The 13-member Organization of the Petroleum Exporting Countries (OPEC), led by Saudi Arabia, agreed with its allies, including Russia, on April 9 that they will cut output in May and June by 10 million barrels per day in principle, the largest ever production cut in history. The move temporarily eased a month-long tension between Saudi Arabia and Russia on lowering production and keeping prices stable, but its smooth implementation is still in doubt.

Negotiations over production cuts between OPEC and Russia broke down at their meeting in Vienna, Austria, on March 6. Russia rejected OPEC’s suggestion that exporters cut production by 1.5 million barrels per day on the basis of an existing quota system.

Saudi Arabia, the world’s largest oil exporter, then made it known that in April it would raise its output from 9.7 million barrels per day to 10 million or even possibly 12 million barrels as a countermeasure. It also announced a stunning slash in April oil prices for its buyers in Asia, Europe and the United States, $6-8 less per barrel. Russia, in response, said it would also increase its output. Subsequently, oil prices went into a nosedive.

On March 30, Saudi Arabia announced it would raise its oil exports to 10.6 million barrels per day from May since it was consuming less domestically due to the novel coronavirus disease (COVID-19) pandemic. The announcement shocked the international oil market, with prices dropping to an 18-year low of $20 per barrel.

Falling off a cliff

A global recession and the sharp drop in oil demand due to the COVID-19 pandemic fanned the price war.

Since late February, the deadly respiratory disease has been spreading rapidly around the world. On March 11, the World Health Organization declared it a pandemic. The ensuing travel restrictions adopted globally have frozen international trade. Roberto Azevedo, Director General of the World Trade Organization, said the resulting economic downturn and job losses are worse than those during the 2008 global financial crisis.

According to forecasts by the Economist Intelligence Unit (EIU), the research and analysis division of the Economist Group, the global economy will contract 2.2 percent this year—2.8 percent in the U.S., 5 percent in the UK and 6.8 percent in Germany.

Against this backdrop, the global oil demand is falling off a cliff. Fatih Birol, head of the International Energy Agency, said it could dip 20 percent with billions of people in lockdown, the first negative growth since 2009. Facing the unexpected drop in oil demand, Saudi Arabia repeatedly asked OPEC members and other oil producers such as Russia, Mexico and Bahrain to cut their production, which eventually triggered a rebuff from Russia.

The price war between the world’s two largest oil exporters has sparked panic in the market. Within a month, U.S. West Texas intermediate crude futures tumbled 56.2 percent and British Brent crude oil prices plunged 54.5 percent. Since early this year, the drop in the prices of the two has been as high as 67.1 percent and 65.5 percent, respectively. The global oil market is in turmoil with energy companies’ share prices diving, further affecting the world’s financial market.

Oil exporters under threat

The nosedive would inflict significant damage on major producers, including Saudi Arabia, Russia and the U.S. though some countries such as Saudi Arabia have extremely low production costs (under $10 per barrel), their revenues are dependent on oil exports. They must maintain high prices to achieve fiscal balance.

According to the International Monetary Fund, Iran, which is subject to U.S. sanctions, needs an oil price of $195 a barrel to balance its budget, Saudi Arabia $84, the United Arab Emirates (UAE) $70 and Kuwait $55. Russia, which is also heavily dependent on energy exports, put forward its budget for 2020 based on an international oil price of $42 per barrel. Thus the current drop will put great financial pressure on these countries and hit their economic growth, leading to sharp currency depreciation and capital flight.

The breakdown in negotiations has already led to the Russian ruble tumbling. The Central Bank of the Russian Federation had to support the currency and push it up. However, the results have been limited. From March 6 to 23, the ruble lost about a fifth of its value against the U.S. dollar. The EIU forecasts that the Saudi and Russian economies will shrink 5 percent and 2 percent, respectively, in 2020.

Saudi Arabia, with its offense strategy, will gain more market share at low oil prices, while Russia may gain little due to its limited production capacity. The hardest hit will be U.S. shale oil producers, whose cost now is as high as $35-40 a barrel. Shale production in the U.S. will inevitably slow down in the short term.

But once the price rises above the cost, shale oil will make a comeback. Currently, the U.S., Saudi Arabia and Russia are the top three oil producers, all possessing a production capacity of more than 10 million barrels per day. Their combined production accounts for one third of the world’s total. In the future, a tripartite confrontation in global oil supply seems likely.

Major importers such as China will probably benefit from the price war. With an oversupply of oil, exporters are keen to ensure demand security, and as a strategic buyer, China has a prominent role. In recent years, Russia, Saudi Arabia and the UAE have expanded their energy cooperation with China to maintain their oil trade. By building joint-venture refineries and wooing Chinese companies to participate in the development of upstream resources, they want to strengthen China’s interest in their oil industry.

The price drops have reduced China’s import costs and helped to stabilize its economy after the effects of COVID-19. However, at the same time, the extremely low oil prices may create new uncertainties in the China-U.S. energy trade, affecting the implementation of their phase-one economic and trade deal. The low prices also pose a big challenge for the profitability of Chinese companies’ overseas energy investments.

Price rebound unlikely?

In the short term, oil prices are likely to continue to fall. Historically, any collapse in international oil prices since the 1980s was always initiated by Saudi Arabia, but ended eventually with it cooperating with other producers to keep prices stable. With their economies and finances heavily reliant on oil prices, neither Russia nor Saudi Arabia can afford a price war for more than half a year. When the world economy recovers and oil demand rebounds after COVID-19 wanes worldwide, there might also be a wave of compensatory price rises.

But international oil prices, in the medium and long term, will find it hard to bound back to the previous level. The world economy has entered a new normal of low-speed growth in recent years, and people are getting more aware of energy conservation and environmental protection. This consciousness as well as the progress in technologies will reduce the oil demand growth, and prices can’t maintain a rise.

The world is awash with oil, with U.S. shale oil production reaching 8 million barrels per day and showing great potential. Currently, the U.S. crude oil production is more than 13 million barrels per day, the highest in the world.

In addition, countries such as Canada, Brazil and Norway have seen rapid increase in their oil production. The abundant and diversified supply sources and the emergence of new energies will ensure a buyer’s market in oil, thus lowering prices. According to the Goldman Sachs Group, the average oil price over the medium to long term will be $45 a barrel, down sharply from the average of the past decade. Hence it remains to be seen how the production cut agreement led by Saudi Arabia and Russia bolsters prices.

The author is an associate researcher with the Institute of World Economic Studies at the China Institutes of Contemporary International Relations