March 9, 2020 / 10:16 AM / a month ago

Breakingviews - Saudi sets global oil a stress test few will pass

An employee looks on at Saudi Aramco oil facility in Abqaiq, Saudi Arabia October 12, 2019.

LONDON (Reuters Breakingviews) - The oil market is undergoing another seismic shift. Following Friday’s failure to reach a supply deal with Russia, Saudi Arabia has turned its guns on everyone including its erstwhile partner by slashing prices. The new “every man for himself” approach knocked the value of a barrel of Brent crude by a fifth to around $36 on Monday morning, almost half the level in early January. Many players will sink rather than swim.

Saudi has supported the global oil market since 2016 by pumping less than its capacity of 12 million barrels per day (bpd). The recent demand slump prompted by the coronavirus – which consultant Rystad Energy thinks will see supply exceed demand by almost 3 million bpd in the first quarter – prompted the kingdom to return to its earlier approach of grabbing as much market share as possible.

The move has a brutal logic. Onshore oil producers in the United States need a price of nearly $50 a barrel to cover their costs on a new project and deliver a 10% return to investors. The equivalent break-even for Saudi oil giant Aramco is well under $20 per barrel. In other words, Riyadh’s restraint was keeping U.S. shale in business.

Wood Mackenzie reckons it will take at least six months for U.S. shale production to ease off even if capital spending is cut now. That means supply will remain elevated and the oil price could stay around $35. At that level Aramco, whose market value dropped under $1.5 trillion on Monday, would be worth barely half that figure even it cranks up output, according to a Breakingviews calculator.

Big western oil majors are also in the soup. Royal Dutch Shell, BP and Exxon Mobil need prices at $50 a barrel to finance capital expenditure and dividends from 2020 operating cash flow, according to Jefferies analysts. BP and Shell therefore face a starker choice between spending on non-fossil fuels and appeasing shareholders with big share buybacks and dividends. Exxon will have an even harder time justifying more investment in loss-making oil.

Meanwhile, state coffers will feel the strain. Saudi requires an oil price of $83 a barrel to balance its budget, the International Monetary Fund reckons. Though the country has around $500 billion in foreign currency reserves, the price war will make it even harder for Crown Prince Mohammed bin Salman – who enhanced his authoritarian reputation by detaining his predecessor Mohammed bin Nayef over the weekend – to pursue his Vision 2030 scheme to overhaul the nation’s economy and society.

The final stress test is climate change. At a time when their economies are under strain from Covid-19, big importers like China and India now have fewer financial incentives to shift away from oil to wind and solar power. That may be the new Saudi price war’s most baleful legacy.

Breakingviews

Reuters Breakingviews is the world's leading source of agenda-setting financial insight. As the Reuters brand for financial commentary, we dissect the big business and economic stories as they break around the world every day. A global team of about 30 correspondents in New York, London, Hong Kong and other major cities provides expert analysis in real time.


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