Over the weekend of March 7-8, Saudi Arabia declared economic war on Russia’s oil industry. Russian President Vladimir Putin had refused to cut back oil production in the face of depressed prices caused by an unprecedented 3.5 million barrels per day (b/d) fall in demand occasioned by the coronavirus crisis. The Saudis are now flooding the market for oil and unilaterally slashed their own prices enough to drive down prices on Monday by 25 percent. This price shock threatens serious damage to the overleveraged U.S. oil and gas sector already weakened by depressed demand and prices. U.S. President Donald Trump needs to push back on our Saudi friends, and also the Russians who have long sought to keep prices low enough to destroy the American shale industry. At a minimum, the Trump administration should pressure both the Saudis and Russians to stop flooding the depressed market at a time of global crisis, as their dispute threatens to trigger widespread bankruptcies and debt default in U.S. markets.
The timing of the Saudi face off with Russia is perplexing. The world has already seen a major demand contraction due to the coronavirus outbreak which shut down large swathes of the Chinese economy in February and is almost certain to drive the economies of Europe, Japan, and the United States into recession. Natural gas prices are also historically low for the same reasons and due to a warm winter. Shale producers were already vulnerable in the last year partly because of their historic success in increasing production domestically.
According to a report by Evercore ISI, shale operators have had cumulative negative cash flow of over $280 billion since 2007. U.S. banks and private equity firms, which have financed growth in the shale boom, are starting to ratchet back their support of shale firms as their balance sheets deteriorate. Recent reporting indicates that over $140 billion in debt for the exploration and production sector is in danger of falling into the junk range, and the total is over $300 billion for associated gathering, processing, and transportation companies. The entire sector accounts for between 10 and 16 percent of all high yield debt on the market. Since 2015 there have been over 400 bankruptcies in the entire industry, causing untold losses of shareholder value in publicly trade firms in addition to bond losses. Direct losses from bankruptcies are over $200 billion. Major marquee names such as Occidental and Noble Industries are at risk, as indicated by Occidental’s recent slash in its dividend by 86%.
Very few U.S. firms can prosper with prices in their current ranges. A Dallas Federal Reserve Board survey late last year found that 59 percent of operators in its region need prices of crude at $50 or more per barrel to support new capital investment in 2020. As of March 12, the West Texas Intermediate benchmark was at $30.71.
In 2014 and 2015 the Saudis engineered lower prices to try weakening the U.S. shale boom, with complicity from the Russians. Although they failed to destroy the industry, the episode did result in a 15 percent drop in U.S. oil production and some 150 bankruptcies. Since then, total U.S. oil production has surged to over 12 million barrels per day, a gain of 60 percent, and U.S. exports of oil and gas and related products now are running at a rate of over $200 billion per year, a major component of U.S. economic strength and support for jobs.
The overall U.S. oil and gas sector produces around $1 trillion each year in employee compensation, largely in very high wage blue- and white-collar jobs. Capital investment in the sector was around $150 billion in 2018, although preliminary 2019 data indicates it may have fallen by over 20 percent, another sign of weakness. Much of the growth in employment in the shale boom era has occurred in states like Ohio, Pennsylvania, West Virginia, Texas, and New Mexico—some of which have helped to determine the results of recent U.S. presidential elections.
The oil and gas sector is clearly one of the great pillars of strength in the U.S. economy, especially in the relatively slow growth years after the great recession. It is a highly leveraged industry characterized by cycles of boom and bust, and its cycle is frequently correlated with overall U.S. economic performance. In the current environment of crisis, pushing prices well below cost for most domestic producers threatens additional bankruptcies and bond defaults, and raises the specter of financial sector instability and job losses in politically important states. Low prices will help U.S. consumers who spend over $500 billion annually on gasoline but the macroeconomic impacts and associated job losses outweigh these gains. This is especially true if massive bond and bank loan defaults undermine the stability of financial institutions.
In short, the Saudi effort to call the Russian bluff and drive them into either submission or financial crisis, as the Russians need prices of $42 per barrel to support its welfare state, threatens to inflict severe collateral damage to the U.S. economy. It is undoubtedly true that the highly innovative and productive U.S. industry is some threat to the Saudi economic model, as some 70 percent of government revenue is derived from oil. But Saudi Aramco—which until very recently was listed publicly—is actually damaged by the price war; Saudi Arabia needs prices of well over $80 to support their welfare state and diversify their economy.
The Saudi-engineered geoeconomic assault on other oil producing nations demonstrates what a fickle ally it is for the United States. In a time of real crisis—with the coronavirus threatening the lives of people around the world—President Trump needs to forcefully suggest to Saudi Crown Prince Mohammad bin Salman that he back off this mutually destructive program. Market forces will eventually adjust to supply and demand dynamics, and both U.S. and Saudi producers will survive as the most efficient producers in the world. Persisting in a brutal price war undermines both countries and risks a more lasting deterioration of the relationship.
Read in Forbes