How Iran and Saudi Arabia Can Together Bring Peace to the Middle East
The Promise of Diplomacy as the United States Withdraws
The global oil market has never in history collapsed as precipitously as it has right now. The oil and gas industry, which provides almost 60 percent of the world’s energy, is engulfed in a double crisis that would have been dismissed as unthinkable at the start of this year. A price war, with producing nations battling for market share, has become lodged in the larger crisis of the novel coronavirus pandemic and what will likely be the worst recession since World War II. The resulting collapse in demand will be bigger than any recorded since oil became a global commodity. Oil prices are already down two-thirds since the beginning of 2020 and still falling. The decline in global consumption in April alone will be seven times bigger than the biggest quarterly decline following the 2008–9 financial crisis. In areas that lack access to storage and markets, the price of a barrel of oil could fall to zero.
This crash will create turmoil for oil-exporting countries and add to the turbulence of financial markets. It will also add another layer of complexity to an already fraught geopolitical situation—including by pulling the United States into contentious international wrangling over what can be done to ameliorate the crash. In February of this year, U.S. oil production reached its highest level ever, 13.1 million barrels a day—considerably more than either of the other top global producers, Saudi Arabia and Russia. That record followed a decade in which, owing to the shale revolution enabled by new fracking techniques, the United States went from being the world’s largest importer of oil to a major exporter.
U.S. President Donald Trump himself has already stepped into the fray. Although he has long been an advocate of low oil prices—and quick to tweet against the Organization of the Petroleum Exporting Countries (OPEC) and efforts at global supply management in recent years—the current collapse has prompted a reversal. He recently called Russian President Vladimir Putin to talk about what can be done to stem what he would later call the “hurtful” decline. Trump then called Saudi Crown Prince Mohammed bin Salman and announced that a sizable coordinated reduction by the major oil producers is in the works. The Saudis have followed up by calling for a reconvening of OPEC, along with other key oil-producing nations, including Canada and Mexico. All this has sent prices up, although the “when,” “how,” and “who” of the potential deal remain unclear. And the larger the universe of players, the more difficult it will be to implement an agreement.
The nature and sheer scale of the current collapse and the geopolitical wrangling it has prompted present unique challenges for the United States and its energy sector—challenges that will have significant consequences for the U.S. economy and U.S. foreign policy in an already perilous moment.
As with so many other industries, the extreme distress in oil markets was caused by the coronavirus pandemic. But in the case of oil, that distress comes with a geopolitical twist.
The last oil price collapse, which began in 2014 as a result of a surge in supply, finally ended in 2016 with the emergence of a new order in international oil—OPEC+. This was an agreement between 11 OPEC members and ten non-OPEC countries to jointly reduce production in order to stabilize a falling market. Sometimes called the Vienna Alliance because of where it was formed, OPEC+ was at its foundation a Saudi-Russian entente, with the then two largest oil producers (and longtime competitors) embracing the new collaboration. It also provided an opening for a strategic relationship, giving Russia an opening to build bonds with one of the United States’ most important allies in the Middle East and also to attract Saudi investment. For Saudi Arabia, it was a way to hedge its relationship with the United States and gain some leverage in its standoff with Iran.
China, the biggest growth market for world oil, was suddenly shut down.
But the first phase of the coronavirus crisis, the outbreak in China in January and February, fractured the entente. China, the biggest growth market for world oil, was suddenly shut down. Instead of global demand increasing, as was expected, it fell by an unprecedented six million barrels per day in the first quarter of 2020.
At the beginning of March, in and around OPEC and OPEC+ meetings in Vienna, Saudi Arabia and Russia began discussions about how to respond. It quickly became clear that they had very different perspectives. The Russian budget was based on what was seen as the relatively low price of about $42 a barrel. Meanwhile, Saudi Arabia, according to International Monetary Fund estimates, needed higher prices of around $80 a barrel to balance its budget. Accordingly, Saudi Arabia wanted deep cuts in output in order to try to put a floor under the price; Russia, professing uncertainty but assuming the impact of the coronavirus was likely to be much greater and would affect demand worldwide, argued instead to keep the existing agreement until June and then see where things stood.
Saudi Arabia insisted on the cuts. Russia emphatically said no. And so OPEC+ split apart.
Saudi Arabia’s immediate response to the fracturing of the entente was to announce that in the absence of cuts by all producers, it would open the valves all the way. It began pumping as much as it could, aiming to add 2.5 million barrels per day to the 9.7 million it was already producing. The additional production was supposed to help make up for the decline in price. Russia responded by announcing that it would also produce all it could, though its capacity to increase is much lower, closer to 300,000 barrels per day. The battle for market share was on.
But while the price was already falling, the coronavirus outbreak was moving into its second and more devastating phase—the global pandemic. The resulting shutdown of much of the global economy has generated a collapse in demand on a scale the world has never seen before. In April, the decline could be 20 million barrels per day or more—about 20 percent of total demand.
Even as demand craters, oil will still flow out of wells; if it doesn’t go to consumers, it has to go somewhere—and that means into storage, primarily tankage spread around the world. On a country-by-country basis, IHS Markit calculates that virtually every available gallon of storage space in the world will be full by late April or early May. When that happens, two things will result: prices will plummet and producers will shut down wells because they cannot dispose of the oil.
While the price was already falling, the coronavirus outbreak was moving into its second and more devastating phase.
Because of the nature of their oil fields, Russia and Saudi Arabia are able to produce oil at costs much lower than most other countries. In those other, higher-cost countries, when the price that a barrel will fetch is lower than the costs of operating the well, a company can’t afford to continue pumping without losing money on every barrel. At that point, a company will close the well temporarily. Among the hardest hit is U.S. shale oil. As a consequence, the United States will likely have to give up share in the global market, to others’ gain. And as Igor Sechin, the CEO of Rosneft (which produces 40 percent of Russia’s oil) and a critic of the 2016 OPEC+ deal, has put it, “If you give up market share, you will never get it back.” (For some in Moscow, that is welcome, for they see the growth of U.S. shale as having given the United States a free hand to impose sanctions on the Russian energy sector—such as those last December that halted the Nord Stream 2 pipeline from Russia to Germany just before its completion.)
U.S. shale producers are already under pressure. They are slashing their budgets and either greatly reducing or stopping drilling altogether. (With shale, drilling new wells is required to maintain production.) U.S. production could be down by almost three million barrels per day by the end of this year, according to IHS Markit calculations. If that comes to pass, the United States will still be a large producer, but well behind Russia and Saudi Arabia, and imports will rise. The economic costs will be high, given the importance of the shale revolution to the overall U.S. economy—accounting altogether, according to analysis by IHS Markit, for about 2.5 million jobs.
Is there some way to stabilize the global market? Ending the battle for market share would reduce the surplus flowing into the market, take some pressure off storage, and have a positive impact on market psychology, which is one of the factors that shapes prices. It would address only part of the problem of oversupply, but even that would be significant.
How to achieve such stabilization is another matter. But Saudi Arabia has a unique platform for facilitating a resolution, since it is chair of this year’s G-20, the forum for the world’s major economies to address and remedy international economic problems. During the 2008–9 crisis, the G-20 functioned as a sort of board of directors of the world economy. But that was a more collaborative era.
There are limits to what the United States can do. Members of Congress who are normally supportive of arms deals with Riyadh now want to tie the overall U.S.-Saudi relationship to international oil policy: 13 Republican senators from oil-producing states wrote to Saudi Crown Prince Mohammed bin Salman expressing dismay at what they described as Saudi policy “to lower crude prices and boost output capacity”; six of those senators, including the chair of the Senate Armed Services Committee, followed with a more pointed letter, saying that the U.S.-Saudi defense relationship “will be difficult to preserve if turmoil and hardship continue to be intentionally inflicted on the small- and medium-sized American companies.” Secretary of State Mike Pompeo pointedly noted Saudi Arabia’s unique opportunity to “reassure global energy and financial markets.”
Unlike Riyadh and Moscow, Washington cannot tell companies how much oil to produce.
Within the United States itself, the government has only a limited set of tools. Unlike Riyadh and Moscow, Washington cannot tell companies how much oil to produce. It does have the option of putting almost 700,000 barrels a day into available space in the strategic petroleum reserve, but it would need congressional authorization to spend the money to do so, and last week’s $2 trillion stimulus package did not include the $3 billion of funding that would be required. (That $3 billion would have likely been a very good investment for the government, doubling in value when oil prices recover in a few years.)
The power to regulate output of oil lies with the states, most notably with the Railroad Commission of Texas, which despite its name regulates oil production in that state, which accounts for 40 percent of total U.S. production. The commission has the power to reduce output from wells in the name of preventing “waste,” but the last time it exercised that power was half a century ago. Any effort today to “proration,” as it is called, would be supported by some companies and opposed by others. Outside of the United States, it would be read as a signal that other countries should also implement production cuts.
With much of the global economy at a standstill, the oil crisis is going to get worse in the weeks ahead, and the damage will be felt well beyond the oil industry itself. As prices go down and storage fills up, production around the world will decline dramatically. Some of that might be the result of the coronavirus infecting and disrupting operations in different parts of the world. Some of it might be the result of decisions by countries despite an era of fractious global politics. But the bulk of the decline will be the result of a market overwhelmed by the sheer fury of the coronavirus and the shutdown of the world economy.
UPDATE APPENDED (April 2, 2020)
This article has been updated to reflect news of a possible deal to end the price war between Saudi Arabia and Russia.