27 October 2014

Saudi oil – the secret weapon against Russian encroachment


As oil prices remain depressed, my Centre for Policy Studies paper from March, ‘Deploying the Saudi Oil Weapon’, appears prescient. The aim of this article, however, is not to crow, but to examine the reasons for falling oil prices, and to look at why we need cheap oil for as long as it is feasible to have it.

First, to the reason for oil prices falling, which is undoubtedly a conjunction of circumstances. On the demand side, consumer energy demand is anaemic and oil stocks are high. On the supply side, there have been several surprise jumps in production, notably from Libya, as well as surging US output.

Still, the deciding factor is undoubtedly Saudi Arabia, the only ‘swing producer’. As prices tumbled in September the Saudis claimed that they favoured firmer prices and were dropping production. Some market observers doubted that this was the case, as rumours circulated that the Saudi were in fact doing the opposite. The confirmation came on 1st October, with the news that the Saudis were offering a $1 discount to the market price of their oil to Asian customers.

Why would the Saudis do such a thing? One answer is a rush by the Gulf producers to lock in long-term market share in Asia. This is made easier by the disarray of OPEC – several OPEC members are up in arms (particularly Venezuela), but the Saudis and other Gulf producers show no sign of heeding their concerns.

Some commentators are suggesting that the Saudis favour low prices to undermine the economics of US shale oil production. But this explanation hardly bears scrutiny. For one, the US-Saudi partnership is reviving with the joint onslaught against ISIS. Moreover, much of US shale oil production is very cheap indeed, and still profitable at today’s prices, while lifting costs are falling as technology advances. Given the huge existing investment in US shale, and its strategic importance to the US, it is naïve to think that a period of soft oil prices will reverse its march. And the Saudis, while sometimes wrong headed, are seldom naïve.

Much more credible – although impossible to prove – is that the US and Saudi Arabia have indeed agreed to depress oil prices to rein in Russia. This theory has lately become a staple of Russian state media, which generally depicts the West as a conspiracy of evil capitalists and fascists bent on destroying Russia along with running dogs such as Ukraine and Estonia. The irony is that in this specific instance, they may be spot on.

For the Saudis this is more than quid pro quo for help dealing with ISIS. Russia has also become a domestic pest in the Middle East, where it gives extensive direct military assistance to the Syrian regime and does what it can to prop up Iran. Iran too is vulnerable to low oil prices, and the sensitive juncture in nuclear negotiations is a good time to apply leverage: the IMF calculates that Iran needs an oil price of $153.40/barrel for its budget to break even.

Nonetheless, Russia must be the primary target. The combined effect of sanctions and low oil prices is plainly making an impact on Russia. The ruble is in free fall (party as a result of the drop in oil prices), as is the MICEX stock index, and companies such as Rosneft are applying for huge state bail outs. Anecdotal reports point towards growing unease among large sections of the Russian population. The current Russian budget needs an oil price of $100/barrel to break even – up from $85/barrel at the time of writing my paper back in March (when the oil price was $103/barrel). By comparison Saudi Arabia needs just $83.60/barrel to break even (around the current level) and has vastly greater financial reserves to fall back on. There are reports that the Russian central bank and finance ministry are making contingency plans for a price as low as $60/barrel, which would be catastrophic for state finances, but is hardly an outlandish level.

The rationale for squeezing Russia is not just the immediate crisis in Ukraine, grave as it is. Putin has made clear that this is only the beginning of his deranged scheme to dominate Russia’s neighbours and remodel the international system. Speaking in Sochi on Friday, Putin suggested that the answer to global problems is, ‘co-operation between nations, societies, in finding collective answers to challenges, and in joint risk management’, none of which is objectionable in itself. While castigating the West for allegedly illegitimate interventions in Kosovo and Iraq, he continued to deny the presence of Russian troops in Ukraine, and glossed over the annexation of Crimea. What Putin proposes, in other words, is that a revanchist and criminalised Russian state receives a seat at some notional top table where it can legitimise its adventures while constraining its adversaries.

Behind this ambition lies a huge military spending programme. As it stands, Russia plans to spend $576bn between now and 2020, with the aim of replacing 70% of military equipment, including its clapped out nuclear weapons. History suggests that this may not end happily.

Fortunately, the deterioration in Russia’s state finances is already undermining this ambition. In early October the finance minister, Anton Siluanov, said that Russia could no longer afford the rearmament programme: ‘A new defence programme will be prepared now, and in its framework we want to reconsider the amount of resources that will be spent from the budget in order to make it more realistic.’ He went on, ‘When we were adopting the defence programme, the forecasts for the economy and budget revenues were completely different. Right now we just cannot afford it.’

Siluanov, however, has no authority to cut the defence budget, as that decision rests with Putin. He must now decide whether to accept a radical cut in the rearmament programme, or to press ahead with it anyway.

In the latter case, Russia may find itself back in the bear trap of the 1980s, when the Politburo considered high military spending indispensible. As the original US-Saudi oil weapon eroded hard currency earnings and the living standards of the population plummeted, the occupants of the Kremlin unwittingly sealed the fate of the USSR.

There is every chance that Putin will choose the irrational option, but that is hardly an argument for doing nothing: if there is a better containment policy than depressing oil prices, it has yet to be suggested. As for whether it continues, the OPEC meeting scheduled for 27th November ought to give some guidance.

Neil Barnett has 15 years' experience as a journalist in Central and Eastern Europe (CEE) and the Middle East, writing for the Telegraph, the Spectator and Jane's Defence Weekly. He covered the 2004 Orange revolution in Ukraine and the conflict in Iraq and has written a biography of Tito. He now runs Istok Associates, a risk consultancy specialising in CEE and the Middle East.