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Crude oil prices fell about 20%, with prices per barrel dropping into the $30s. Energy analyst Pavel Molchanov weighs in on the underlying Saudi Arabia-Russia tensions.

Last Friday’s 10% sell-off ended the worst week for oil prices since 2008. Get ready for more pain – much more – in Monday’s trading, following the declaration of what amounts to a price war between Saudi Arabia and Russia, two of the world’s three largest oil producers. As of Sunday night, WTI and Brent were both down ~20%, with WTI in the low $30s and Brent in the mid-$30s. These are the lowest price points since the oil market’s trough in February 2016, during the previous (2014-2016) price war between Saudi Arabia and U.S. shale. Below are some initial insights.

COVID-19 fears initially sparked bear market in crude

Let’s underscore that oil had been in a textbook bear market even before the Saudi-Russia headlines of recent days. From the highs of early January, during the Iran war scare, WTI and Brent had already fallen by close to 25% as economic and transport dislocation from COVID-19 continued to escalate. On February 24, we estimated the virus’s peak demand impact at 2.0 million barrels per day (bpd) in February and March, with 80% of this in China and 20% elsewhere in Asia-Pacific. While there are encouraging signs of stabilization in China, the noticeably worsening situation in Italy, Iran and certain other parts of the world means that the actual demand impact could be greater than our estimate from two weeks ago. For example, just this past weekend the Italian government took the drastic step of imposing a quarantine on 14 northern provinces totaling 16 million people. By definition, this will reduce energy demand, oil very much included.

Saudi-Russia price war adds a supply dimension to the panic

Oil’s sell-off last Friday was a direct result of the failure of Saudi Arabia and Russia to agree on an incremental supply reduction. On Thursday, the Organization of the Petroleum Exporting Countries (OPEC) had proposed a cut of 1.5 million bpd, contingent on Russia’s participation, but on Friday Russia refused. The fight between Saudi Arabia and Russia – which had collaborated, albeit uneasily, as part of the OPEC+ coalition over the previous three years – turned even nastier on Saturday. Here is what happened: Saudi Arabia is offering wider-than-normal crude discounts to European buyers and also signaled that it will increase output to 10-11 million bpd in April, up from the current level of 9.7 million bpd.

Is this the start of a new price war?

In a word: yes. This price war, however, is not against U.S. shale – this is a key contrast to the 2014-2016 price war. Saudi Arabia can see perfectly well what is happening in the U.S. industry: the already depressed rig count and sharply slowing production growth. Rather, this represents an “intramural” fight between Saudi Arabia and Russia. The fight is partly economic – hence the no-deal outcome on Friday – but it is also political. Russia will have a major constitutional referendum in April, arguably the most sensitive moment in domestic politics during Vladimir Putin’s 20 years in power. In the run-up to the referendum, the Kremlin is stirring up nationalist fervor at home, and that translates into more intransigence than usual in foreign policy. Moreover, Saudi Arabia and Russia have never stopped being at loggerheads over Iran (Russia is friendly with Tehran; for Saudi Arabia, it is enemy number one) and Syria (Russia backs the Assad regime; Saudi Arabia helps fund the rebels).

A silver lining

This price war cannot last as long as the 2014-2016 one – neither Saudi Arabia nor Russia could afford it. In the very short run (days, perhaps weeks), oil market conditions will surely be rough. Recall, the floor in 2016 had been set when numerous data points began to emerge about higher-cost / lower-margin oil producers literally shutting in wells: in Venezuela, Canada, even Oklahoma. With light sweet benchmarks in the $30s, and heavier or more sour crudes at discounts to that, our sense is that the shut-in scenario is not far away. Even more importantly, we highly doubt that Saudi Arabia can keep this going for long. Let’s underscore, Saudi Arabia needs $80+ Brent to balance its all-in fiscal requirements, so current pricing in the $30s is not even in the ballpark of what would sustain its economy.

Moreover – and this is another big distinction versus 2014-2016 – Aramco is a public company. Does the crown prince want to deal with angry domestic investors who (as of the weekend) are seeing losses from the IPO price? Again, this factor, a key test of the royal family’s credibility, did not exist four or five years ago. Russia’s economy is less oil-sensitive, but it, too, would begin to feel real pain within months. Thus, we look at this Saudi-Russia breakup as a fundamentally transitory issue. Above all, though, what oil needs to begin to sustainably recover is clarity on the COVID-19 situation. This is a matter of medical advances (antiviral treatment development, followed longer-term by a vaccine) and public health management, rather than something energy-specific.

All expressions of opinion reflect the judgment of Raymond James & Associates, Inc., and are subject to change. There is no assurance any of the trends mentioned will continue or that any of the forecasts mentioned will occur. Economic and market conditions are subject to change. Investing involves risk including the possible loss of capital. Investing in oil involves special risks, including the potential adverse effects of state and federal regulation and may not be suitable for all investors.