The late deal 

On April 11, 23 countries, including Russia and Saudi Arabia, agreed to cut oil production as part of the OPEC+ deal. The new agreement was reached a month later, since the first negotiations had failed when Russia refused to cut its output. During this time global oil prices collapsed more than two times over.

According to the new deal, starting May 1, OPEC+ countries will cut their oil production by 9.7 million barrels per day, with Saudi Arabia taking on a 1.5 million share and Russia 2.5 million, which for the latter means a 23-percent output reduction. The new limit of 8.5 mln barrels per day will be the lowest production level in Russia since 2004. The new quota of 9.7 million barrels per day will be in effect for two months. On July 1, it will be reduced to 8 mln until the end of 2020, and then further lowered to 6 mln until April 2021. At each stage Russia will be able to increase its production by 500,000 barrels per day.

It is already clear that the production cut is insufficient. Before the COVID-19 pandemic hit the global economy, daily oil production worldwide exceeded 100 mln barrels, but by end-March global demand had declined by 20 percent, according to leading oil trader Vitol Oil. These data are confirmed by S&P Global Platts analysts who estimate the global oil glut to be around 20-25 mln barrels per day. 

Market players expect that on top of the 9.7 million barrels per day envisaged by the OPEC+ deal, an additional 10 million can be removed from the market by other oil exporters—countries that are formally not party to the agreement (U.S., Canada, Norway, Brazil)—through a natural decline in oil production, and by the Energy Information Agency, which plans to buy oil for the U.S. reserve.  

The disbalance of the oil market is currently reflected in the prices. The news that the deal was finally reached failed to rally the markets. On April 13, the price for the international benchmark crude, Brent, increased only by 1.8 percent (up to $32 per barrel), while another influential benchmark, WTI, dropped by 0.4 percent (to $22.7). At the same time, Russian brand Urals grew by 19 percent to $28.5 per barrel, but market corrections could change that within days. For example, on April 14, both U.S. benchmarks declined further by 4.9 and 5.2 percent, respectively (the Urals data are lagged by one day). According to ING analysts, the OPEC+ deal arrived too late when a “significant destruction of demand” had already been happening everywhere. They believe that the oil glut will last till the end of the second quarter of 2020, but on the plus side Brent is now unlikely to crash below $25 per barrel.

Strategic blunder

During the March 6 negotiations over the terms of the first OPEC+ deal, Saudi Arabia suggested cutting production by 1.5 mln barrels per day in the second quarter of 2020, with Russia taking on a share of 500,000 barrels. Russian Energy Minister Alexander Novak’s refusal shocked oil exporters who had come to Vienna for the urgent talks. In the fallout, the existing 2016 deal on limiting oil production signed by OPEC and Russia to maintain higher oil prices was suspended.   

A month later, as oil prices kept falling to record lows, and the global economy was suffering from the COVID-19 pandemic, Russia was forced to reverse course and agree to cut output. Except that its quota—2.5 mln barrels per day—was now five times higher than the original offer.

Market analysts and players speculated over the reasons for the Russian delegation’s behavior in Vienna. Decisions with such serious implications are not made at the ministry level—they have to be initiated and vetted by Vladimir Putin personally, who oversees the OPEC deal implementation. According to Bloomberg, in the runup to the March negotiations, the Kremlin decided that higher oil prices would play into the hands of the United States, where in 2019 shale oil producers increased production by over 1 mln barrels per day, while other countries had to restrict output. The media firm names Igor Sechin, head of state-owned Rosneft, as the main lobbyist for this decision. Last December, in a letter to Putin, Sechin described the OPEC+ deal as a “strategic threat” to the development of the Russian oil industry, since it creates “preferential advantages” for the U.S.

Bloomberg quotes Alexander Dynkin, head of the Institute of World Economy and International Relations (IMEMO), who identifies two motives behind the Kremlin’s decision: to stop American shale oil producers and punish the U.S. for imposing sanctions against Nord Stream 2, a major Russian gas pipeline project in Europe. The February decision by the U.S. Treasury to sanction Rosneft’s subsidiary for conducting business in the sanctions-targeted Venezuelan oil sector could have played a role as well. Earlier, the U.S. had claimed that Russia controls over 70 percent of oil production in Venezuela. The Kremlin interprets these actions by the U.S. government as an attempt to weaponize sanctions against Russia’s economic interests. 

Walking out of the March deal with OPEC+, the Kremlin might have expected to wait out the low oil-price stretch, since the breakeven price for the majority of Russian oil wells is $15 per barrel, while for U.S. shale oil producers it is $50-55. As Bloomberg’s sources in the Kremlin report, the Russian authorities did not expect that the COVID-19 pandemic would cause such severe damage to the global economy. Having realized the scale of the crisis, Putin made the “painful” decision to reach a compromise with OPEC.

The irony of this entire story arc for the Kremlin is that the winner of the OPEC+ deal is its nemesis, the United States—the largest oil producer in the world, which is not constrained by the terms of the oil cut agreement. The U.S. is expected to naturally decrease its output by 2 mln barrels per day, but with higher oil prices the majority of shale oil producers will be able to survive, given that the breakeven price for five of the majors (including Exxon and Chevron) is $31 per barrel.

Double shock 

According to the Russian Central Bank, in the first quarter of 2020, the county’s exports of crude oil declined by 17 percent and of petroleum products by 20 percent (year-on-year basis). Considering that these provide about 40 percent of export revenues, Russia’s economy is facing a serious challenge.

Some economists estimate that the OPEC+ deal alone, with its oil production commitments, can cost Russia 1-2 percent of GDP. Oxford Economics calculates that without output cuts and with low oil prices ($25 per barrel), Russian GDP will lose 0.6 percent, while with output cuts down to 8.5-9 mln barrels per day and oil prices at $32–36, the decline could be 2 percent (this model, however, does not account for the coronavirus factor). Oxford Economics analysts point out that in reality Russia has experienced a “double shock”—large production cuts and low oil prices. This means that the GDP decline could significantly exceed 2 percent.

According to end-March scenarios outlined by McKinsey, based on the Oxford Economics model but accounting for the pandemic factor, Russia’s GDP can drop by 3.8 percent at best and by 10.2 at worst (if the global economy contracts by 5 percent). On April 14, the International Monetary Fund published its outlook, forecasting that this year the global economy will decline by 3 percent, and Russia’s GDP by 5.5 percent.

The current Russian budget is based on an oil price of $42.40 per barrel, but the price is now predicted to average $33. The budget deficit can potentially be covered by the National Wealth Fund, which, as of March 1, counted $123.4 billions of reserves. However, tapping the fund would effectively cut spending on the ambitious social projects that Vladimir Putin was urging the government to implement just last winter.

Finally, the open question is how Russia intends to cut oil production. In the past, the country was known to skew commitments to quotas, and there are reasons to expect that this could happen again.

According to Loko-Invest analyst Kirill Tremasov, the significant cuts envisaged by the OPEC+ deal are hard to implement due to the specifics of Russian oil production. Unlike in Saudi Arabia and the U.S., in Russia “mothballing oil wells for several months can jeopardize them, since restoring production after a lengthy idle period can be simply impossible or too expensive.” Tremasov estimates that if Russia fulfills its obligations, oil production in the country can decline by 12.5 percent this year, and by an additional 3.5 percent in 2021. Such decline, he concludes, paraphrasing Putin’s infamous quote, can become “Russia’s greatest economic catastrophe since the collapse of the Soviet Union.”