Changing Landscapes: New Strategies for the Big Three Oil Producers
Two Crises for Today, One for Tomorrow
Three crises have shaken oil markets in the last seven years. The first two crises have primarily cyclical challenges resulting from a glut of oil in the markets: From 2014 to 2019, the tremendous growth of unconventional oil production in the United States due to technological developments in hydraulic fracturing triggered a supply-side shock. From 2020 to 2021, the COVID-19 pandemic and resulting lockdowns led to an unprecedented demand-side shock as economic activity declined worldwide. As a result of these crises, oil prices moved out of equilibrium from levels that ensured sustainable business operations for most producers to levels that were only sufficient for the near-term survival of some producers. In effect, markets introduced a live experiment that tested the pain thresholds of oil-producing nations with respect to the economically viable cost of production, fiscal breakeven points, and elasticity of supply and demand in a rapidly evolving business environment.
The third crisis is different. Transitioning to low-carbon energy will fundamentally alter the structure of the oil industry and poses a grave threat to the holders of the world’s largest oil reserves. Oil demand will shift from transportation to petrochemicals, and increased regulation of polluters is likely to impose a heavy toll on carbon emissions. Oil-producing countries may be left with stranded assets and will need to experiment with new economic models for their oil-dependent economies to survive.
Saudi Arabia, the United States, and Russia, the so-called Big Three, account for over one-third of the global oil supply and have been the main driving forces in the oil market. They have adjusted their strategies to face the first two crises but face a serious challenge from the transition to low-carbon energy and urgently need to come up with new solutions.
The Changing Roles of the Big Three
As the driving force within the Organization of the Petroleum Exporting Countries (OPEC) and an indispensable swing supplier capable of quickly increasing or decreasing its output, Saudi Arabia has been the true global manager of oil market volatility. This position is based on abundant, low-cost oil production and readily available spare production capacity. The sustainability of the budget and spending programs is Saudi Arabia’s greatest concern. Saudi Aramco, Saudi Arabia’s largest public petroleum and natural gas company, has the world’s lowest oil production cost. However, the Saudi economy depends on oil revenues, leading to a Saudi budget with fiscal breakeven oil prices exceeding market prices since 2014. As a result, the Kingdom has drawn down its foreign exchange reserves and resorted to debt to finance its budget deficit.
The largest global oil producer outside of OPEC and the world’s largest oil consumer is the United States. The U.S. shale boom has turned the United States into a net petroleum exporter and allowed it to capture more than two-thirds of the increase in global oil demand over the past decade. U.S. shale producers’ technological advances in hydraulic fracturing have been spectacular, increasing productivity and reinvigorating old U.S. oil production basins. Unlike conventional oil production, the short production cycle of shale makes it more responsive to price signals so that output can adjust as necessary. The main challenge is to find a balance between output growth and profitability. In terms of production volumes and technical improvements, the miracle has been offset by negative cash flows in each of the past ten years, frustrating investors.
As the growing U.S. oil output started taking market share away from Saudi Arabia in the first half of the 2010s, the Kingdom’s initial response was to start a war for market share. But U.S. oil producers demonstrated a surprising resilience to low oil prices, functioning instead at the level of short-run variable costs and prompting the Saudis to change course. They envisioned a larger and more influential OPEC that could rebalance the market through collective action. To achieve such a powerful OPEC+, the Saudis needed Russia to cooperate with their decisions. Russia’s traditional policy was to free ride on OPEC’s efforts, but, facing economically damaging international sanctions, the Kremlin was looking for ways to repair the situation with oil revenues and was open to collaboration.
Russia, also rich in oil reserves and heavily dependent on oil revenue, has steadily grown its oil output from 7 million barrels per day in the early 2000s to over 11 million by the mid-2010s. However, unlike Saudi Arabia, Russia does not have a significant spare production capacity and cannot quickly swing its oil output, making them more vulnerable to volatility in the oil market. Russia’s solution to its budgetary dependence on oil revenue has been a large-scale depreciation of the ruble and active import substitution. Russia has high foreign currency reserves and a self-adjusting tax that protects oil producers, making them more resilient to a prolonged low oil price environment.
Although the creation of OPEC+ towards the end of 2016 surprised market watchers, Moscow was convinced that a more predictable and managed oil market would give Russia more benefits than a destructive war for market share. Russia’s main interest in the OPEC+ alliance has been to avoid extreme price volatility and protect itself from the downside, especially after the oil price crash in 2015.
The Russian decision-makers initially envisioned having a limited role in the OPEC+ alliance but eventually realized the importance of formulating the OPEC+ pricing policies. Despite their differences, Russia and Saudi Arabia’s cooperation has been productive, save for an incident in March 2020. Russia had to introduce major production cuts and face difficult technical and economic trade-offs for the first time because of the oil demand slump during the COVID-19 pandemic. The dwindling demand led to tactical disagreements that almost dissolved the pact. The parties negotiated and came to an unprecedented agreement in April 2020 that helped stabilize and then rebalance oil markets by the beginning of 2021. This suggests a possibility of longer than expected cooperation between the two countries based on mutual compromises.
Keeping the market in balance, however, is a juggling act. Moving forward, Saudi Arabia has a strategic interest in OPEC+ limiting the oil supply so that oil prices remain at a level where it has some fiscal breathing room, which is around $70 per barrel. On the other hand, Russia’s main challenge will be maintaining stable oil output by managing the decline of its legacy fields while transitioning to new, higher-cost assets, such as deeper layers of existing oil fields and remote new greenfields. Russia needs predictable and stable oil prices around $50 to $60 per barrel to achieve this. If the market becomes too tight, it might result in a price spike that would allow U.S. shale producers to bounce back. These concerns mounted as oil prices approached $70 per barrel in March 2021. Therefore, U.S. producers’ response to a higher price environment in 2021 will be a key bellwether. If both the oil service sector and oil producers focus on returning to profitability, U.S. shale output may not grow as quickly as before, but it may become more sustainable.
The U.S. interests with regards to oil prices have become more nuanced and complicated. Previously, as a large net importer of oil, U.S. policy supported lower oil prices to benefit consumers. The shale revolution has since transformed the United States into a net oil exporter, making the oil and gas industry an important engine of economic growth and domestic job creation. As a result, extremely low oil prices are potentially damaging to important parts of the U.S. economy.
The Divergence of Longer-Term Strategies of the Big Three Amid Energy Transition
The new Joe Biden administration in the United States has already indicated its focus on decarbonization, setting the course for less friendly policies towards hydraulic fracturing. Tougher economic terms and stricter regulations would increase costs for U.S. shale producers and raise their average breakeven prices, thus avoiding the next unsustainable surge of U.S. oil output. In sum, if U.S. shale becomes more constrained by financial self-discipline and the need to reduce carbon emissions, it would be less responsive to price signals. Counterintuitively, this would make it easier for Russia and Saudi Arabia to cooperate in managing the global oil market. In this scenario, oil prices in the range of $50 to $70 per barrel could satisfy the main oil-producing countries, allowing them to reach their immediate goals.
Decarbonization policies will also impact the long-term demand for oil. Therefore, in addition to reaching the immediate goal of bringing near-term supply and demand to equilibrium, the world’s largest oil producers need to ensure the long-term marketability of oil against the competitive market pressure of non-carbon sources of energy. With this in mind, Saudi Arabia has been calling for adopting a Circular Carbon Economy, which focuses on reducing, reusing, recycling, and removing carbon through reliable and sustainable technology solutions. As part of these efforts, it expands its value chain by investing downstream, particularly in petrochemicals. Russia has been slow to start its energy transition, incentivizing demand for oil and gas at home instead. Its immediate efforts focus on diversifying its export markets toward Asia, where the energy transition is likely to take longer. The United States is hoping to use its competitive advantage in greener technologies as it charts the path in its energy transition and foreign policy.
The energy transition will increase divergence in oil producers’ long-term strategies and increase competition within the traditional energy markets driven by economics, regulation, carbon border adjustments, and trade restrictions. However, this does not necessarily mean that competition will prevail over cooperation in global oil markets. Increased pressures from the energy transition could bring long-time rivals closer together, but the forms of cooperation will have to evolve to survive.
Vitaly Yermakov is an expert with the Center for Comprehensive European and International Studies at Higher School of Economics in Moscow and a Senior Research Fellow at the Oxford Institute for Energy Studies. Over the past 25 years, he has held positions for Cambridge Energy Research Associates, KAPSARC (Saudi Arabia), and TNK-BP oil company. He holds an M.A. from Duke University and a Ph.D. from Samara State University.