adel al-Jubeir, pointedly stated that “There is a moderate Syrian opposition that is fighting against President Assad. We expect this support [for those rebels] will continue and be intensified.” Saudi support can take at least two possible forms.

One option is direct action—i.e. funds, weapons, and supplies supplied to preferred rebel groups. As in the 1980s, the economics of insurgency will work against Moscow. While a rebel with a $500 RPG or IED can destroy a $500,000 armored vehicle, each Russian airstrike costs hundreds of thousands of dollars just to hit a single, often easily replaceable point target. That same sum could fund dozens of sizeable rebel attacks. In addition, Russia does not have the geographical advantages it enjoys in Ukraine.

Syrian rebels and their Saudi and Gulf Arab backers are dug in for the long haul and have the willingness and capacity to pay a much higher price for victory than Russia can at the end of a precarious supply chain. Riyadh has also positioned itself well to equip its Syrian proxies against Russian forces. In December 2013, the U.S. Defense Security Cooperation Agency, approved a Saudi request to purchase nearly 14,000 TOW anti-tank missiles – ideal for Syrian rebels needing a cheap and effective counter to the Russian-backed Assad regime’s tanks. The missiles were reportedly scheduled to begin arriving in 2015, with deliveries continuing for three years thereafter.

But Saudi Arabia has another, and perhaps more powerful weapon at its disposal: punishing Russia economically by keeping oil prices low. In 1985-1986, the Saudis massively expanded oil production to regain market share (Exhibit 1). Riyadh’s action drove prices down by more than 60% and they did not recover until the Iraqi invasion of Kuwait five years later. The prolonged period of low oil prices shattered the Soviet Union’s brittle, oil-dependent economy, hastening its collapse. In the current situation, oil prices have also fallen by roughly 60% and a recovery to the levels Russia needs to fund itself (more than $100/bbl) could take years.

Russia is highly vulnerable if the Saudis open the taps a bit more and further depress prices. Like the 1980s-era Soviet Union, Russia’s industrial sector has been destroyed by years of kleptocracy and mismanagement. Oil & gas revenues underwrite virtually all economic activity in the country. More importantly, they allow Putin to purchase the loyalty of his former KGB/FSB cronies who control much of Russia’s economic output and political power levers.

Russian Deputy Energy Minister Alexei Teksler recently told journalists that if prices fall below $40/barrel, Russian oil production is likely to contract. Furthermore, the impact of low oil prices on Moscow’s coffers is not limited to crude oil: much of Gazprom’s gas exports to Europe are still priced on oil-linked formulas.

Putin is unlikely to withdraw from Syria soon; without a decisive result because he will lose face internationally—and perhaps more importantly—at home. A protracted conflict, however, would also give the oil weapon time to work. Thus, while a deliberate effort to drive down the price per barrel would hurt both Saudi Arabia and Russia, it would not hurt both equally. Indeed, it is likely that the powerful economic and political currents unleashed by a longer period of low prices would force Moscow to capitulate much earlier than Riyadh. The Saudis almost certainly see through Russian bluster—for instance, Lukoil’s recent claims that it can still produce at $24/barrel--and may be increasingly tempted to try and see how Moscow weathers $30 crude.
Can Saudi Arabia Still Wield the Oil Weapon?

A crucial question is whether Saudi Arabia could actually implement such a strategy some three decades after it opened the taps to regain market share. At its peak in the mid-1980s, the Kingdom’s ample spare production capacity enabled it to wield the oil weapon in almost total defiance the supply and demand dynamics that applied elsewhere in the world.

While Saudi Arabia now struggles to maintain market influence with the rise of North American shale production and strong Iraqi output growth, it clearly retains the ability to rapidly boost production in a way few other crude oil producing countries can. With the end of the air conditioning season alone, Saudi Arabia can credibly put another 500 kbd of crude on the market if it chooses to do so and could sustain this at least through 1Q2016. With high crude and products inventories in the US and Northwest Europe and coastal storage facilities reportedly brimming with crude in China, additional supplies from Saudi Arabia could very well have prices flirting with $40 again.

Ultimately, though, wielding the oil weapon over the long term is a question of production muscle. Even here, despite a relative decline, Saudi Arabia remains without peer in terms of the volume of additional supply it can bring online with relatively little lead time. Saudi Arabia’s core fields produce oil for as little as US$ 4-5 per barrel.

The bulk of Russia’s Western Siberia fields, which account for the lion’s share of the country’s oil output, likely have production costs closer to $35/bbl even accounting for the ruble’s devaluation. Atop this, pipeline and maritime shipping likely adds another $10-15/barrel. In contrast to Russia, Saudi Arabia likely has the productive and national financial wherewithal to survive at least a year in a $30/barrel environment. It has also aggressively boosted its oil-focused drilling rig count in recent years, potentially helping to underpin its ability to pursue a volume-based revenue approach (Exhibit 2).

This increasing rig count suggests that Saudi fields do not flow as easily as they once did. Equally, however, it demonstrates Riyadh’s determination to overcome geology and ensure its place as the world’s largest combined crude/products producer. The Kingdom has also dramatically boosted natural gas development, so that gas can be burned at home to generate power and free up additional crude oil for export. At present, the Kingdom burns as many as 900 kbd of crude to generate electricity during the peak summer air conditioning months, according to JODI data.

If the Saudis decide to try and punish Russia by running more oil into the market, the success of their efforts will hinge in part on US production trends. Shale drillers’ banks are presently assessing their lending levels and to boot, many producers’ hedges expire in the next 2-4 months. How this translates into production impacts remains to be seen, because struggling producers’ high debt loads strongly incentivize continued production, whether the firm declares bankruptcy, seeks strategic investments, renegotiates its loan terms, or attempts to tap the capital markets. If US production declines significantly, this would undermine a Saudi oil output boost. Conversely, if US production remains more resilient than expected, a Saudi output boost of as little as 500-600 kbd could meaningfully depress crude oil prices late this year and into 2016.

The bottom line is that Russia’s military action in Syria risks further destabilizing the oil market and US producers and service companies stand to suffer from it. If Riyadh decides to open the taps, it is increasingly likely that New Year’s Day 2016 will find crude hovering near $30/barrel.

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