The Saudis Have a High-Stakes Plan to Win the Global Oil War
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On March 4, Prince Abdulaziz bin Salman, the 59-year-old Saudi oil minister, was locked down in his suite at the Park Hyatt hotel in Vienna, preparing for what would turn out to be the most important meeting of his life.
A veteran negotiator, the prince is skilled in the Byzantine diplomacy and backroom deals that have characterized OPEC since its founding 60 years ago. Few others can bridge the political enmities among oil producers, who often have little in common other than their addiction to petrodollars. It’s a world where a few barrels here or there in a production deal often make all the difference. “How can we work in dividing these things?” Prince Abdulaziz told Bloomberg TV last year. “It is not going to be a science. It’s science, art, and sensibility.”
But when Prince Abdulaziz met his Russian counterpart, Alexander Novak, that day at the OPEC building in Vienna, both science and art failed. The talks were the prelude to a seismic oil price decline that’s still reverberating through the global economy—a crash that may reshape the energy industry for decades to come. And what started as a price war may turn out to be a much more important strategic rethinking of Saudi oil production policy, as the kingdom seeks to monetize its giant petroleum reserves as fast as possible rather than shepherding that store of wealth through the generations. Such a shift would fundamentally change the economics of the industry, using Saudi Arabia’s ultralow cost advantages to win a race to the bottom. For Prince Abdulaziz’ younger half-brother, Crown Prince Mohammed bin Salman, it would represent a massive gamble: the world’s preeminent oil exporter choosing to live with lower long-term oil prices.
Riyadh has kept mum on its motivations, but if the suspicions of many in the oil market prove true, this oil war will be a Darwinian survival of the fittest. As the world steps up the fight against climate change, the demand for oil will peak in a few decades. Saudi Arabia and Russia will likely emerge bruised but standing. Many others, including U.S. shale producers, will be in dire straits.
In the kingdom, the current thinking is to let free markets work. If officials are worried about low oil prices, they aren’t showing it. Saudi Arabia is hunkering down for one to two years of cheap oil, adjusting government spending and drafting measures to protect the vulnerable among its citizenry. “We are very comfortable with $30,” Khalid Al-Dabbagh, finance director of state-owned Saudi Arabian Oil Co., told investors on March 16, an opinion widely repeated in the ministries and royal palaces in Riyadh. “In a nutshell, Saudi Aramco can sustain very low oil prices and can sustain it for a long time, and that is especially the case compared to others in the sector.”
Looking back, the omens for the Vienna meeting weren’t good. With oil prices falling rapidly because of the economic impact of the coronavirus outbreak in China, Riyadh was pressing Moscow to deepen the production cuts they implemented together in late 2019. Cutting output by only an additional 1.5 million barrels a day would suffice to rebalance the market, Prince Abdulaziz argued. Almost everyone else in the OPEC+ alliance—22 countries that account for half the world’s output—agreed with him.
Novak was unmoved. The oil supply and demand outlook, the Russian said at the Vienna meeting, was too cloudy—better to roll over the existing cuts for another three months and then decide what to do next. Moscow also felt that output cuts and higher prices were simply fueling the U.S. shale industry. Instead, the time had come for lower prices.
With the talks in Vienna at an impasse, Prince Abdulaziz delivered an ultimatum: Accept the output cuts, or Riyadh will abandon the deal altogether, unleashing a wave of extra oil. Novak called what many thought was a bluff, and he walked out. When he left the OPEC building, he turned to the television cameras and delivered his counterpunch: Beginning on April 1, every OPEC+ member country was free to pump at will.
The shock waves are still being felt. By the estimate of some traders and consultants, global oil demand is in free fall, down about 10% from the previous year—the largest drop ever. “This is an epic fail,” says Bob McNally, founder of Rapidan Energy Group and a former oil official in President George W. Bush’s White House.
Riyadh will say Novak started the oil price war, not Saudi Arabia. But the kingdom was ready for a fight. Unknown to anyone but a few royals and senior officials in Riyadh, the kingdom had been preparing precisely for that moment for several weeks. For the Saudis, Novak’s pump-at-will comment was a green light to ramp up the country’s own production.
The first sign that something was amiss went largely unnoticed, even in the world of oil. Saudi Aramco had set its oil prices like clockwork at the same time, on the same day of each month. But without explanation on March 5, a day after Prince Abdulaziz and Novak met, it didn’t.
When Saudi Aramco finally set its price a few days later, it was the oil market equivalent of a declaration of war. The company cut its prices by the most in 30 years, offering unprecedented discounts to its customers, which include some of the world’s largest refiners, such as Exxon Mobil, BP, and Chevron. The refiners also got word that Aramco was about to increase output significantly, by as much as 25% to a record of more than 12 million barrels a day. “The Saudis are looking to intensify short-term pain with the goal of drawing everyone back to the negotiating table to impose a more favorable supply management deal,” says Roger Diwan, a veteran OPEC watcher at consultant IHS Markit Ltd.
When Brent crude, a global oil benchmark, opened for trading on March 8, it plunged within seconds by more than 30%—the largest one-day price drop since the Gulf War in 1991. In early January, Brent had briefly risen above $70 a barrel; now, it’s fallen below $30.
The price plunge reverberated well beyond oil. It hit the markets at a vulnerable time: Stocks had been rising for years, and valuations were sky-high. Meanwhile, economic growth looked wobbly in the face of the novel coronavirus. When the price of petroleum plunged, it triggered a domino effect across global equity and credit markets.
The Saudi shock-and-awe campaign was so brazen that many took it as an attempt to impose maximum pain on Russia. The aim, according to this theory, was to bring Moscow back to the negotiating table.
The argument made sense: Why would Saudi Arabia want to push oil prices down and keep them there? It’s true that Riyadh would seem to have the advantage over Russia in a price war, mostly thanks to its spare production capacity and the world’s lowest production costs—less than $3 a barrel.
Russia can’t match Saudi Arabia’s ability to boost oil production. But Moscow is much better at defense than the Saudis are. Russian President Vladimir Putin used the last few years to build a war chest of petrodollar reserves. At $577 billion, the cash pot is up 60% since 2015. Over the same period, Saudi petrodollar savings have declined 28%, to $502 billion. Moreover, Russia benefits from a floating exchange rate, which absorbs part of the blow of low oil prices. Perhaps more important, Russian society has already endured a few tough years of U.S. sanctions: It can absorb more pain.
So far, the tactics aren’t prompting the Russians to seek talks. The Kremlin has said it isn’t surprised by the fall in prices and doesn’t see a need to meet with OPEC. That’s partly because the price war is giving Moscow something it wanted: It’s prompting U.S. shale companies to announce big spending cuts. Rather than wait and see, as U.S. shale executives did when the Saudis tried to bankrupt them in 2014-16, this time spending cuts “have been swifter than expected,” says Brian Singer, a managing director at Goldman Sachs Group Inc.
So why didn’t Saudi Arabia cut production to support prices earlier and unilaterally? History provides some perspective on going it alone. For several years after the oil crisis in 1979, then Saudi Arabia oil minister Sheikh Ahmed Zaki Yamani, cut production unilaterally, with little help from others at OPEC, to keep oil prices high, at about $34 a barrel. In 1985, with output plunging, Riyadh turned his policy around, and soon after Yamani was fired.
Overnight, the kingdom boosted production significantly, and oil prices collapsed almost 70% from November 1985 to May 1986. When Riyadh made peace with its OPEC allies about a year later, the group targeted a price of about half what it had been before the Saudi production increase: $18 a barrel. Except for a brief spike during the 1990-91 Gulf War, it took 15 years for oil to trade again at its 1985 level of $34 a barrel. Every Saudi oil minister since Yamani has promised not to repeat his mistake of cutting production unilaterally. Prince Abdulaziz is no different.
Once the Russians opened the floodgates in Vienna, though, the Saudis opportunely jumped in. The kingdom has ordered Aramco to boost production capacity to 13 million barrels a day, up from 12 million. The expansion is a hugely expensive commitment. When Aramco decided in 2004 to lift output capacity to 12 million from 11 million, it spent six years and billions of dollars working on the project. Khalid Al-Falih, then Saudi energy minister, said in 2018 that lifting production capacity by another million barrels would cost the kingdom $20 billion to $30 billion.
It will also be difficult to reverse course. “As Saudi Arabia increases its productive capacity, its willingness and ability to cut production becomes more challenging, as no producer wants to be operating well below its maximum sustainable capacity,” Bassam Fattouh, director of the Oxford Institute for Energy Studies, wrote in a research paper published last year.
Riyadh is obsessed with an energy market that is being shaped by the fight against climate change. Aramco, on the prospectus for its 2019 initial public offering, warned that oil demand might peak within 20 years. The Saudis may be choosing a completely new strategy. As owners of a huge geological petroleum endowment, they could be moving to monetize their reserves more quickly to avoid being stuck with a rapidly depreciating asset. Energy scholars call it a “fast monetization strategy,” and Saudi advisers have been discussing it in private for some time.
The approach has advantages. It would secure a growing share for Saudi crude, as higher cost producers are pushed out of the market. Not just shale drillers, but even Big Oil, which is already under pressure from shareholders to boost profits, will have to cut spending on the development of new wells and, therefore, supply. Lower oil prices could also slow down the adoption of green technologies, particularly the electric cars that Tesla Inc. and others are building. And if Saudi Arabia and Russia can drive enough rivals out of business, perhaps the oil market would tighten again.
But the monetization strategy also carries enormous risk. Higher production, alongside weaker demand, is a certain recipe for low prices. If the kingdom follows it, others in OPEC will join, too, pushing even more crude into the market, further depressing prices. Saudi Arabia can barely afford that. According to the International Monetary Fund, Riyadh needs an oil price of about $80 a barrel to balance its budget. More important, its balance of payments only breaks even at about $50 a barrel. Without higher prices, Saudi Arabia will start to run large and sustained balance of payments deficits, putting the peg between its currency, the riyal, and the U.S. dollar at risk. Since he became de facto ruler of Saudi Arabia, Mohammed bin Salman has made a number of risky economic and political moves—the change of oil policy is one of the riskiest yet.
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