Oil markets are once again facing a price collapse—not unlike the swan dive seen when OPEC’s market-share war took prices from more than $110/barrel in mid-2014 to $26/barrel by early 2016.

The proximate aim—led by the Kingdom of Saudi Arabia (KSA)—was to reduce the revenue Iran would receive when it returned to export markets following its agreement with the U.S. to end its nuclear program.

U.S. Oil Production 

U.S. shale-oil producers may have also been targeted, although it was never clearly articulated by the KSA. Undeniably, the U.S. was hurt, but not destroyed. If anything, it forced shale-oil producers to focus on their best drilling prospects, which helped introduce a more productive, technology-driven cohort of drillers. Indeed, by the end of 2019, production levels made the U.S. the largest oil and gas producer in the world.

Background on Oil Price War

However, the market-share war brought KSA and Russia together as the de facto leaders of OPEC+, with their mission to clear the global inventory overhang left in the wake of the market-share war by managing energy supplies. Ahead of OPEC+ meetings in Vienna, Russian representatives inevitably demanded higher output levels but ultimately acquiesced to an oil production détente with KSA.

Time will tell, but Friday’s breakdown in Vienna could be just what Russia has been waiting to deliver to U.S. shale producers since the formation of OPEC+.

On the other hand, it could simply be a reminder that Russia’s compliance with production-restraint agreements is not to be taken for granted. Whatever the case, Russia was certainly well prepared to deliver the blow as it has steadily built its foreign-exchange reserves since the price collapse begun in 2014, which now stand at almost $450 billion.

Conversely, KSA’s foreign-exchange reserves have fallen sharply in the wake of the market-share war to around $500 billion, down from more than $700 billion entering 2015.

The economies of both KSA and Russia are highly linked to oil prices. Therefore, another market-share or price war is a strategy that cannot be sustained by either country for an extended period. While both are highly dependent on oil revenues to sustain their economies, of the two, Russia’s economy is far more sensitive as it markets a greater share of its output in the energy-trading markets.

Estimates suggest that Russia needs oil prices of around $50-$60 to achieve fiscal breakeven, while KSA’s is the same or slightly higher. While that might give Russia more staying power in the short run, with a per-capita income at roughly half that of Saudi citizens, it will likely not want to revisit a scenario like 2014-2016 when its economy last suffered through an oil-price collapse.

Energy Sector Pressures 

Low prices will not work for U.S. shale producers for any length of time either. While some may have hedged their costs at higher price points, an extended bout of sub-$40/barrel will cause disruption from drillers to capital expenditure plans that include even the big integrated energy companies. The Energy sector weight in the S&P 500 Index has fallen to less than 3.5%, a remarkable feat. While energy company yields look appetizing, care is warranted as energy share prices will be volatile and, in some cases, the sustainability of dividends could be questioned.

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About the author

Mark Luschini

Chief Investment Strategist, President and Chief Investment Officer, Janney Capital Management

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