Russia Preparing For Oil War

The oil market is in free fall. Oil prices suffered some of their biggest falls on record on Monday after Saudi Arabia triggered a price war with Russia by increasing production and selling its crude at a discount. Last week’s OPEC+ meeting in Vienna unexpectedly ended with no agreement on further output cuts due to opposition from Russia. Russia is now battening down the hatches in the price war as the damage to the US shale industry plays out.

Russia Didn’t Comply With Earlier Agreed Production Cuts

In the weeks preceding the March OPEC meetings, Russian oil producers spoke out against further output cuts. Russian officials, including Energy Minister Alexander Novak, said it was too early to make estimates of the possible impact of the coronavirus outbreak on global demand. On 1 March, at a meeting with heads of local oil companies, President Putin hinted that Russia was happy with the then level of the oil prices and that its budget would remain in good shape even if the situation in the oil markets worsened.

Russia has not complied with its obligations made at the December OPEC+ meeting for additional output cuts in 1Q 2020. According to the IEA, in Russia’s compliance was only 78% and 81% in January and February, respectively.

Russia Has Buffers to Withstand a Low Oil Price

In the last few years, Russia has replenished its FX and fiscal buffers and perfected mechanisms cushioning its economy from external oil shocks. Owing to the implementation of the budget rule that came in force in early 2017, the CBR has managed to quickly replenish its FX and gold reserves following the dip during the crisis of 2014-2015. Gross reserves currently exceed $560bn; they include the National Welfare Fund of $124bn created to cushion the impact of oil shocks on public finances. Russia’s public debt is low at 16% of GDP and its banks and companies have reduced the levels of their external indebtedness in the last few years. The government can afford to suspend debt issuance until the end of the unfolding crisis in the global markets.

Reluctance to Support Production Cuts a Strategic Move Aimed at US Shale

Russia’s decision to exit the OPEC+ arrangement follows two US actions which Russia is undoubtedly considering as hostile. In late December, President Trump signed an executive order imposing sanctions on companies participating in Russia’s gas pipeline projects Nord Stream II and Turkstream. This created a significant obstacle for Gazprom which had Nord Stream II 92% ready. The pipeline’s completion is now expected at the end of 2020. On 18 February, the US administration imposed sanctions on the trading arm of Rosneft, Russia’s giant state-owned oil company, for transporting Venezuelan oil.

Russia’s decision not to support further oil output cuts is likely a strategic move aimed at the US shale industry. Russia’s 2020 budget is based on the underlying Urals oil price of $42.4/bbl and is targeting a surplus of 0.8% of GDP. Today, the Finance Ministry stated that with Urals at $25-30/bbl, the funds accumulated in the NWF should be sufficient to compensate for the lower budgetary revenues for 6-10 years.

Rouble Could Weaken Beyond 85

The rouble will also be used for cushioning the impact of the negative oil shock on the economy. Following the significant nominal RUB appreciation in 2019, inflationary pressures have been practically absent. In February, headline inflation declined to 2.3%, which is 1.7ppts below target.

In the last few years, the population has become less prone to running on the currency, and the pass-through from FX rate fluctuations to prices has decreased. The authorities are not going to stand on the way of orderly RUB FX rate depreciation caused by an adverse oil shock. Moreover, a weaker rouble would cushion the impact of the lower oil prices on government revenues.

Local markets were closed for International Women’s Day on 9 March leaving trading limited to the offshore FX market. The rouble weakened to ~74.5 vs. the USD vs. ~66 vs. USD at the beginning of March, but given the 31% collapse in the Brent oil price we expect further weakness to come. In the short term, USDRUB could weaken beyond 85 when the local market opens on Tuesday. At that point, verbal intervention from the CBR looks likely. Given that headline inflation is at historic lows, a rate hike does not seem to be on the cards immediately but could be deployed if USDRUB quickly rises above 90.

The CBR today on Monday that it had suspended its purchases of FX in the open market for 30 days. Under the budget rule, the CBR purchases FX in the open market when the Urals price exceeds $42.4/bbl. It should start selling FX from the NWF following the drop in the oil price below this level. To some extent, this should support the rouble. That said, the CBR would have to intervene if there are signs of a market breakdown. The regulator has also warned that it is ready to deploy additional measures if financial stability comes under threat.

Russia May Re-join OPEC+ Once Damage to US Shale is Clear

Saudi Arabia’s decision to offer its oil at a discount looks like a declaration of a price war on Russia and other high-cost producers, notably the US shale industry. In the short run, Russia is likely to suffer relatively modest damage from the OPEC+ breakdown vs. those OPEC members whose budgets are based on higher breakeven oil prices. Russia may re-join OPEC+ in a few months following a period of low oil prices when it sees enough evidence of the damage to the US shale oil industry.

Tatiana Orlova holds a MSc in Economics from the LSE and has worked as an Emerging Market economist and strategist since graduation in 2001. She has been employed in EM research teams in four investment banks covering a diverse range of CEEMEA economies, with a particular specialism in the post-Soviet economies.

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