Russia Balks at Further OPEC+ Cuts – Here’s What That Means

Oil prices continue to advance this morning as crude recoils from a very oversold situation. That the newly named COVID-19 – the “Wuhan flu” coronavirus pandemic – appears to be slowing is regarded by the market as a respite, although there is as yet no breakthrough in either prevention or treatment.

Both major oil benchmarks – West Texas Intermediate (WTI), the yardstick for futures contracts in New York, and Brent, the more widely used global standard set daily in London -had significantly weakened for the month, down 16% and 17.9%, respectively, before a floor developed yesterday.

Yet this morning OPEC is cutting forward demand projections in consequence to indications that COVID-19 will continue to impact all manner of trade and commerce in an expanding worldwide slowdown.

That means there will be some headwinds forming in short order…

With COVID-19, Perception Is Reality for Now

Now, I have said previously that perceptions of how the coronavirus has adversely affected economic activity has been an overreaction. Certainly, there is some effect from curtailed air flights and cut cruise line traffic.

Nonetheless, the justification for significant declines in energy usage have not emerged.

Yet it makes little difference to an investment climate taking its signals from emotional reactions and a “sky is falling” approach to each new adverse development requiring an immediate solution. That almost always translates into a mad rush to the exits.

All of this means countries relying upon the production and export of raw materials are confronting severe budgetary concerns. OPEC+ (the producing organization led by Saudi Arabia plus major outside producers headed up by Russia) is the most apparent.

Last week, OPEC’s technical group recommended that existing OPEC+ aggregate production cuts already in force continue until the end of 2020. The group also proposed an additional removal of 600,000 barrels a day through the end of the second quarter in response to the pronounced decline in price.

This announcement is the primary reason oil prices have found a floor, at least for now.

That additional cut was less than many in my network of sources had predicted. There, the consensus had been for upwards to one million barrels, perhaps phased in over the next several quarters.

The restraint currently in force amounts to a 1.2 million barrels a day decline from the totals registered some five quarters ago, 1.4 million after factoring in additional unilateral reductions by the Saudis. The figures should be properly regarded as “on paper,” since some OPEC members have been evading their quotas of the cuts.

However, the effectiveness of continued production declines requires the continued agreement between the two main parties – Saudi Arabia and Russia.

Some problems have emerged there…

Russia Is Playing Its Cards Close to the Vest

Moscow has been noncommittal in response to the OPEC technical group’s recommendation, saying that it is reviewing the matter. The official line remains that of Russian Energy Minister Alexander Novak who on Tuesday avoided any direct comment.

Rather, the minister said that Russia is carefully studying the recommendation of the technical committee in order to assess the situation on the market and take a balanced approach based on the interest of the market as a whole, refusing to reveal anything about the Russian position.

Several of my contacts both in Minenergo (the Russian Energy Ministry) and OPEC now believe there will be no formal Russian response until the next OPEC+ meeting scheduled for March 5-6. Another session of the OPEC technical group is likely before that meeting. Any move forward on additional production cuts will have difficulty succeeding should Moscow decide against them.

Russian oil companies have complained about the cuts in the past, regarding them as inimical to their own expansion requirements and only serving to provide more leverage to U.S. shale exports. As an indication that company opposition exists, Russian President Vladimir Putin yesterday met with his close political ally Igor Sechin, president of the Russian state oil company, PJSC Rosneft Oil (OTC:OJSCY).

Word is that Russian oil company officials will meet with Novak today. I have confirmed that discussions have already taken place this week among the companies in advance of any set down with the government. Sources tell me the companies are in opposition to any further cuts beyond those already in force.

The situation is shaping up as the latest test of Putin’s ability to dictate policy.

Nevertheless, the Oil Must Flow

There are two overriding problems for Russia arising from the low price of oil. Both have resulted in the companies preferring to increase production, even evading cuts Moscow has agreed to in the process.

First, Urals Export Blend, Russia’s main export grade, trades at a discount to Brent. Consignments offered in Mediterranean trade last week priced $1.50 lower per barrel to Brent were withdrawn after attracting no bidders.

The Russian central budget is dependent upon the proceeds from oil exports. Last summer it was set based on a price of $49 a barrel for Urals Export, the lowest level in a decade. Currently, with Brent at slightly more than $54 and Urals Export selling lower, there is no budgetary flexibility and sectoral deficits emerging.

In addition, the Kremlin runs some operations “off the books,” relying on proceeds from oil and natural gas sales (having an ongoing and pronounced pricing decline of its own). That makes the need to sell more crude even more acute.

Second, and from the standpoint of the companies looming even more important, Russia is experiencing an accelerating and acute problem in arresting production declines from its traditional Western Siberian basins. The vast majority of Russian oil comes from these mature locations.

To offset this approaching crisis, which some analysis indicates could reach an 8% annual decline by 2022, Moscow must move in four directions:

  • above the Arctic Circle;
  • out onto the continental shelf
  • into Eastern Siberia (where there are known reserves but no expensive infrastructure and support); and
  • below the current mainstay production locations in Western Siberia.

This last category comprises large resources of heavy oil – more expensive to produce and needing production approaches not available in Russia. The usual steam-assisted approach succeeds only in collapsing the Siberian tundra.

All of these require vast amounts of capital expenditure (capex) and access to sophisticated equipment and technique. Russia is limited in acquiring the latter from the West due to U.S. sanctions, which are also putting a major dent in possible Western investment.

Russian oil companies need to rely on working capital derived from sales. The government agreeing to a further cut in exports makes that even more difficult.

One Russian contact put it to me this way: “An additional cut in oil may help the global price a bit. But it runs the risk of an economic downturn [in Russia]. And that is without a single case of coronavirus appearing here.”

Putin may be able to jawbone the companies into line. But it is not going to be easy. Even if he succeeds, the Russian budget and company needs will oblige a heavier reliance on exports.

The stage for a renewed Russian-Saudi competition to provide product for the Asian market is likely. That might become the biggest threat to OPEC+ moving forward.

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