Oil, Saudi Arabia and the Russian Romance

Oil, Saudi Arabia and the Russian Romance

Lionel Kruger Weekly bulletin December 2018
Crude oil has suffered a substantial sell-off over the past two months. The international benchmark Brent Crude dropped 32% from a high of $86.29 per barrel on 3 October 2018 to a low of $58.71. The US benchmark WTI Crude reached a high of $76.41 on 3 October before dropping to a low of $50.29 on 28 November.

The price rallies leading to the October highs were driven primarily by market expectations of a looming supply shortage following Iranian sanctions. These sanctions came into effect on 4 November 2018. A subsequent decision by US authorities to offer waivers to some of Iran’s largest buyers caught the market by surprise, with eight countries benefitting. This had a significant impact on the market. In addition, US shale production ramped up higher than the market thought possible and, together with signs of slowing world growth, added to the bearish sentiment.

All eyes turned to the OPEC meeting in Vienna on December 6. Expectations were for a supply cut of up to 1.4 million barrels a day (bpd), which would send prices higher. After protracted haggling, OPEC and non-OPEC producers including Russia, agreed to a cut of 1.2 million barrels, most of which is to be shouldered by OPEC – 800 000 bpd. These cuts will become effective in January 2019 with a further review in April 2019.

Following the December meeting, prices rallied with Brent Crude rising above $63 per barrel. Saudi Arabia and Russia, the two largest producers in this group, were the two heavyweights in the negotiations. Both countries are increasingly co-operating on matters within the Middle East region. They produce 20% of daily global consumption.

This new era of détente between Russia and Saudi Arabia, or indeed their budding romance must be of growing concern to the White House. Saudi Arabia has traditionally been a strong US ally in the region, while Russia partnered with Iran, Saudi Arabia’s arch-rival. Attempts by Obama to bring Iran into the international fold and end decades of animosity had strained the relationship between America and Saudi Arabia. But Trumps overtures and in particular his re-introduction of sanctions against Iran had seemed to have supported the improving relationship between the two nations.

However, the recent murder of journalist Jamal Khashoggi, which appears to implicate Crown Prince Mohammed bin Salman is bringing Trump under increasing pressure to act against its long-standing ally, Saudi Arabia. Friday 7th December’s agreement to cut production flies in the face of Trump’s attempts to pressurise Saudi Arabia to support lower oil prices and may be indicative of a shift of priorities for the Kingdom.

Critics of the US relationship with the Saudi Kingdom argue that the US no longer needs Saudi oil and believe that rather than providing regional stability, the Kingdom is actively destabilising it. They point to the Kingdom’s war in Yemen and its support for Trump to dismantle the nuclear agreement with Iran, which according to the critics was showing tangible proof that it was working. This changing power dynamic in the region leaves the West with declining influence at a time when Russia is resurgent. What this may mean for oil security and future prices remains to be seen, but one thing is certain: the region remains a key source of crude with approximately 53% of the world’s proven oil reserves.

Alternative energy solutions and other initiatives will take a long time to replace fossil fuels and our dependence on the region will continue to require strong connections and diplomatic solutions.

The next direction in oil prices could be up as current prices are under recovering costs. The market will be looking for compliance of the announced cuts by OPEC and non-OPEC members in the coming months. The Brent curve has flattened substantially from the October highs, where it was backwardated by circa 15% over three years. With the current price uncertainty, in my view, optionality via caps and puts is the preferred route for current hedging activities, as opposed to locking in the forward price.

For more information, please contact Lionel Kruger, Director at JCRA, at Lionel.Kruger@jcrauk.com.

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