Russia and Saudi Play a Dangerous Game of Chicken

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This article will tackle the big news. Saudi Arabia announced that it will increase oil production from 9.7 million barrels a day to 10 million and then to 12 million if needed. This news alone sent the oil price down 20% – and the whole stock market with it.

I understand the market’s reaction, but I don’t view this news as negatively as the market does. Let me explain what Saudi Arabia is trying to achieve.

Saudi Arabia and Russia have had a very cozy relationship over the last few years. Though Russia never officially joined OPEC (the cartel that controls 42% of oil produced globally and that consists mostly of Middle Eastern members), Russia coordinated with OPEC; and thus for a while OPEC became OPEC+ (like Disney+, but less entertaining).

However, over the last few months Russia has had a falling out with OPEC. The coronavirus has brought global travel to an abrupt stop and has thus reduced the demand for oil, while production (supply) has not changed. OPEC wanted to reduce production to stabilize the falling oil price. Russia refused.

We need to understand how both sides view oil. Saudi Arabia views its oil as a large but finite reservoir, and it tries to maximize its value over the long term. Therefore, it wants oil prices to be not so high that the global economy is crippled and companies are forced to switch to alternatives, but not too low, either, since the Middle East (with the exception of Israel, which was blessed by not having oil) is a one-trick petrochemical pony. Thus, the Saudis are willing to sacrifice their revenues in the short run (by lowering their production) to increase the value of their oil reservoir in the long run (by keeping supply and demand in balance).

Russia, on the other hand, would love nothing more than a $100 or even $150 oil price. It would solve a lot of Russia’s budgetary problems, so on the surface the country’s interests seem to be aligned with those of OPEC. But here is the wrinkle: Today Russia cannot afford to think long-term. Unlike the Saudis, the Russians cannot afford to cut production. Russia’s budget is balanced (in theory) at $50 oil and current production levels. Lower volumes would bring higher prices in the long run but also result in a revenue decline in the short run.