The next in our RD Explainer series takes a closer look at falling oil prices and their impact on the Russian economy.
A Noyabrskneftegaz oil well, located in the middle of Russia's West Siberian oil fields. Photo: AP
Plunging oil prices have thrown Russia’s economy into disarray. Combined with the impact of Western sanctions and a weakened ruble, lower oil prices have the potential to forestall any growth in the Russian economy in 2015 and beyond.
Through a series of questions and answers below, we review how and why global oil prices have been so volatile since mid-2014, and what all this means for the future of both Russia’s oil and gas industry and the broader Russian economy.
Source: IEA / BP
Why is the price of oil plunging?
The price of crude oil started declining in July 2014 and is now in free fall. In June 2014, benchmark European oil (Brent crude) peaked at more than $100 per barrel. By mid-January 2015, it was trading at $48.7 per barrel, slightly more than the five-year low of $46.6 hit earlier in January.
In less than 10 months, then, the price of oil has lost more than 50 percent of its value. The main cause of such an event, widely unexpected, can largely be attributed to the simple law of supply and demand: there has been an increase in global oil production accompanied by a slowdown in global demand.
What's happening to global demand for oil?
The demand for oil is decreasing due to a slowing world economy. Global growth is around 2.5-3 percent per year, well below the pre-crisis average of 7 percent, and is particularly weak in advanced economies.
The eurozone is still in deep crisis, with some of its members possibly sliding into recession again and a domestic market mainly stagnant. All of this is driving the fear of imminent deflation.
The U.S. economy is having good results but its growth rate has just reached the same level of 2006 (5 percent) and signs of inflation are increasing.
China, despite still experiencing significant growth, has seen growth slow from 12 percent to almost 7 percent since 2010.
In the second half of 2014, as prices were already tumbling, the International Energy Agency downgraded the expected oil demand for 2015 by 0.8 million barrels per day.
What's happening to the global supply of oil?
The shale revolution in the U.S. played a key role in boosting the global supply of oil. Starting from 2009, new engineering technologies enabled companies to exploit shale oil (i.e. oil present in “tight” spaces between rocks), which is abundant in America as well as in many other parts of the world.
Because of the high costs, this process is very expensive, but prices over $100 per barrel at the time made it profitable to drill. As a result, both new and established energy companies made the most by drilling extensively and increasing global output.
In the U.S. alone, oil supply rose from 5.6 million barrels per day in October 2011 to more than 9 million barrels per day in October 2014, according to the Energy Information Administration.
However, the real crisis started when Saudi Arabia, the UAE and Kuwait failed to cut their production in July 2014. These countries participate in OPEC, which sets a total production ceiling, currently 30 million barrels per day.
Many of its members have been under-producing for several years because of wars and sanctions, letting others, Saudi Arabia in particular, to expand well over their theoretical quotas. For example, this was the case with Libya, which almost suspended its production twice, first in 2011 and then in 2013.
Last summer, Saudi Arabia should have cut its production level to let Libya enter the market again, but refused to do so. As a result, oil output saw a steady increase, which consequently led to the quick fall of oil prices.
Who are the big losers from the falling price of oil?
The biggest losers in this story are the oil exporting countries. The drop in oil prices is putting in serious danger their economies, which often rely heavily on this fossil fuel to sustain public finances and growth. In particular, Iran, Venezuela and Russia have been suffering longer and more painfully than others. Their government spending plans require oil prices at $136, $120 and $100 per barrel, respectively, in order to breakeven at current output.
Furthermore, all three of these nations are facing either the possibility of funding crunches because of economic sanctions (Iran and Russia) or very poor credit ratings (Venezuela was downgraded to CCC+ last year by S&P). As a result, they are being forced to cut their spending and are struggling to repay their debts.
However, the current $40 oil price is way too low for any of the OPEC countries, Saudi Arabia included, since its government’s budget breakeven price is $95 per barrel.
An oil well pump operates in Boca de Jaruco, Cuba, Friday, July 11, 2014. Russian companies are expected to participate in petroleum projects around Boca de Jaruco on the island's north coast, and that cooperation will extend to offshore oil deposits, Cuban government website Cubadebate said. Photo: AP
Who are the big winners from lower oil prices?
The World Bank expects the oil importing developing countries to be the main winners from a low oil price.
In future years, according to the World Bank’s Global Economic Prospect, there will be a shift of income from oil exporting to oil importing countries. Analysts at the IMF have estimated a 0.2 percent increase in the world’s GDP for every 10 percent decrease in oil price. This will especially boost the manufacturing and agriculture industries, both of which are heavily dependent on oil products.
As a consequence, countries where economies are mainly based on agriculture and where oil products are massively subsidized may see a rise in their living standards and windfalls in public accounts.
Countries facing high inflation will take a breath as well. But developing economies will not celebrate alone. As The Economist has highlighted, China will also benefit, saving around $60 billion from oil imports without any major repercussions.
Russian President Vladimir Putin, left, is greeted by Chinese President Xi Jinping, center, who is hosting a welcome dinner for APEC leaders at the Beijing National Aquatics Center in Beijing, November 10, 2014. At right is Peng Liyuan, Xi’s wife. Photo: AP
Why didn’t the big OPEC oil producers cut their output?
The swing producer in the oil market is OPEC, and Saudi Arabia is the key player of this club. Riyadh and its neighbors are not eager to lose market share, threatened as they are by higher global output. They also are not eager to let competing members in.
As a result, OPEC, whose 12 members account for 81 percent of global reserves, broke into two factions (the Gulf countries opposing the cut; and Iran, Libya, Venezuela and Ecuador supporting it) and ultimately failed to find a solution, which resulted in oil prices tumbling.
Rivalry inside the organization is nothing new. In 1985, under similar circumstances, the Gulf monarchies opened the spigots and let their oil flood the market in order to cut out the U.S. and send Iran and Iraq almost to bankruptcy. At the time, Iran and Iraq, two of the largest producers of OPEC, were fighting a five-year war against each other.
Officials from the UAE stated during the latest meeting of the organization in November that the oil price was falling due to irresponsible behavior by producers outside the cartel, and OPEC president Diezani Alison-Madueke also called for international producers to “share the burden.”
The target of this criticism was the shale revolution and its main supporter, the United States, which has been blamed for boosting output without thinking about the international equilibrium for energy prices.
Why are people talking about a U.S.-Saudi conspiracy to lower global oil prices?
Rather than impacting the U.S., the Arab faction’s decision not to cut production is hitting American foes and critics, such as Russia, Iran and Venezuela. This apparent contradiction has led many to suggest a tacit win-win agreement between the wealthy Arab kingdoms and its overseas ally.
This logic implies that OPEC would help to ruin America’s enemies in exchange for a reduction in its shale output or military assistance against the Islamic State of Iraq and the Greater Syria (ISIS), which is threatening the Gulf and questioning the religious authority of Saudi Arabia.
U.S. President Barack Obama (right) meets with King Abdullah of Saudi Arabia in the Oval Office of the White House in Washington June 29, 2010. Photo: Reuters
But Saudi Arabia and its neighbors have hardly ever been so collaborative with the United States, and if a drop to $85 wouldn’t have changed much for Riyadh, the current freefall in prices is generating huge losses even for Saudi Arabia.
It is unlikely that the country would risk so much for a quite weak American response against Islamic State, which would have probably occurred anyway. This reckless policy makes more sense in a long-term view. By cracking down on the global shale industry and weakening other major producers, the OPEC group is driving competitors out of the market. This way the Arab producers would maintain preeminence for a few more years. In other words, it is a bet on the future: lose some money today to gain a larger market share tomorrow.
What are the effects of lower oil prices on the overall energy market?
Source: IEA / BP
Gas has also declined sharply in price during the last few months, since it is mainly sold via long-term contracts with the price pegged to oil. Hence, crude oil prices drive those of refined products, such as liquefied natural gas (LNG).
Furthermore, they influence the use of carbon-based and renewable energy resources (wind, solar, geothermal). As a consequence, if prices remain stable, oil will probably gain back part of the market share lost to other fuels.
Natural gas in Europe has already seen a significant drop in price after an agreement between Russia and Ukraine relaxed tensions over a new “gas war” and storage facilities returned to being full. LNG, on the other hand, will remain generally expensive, since trading costs must include those of liquefaction, transportation and re-gasification.
Used especially in areas lacking infrastructure (e.g. the ASEAN countries) or in regions difficult to reach via pipeline (e.g. Japan), this new entry in the energy market enjoyed great success recently, but will lose competitiveness against oil and many development plans could be put on hold.
Carbon, which is still widely used in Asia and was gaining market share from oil in that region, will become less competitive as well. In China, carbon is the main energy source but causes huge pollution. Low oil and gas prices are a golden opportunity to get rid of carbon dependence and improve air quality, a long-time plan of Beijing.
The fate of renewable energy sources essentially depends on the geographical area. Renewables are mainly used to produce electricity, so in countries where oil is not in use for this purpose, there won’t be any change. This, for example, is the case of the U.S. and UK. But in the Middle East and South America, where oil plays an important role in electricity production, we will probably see much stronger competitive effects.
The same will happen in the transportation sector. In 2013, this sector consumed 53 percent of global oil production and greener fuels are often subsidized by the state.
What is the impact of lower oil prices on Russia?
The oil price drop has caused high volatility in the foreign exchange markets for many economies. In Russia, the situation is particularly critical since the country was already tackling a currency crisis brought on by economic sanctions.
Since May 2014, the ruble has fallen in a downward spiral, losing as much as half of its value against the dollar. It is now trading at around 64 rubles to the dollar, down from 40 in January 2014.
Huge capital outflows, a near total drying up of foreign direct investment (FDI) and consequent massive recapitalizations led to the erosion of the Russian currency.
By forbidding or undermining relations between Russian and Western banks, the EU and U.S. are making it impossible for Russian state-owned and private sector companies to arrange new loans to repay debt and to finance new investments, Vladimir Milov pointed out at Russia Direct.
Russian banks and companies have a total external debt of nearly $660 billion and have to raise $105 billion to repay their creditors in 2015 without any loans, increasing the risks of default. The rush out of the Russian market, combined with the external debt repayment needs of the above institutions, have put huge pressure on the ruble exchange rate, causing the depreciation.
Furthermore, since more than 50 percent of the Russian federal budget is based on the energy industry, low oil prices have weakened further the currency and reduced the country’s revenues.
Sanctions also have the purpose of crippling oil production. Joint ventures with Western energy companies have been put on hold, cutting Russia out of the newest technology developments necessary to drill in the Arctic, where most of the country’s reserves are. The low oil price and lack of foreign loans will end up sacrificing new investments and exploration activity, marking a major blow to nation’s potential oil output.
What role are Russia’s largest oil companies playing?
Rosneft, the national oil giant, has an external debt of nearly $40 billion after last year’s acquisition of rival oil company TNK-BP. The Kremlin can’t risk the bankruptcy of the nation’s largest oil corporation and tried to save it through the Central Bank.
This led to a financial move that sparked large mistrust in the financial markets and led to a further fall in the national currency: On Dec. 15, during a special auction, the CBR spurred other state-owned banks to buy the $11 billion worth of bonds issued by Rosneft in October.
Source: Russian Ministry of Energy
As economist Sergei Guriev pointed out for The Moscow Times, the opacity of the operation, the risk of defaulting bonds now present in those banks and the obvious purpose of paying back external debt with that money, thus pressuring further the foreign currency market, played in favor of further depreciation of the ruble.
The Central Bank acted, raising interest rates from 10 percent to 17 percent in one day. The aim was to attract foreign investors, but no major results were achieved.
By the end of the year, the state had saved another bank, the National Bank Trust, for more than 100 billion rubles and it is now starting a massive recapitalization.
Rating agencies S&P and Fitch downgraded Russian state bonds just a step above junk amid fears of default on external debt in December 2014. Moody’s, another rating agency, followed the others in January 2105. In January 2015, Russian sovereign debt was downgraded to “junk” investment status.
Under these circumstances, the head of monetary policy of the CBR was replaced at the beginning of 2015. However, Steve Hanke, professor of applied economics at Johns Hopkins University and monetary policy advisor, commented that this change “will not save the ruble’s volatile float problems. In fact, quite the opposite: the problem lies in the floating exchange-rate regime since “the change in the price of oil always has a heavy influence on a floating currency’s value in a country that is exporting a lot of oil,” he said.
Inflation is also rising rapidly, peaking at 11.4 percent in December, up from 6.1 percent in January 2014, as the ruble depreciates and agricultural imports are banned with counter-sanctions. It is the highest rate recorded in five years.
How can we expect the Russian government to react to lower oil prices in the future?
Russia’s Central Bank stopped its currency interventions and abolish an official trading corridor for the ruble. This makes the ruble a freely floating currency. Photo: Reuters
According to the World Bank’s outlook, “oil prices are expected to remain low in 2015 and rise only marginally in 2016.” Exporting countries with extensive reserves and liquid sovereign wealth funds will be able to buffer the loss, but those who don’t will see a consistent contraction in their economies.
In Russia, due to the mix of sanctions and cheap oil, the economy is expected to contract by at least 3 percent in 2015. The will of some European countries to lift sanctions, if put into practice soon, may restore the desperately needed access to foreign loans and direct investments, making it easier to survive this difficult period.
Also, an oil shock may come from an OPEC agreement or from the political turmoil in the Middle East. If the Islamic State seizes larger parts of Iraq, oil production in the country will fall, balancing OPEC’s extra output and bringing up the price. Libya, Syria and Iran are also unstable and subject to production shifts. The death of King Abdullah in Saudi Arabia in January may bring some changes to the country’s policy too.
If this is not the case and sanctions remain the same, Russia will eventually enter recession and spend several years recovering. The Russian government will bail out the banking sector, which continues to experience weakness, driving major structural changes. A last, desperate possibility would be to establish capital controls.
Sberbank CEO German Gref recently stated that, “It's obvious that the banking crisis will be massive. The state will capitalize the banks and increase its stake in them, and the banks will buy industrial enterprises and become financial-industrial groups. All our economy will be state-run.”
Nevertheless, not every sector of the Russian economy will shrink. As with other emerging economies, lower oil prices will help manufacturing and agriculture to expand, and a weak ruble will help exporters. The Russian balance of payments will most probably stay positive, thanks also to the reduction in imports, and reserves remain quite liquid.
In the long run, Russia should try to develop industries other than energy and break the ruble-oil link in order to avoid what Hanke calls “the roller coaster ride.” This results in appreciation when the oil price goes up and depreciation when it goes down, with consequent inflationary highs and deflationary lows.
The solution, as he suggested forThe Financial Post, would be to peg the Russian currency to the dollar, as the Arab producers do, and establish a currency board, a council that supervises the creation of money in order to keep it consistent with foreign reserves, de facto abandoning dangerous independent monetary policy.