Russia just won the oil price war. In fact, they did more than that, they may have won the war that’s been brewing with the U.S. for years without firing a single shot. All they had to do was say, “nyet.”
I told you last week to expect them to do so.
Last week Russia stunned the world by refusing to back a proposed Saudi Arabia OPEC+ production cut. Then, in a fit of spite, Saudi Crown Prince Mohammed bin Salman cut the prices on all of their major export grades by up to $10 per barrel.
Markets which were already fragile collapsed. And this week has been one failed attempt at containing the contagion unleashed after another. The Fed tried on Monday, opening up the limits on its overnight and term repo facilities to nearly $200 billion per day. Then they raised the limits again on Tuesday.
Finally on Thursday, to stave off a failed 30-year bond auction, they opened up a $500 billion window for three-month repos. The crash in the oil markets has immediately and without discrimination blown up dollar funding markets as everyone scrambles and collateral isn’t to be found for love nor money, or at least money at the rates the Fed wants you to borrow at.
Jeff Snider at Alhambra Partners has been warning for weeks that the oil futures curve was signaling, “Iceberg Dead Ahead!” The problem was no one thought for a second that it was Vladimir Putin and not Fed Chief Jay Powell at the helm.
I’ve been warning for weeks that there was no way oil was sustainable at $60-plus a barrel for Brent Crude. It felt for most of 2019 that there was a strong will continually coming into the oil markets to save it from collapse at opportune times.
Most of them centered on some confrontation between Iran and the U.S. as the Trump administration piled provocation on top of provocation but with ultimately, “cooler heads prevailing.”
At least that would goose the price higher and keep important shale players solvent and still issuing new junk debt to drill more unprofitable wells for oil no one can sell and gas that just gets flared off.
Putin, I’m sure, understood the significance of the situation last week, and the timing of the Russian “nyet” to Saudi Arabia couldn’t have been more perfect. Lean on markets already in crash mode and force the Fed and the ECB into panic mode fighting a problem they have neither the tools nor the expertise (Powell and Lagarde? Please!) to solve.
And the reason he can do this is because Russia has all the tools needed to weather this storm they’ve unleashed. Unlike the U.S. shale drillers, Russian oil majors were forced to clean up their balance sheets in 2015-16, get rid of their exposure to the U.S. dollar and build their future business on accepting something other than dollars for their energy.
With a free-floating ruble they convert their earnings back into rubles which rise and fall with the price of oil and are insulated from the exchange rate risk.
I’ve been saying for years that Russia has the lowest cost of production in the world when push comes to shove. Now finally, someone else in the U.S. agrees with me.
“Russian companies can ensure sustainable production until oil hits $15 to $20 per barrel,” Karen Kostanian, BofA’s Moscow-based oil and gas analyst, told Bloomberg recently.
It is the well-developed field infrastructure, as well as efficient railway and pipelines that enables Russian oil majors to operate at low costs. Last year, state-run Rosneft PJSC, Gazprom Neft PJSC and the top private producer Lukoil PJSC spent less than $4 to extract a barrel of oil, according to Bloomberg calculations based on the companies’ financial reports. Add to this around $5 to ship the barrel and $6-8 per barrel of capital spending, and you still get a barrel of oil for under $20.
Moreover, the flexible tax system allows Russian oil firms to pay a sliding scale in taxes depending on the underlying sale price of oil.
At $20 per barrel, they pay no taxes.
This is what Putin meant when he said they can and will be able to weather $25 per barrel oil. In fact, I believe, he’s counting on prices staying in the current range to strangle the U.S. shale producers as well as Saudi Arabia out of the market, as they cannot compete with Russia.
Saudi Arabia ran a $50 billion primary budget deficit in 2019 at an average (and war-inflated) price of over $60 per barrel. With the Saudi Riyal pegged to the U.S. dollar and the kingdom barred by the U.S. from accepting anything other than dollars, the Saudis have zero flexibility except to lower prices and pump more.
But that won’t work against the Russians, who have the whip hand here.
The whirlwind unleashed by this sudden collapse in oil prices hits the U.S. where it is most vulnerable, in its over-geared financial markets. This move by Russia is a geopolitical masterstroke to force the U.S. into a different posture on continuing to use sanctions, tariffs and threats on Russia’s trade and strategic partners.
But, that’s for tomorrow.
For today, the bigger story is that the central banks have been revealed this week to be powerless to stop what’s happening. In fact, the problems unleashed now are beyond their ability to fix. And that’s what this crisis will ultimately prove to most of the world.
The sell-off in equities will continue as the dollar strengthens here and the focus shifts over to the political crises brewing all over Europe. Look for Italy’s coronavirus problems to overwhelm the government there and set up a confrontation with the EU over its rapidly deteriorating banking system.
The Fed and the ECB this week pulled out their big QE guns and the markets were not impressed.
Next week I suspect Atlas might as well.
• Money & Markets contributor Tom Luongo is the publisher of the Gold Goats ‘n Guns Newsletter. His work also is published at Strategic Culture Foundation, LewRockwell.com, Zerohedge and Russia Insider. A Libertarian adherent to Austrian economics, he applies those lessons to geopolitics, gold and central bank policy.