Commodities Corner: What a breakdown in the Saudi Arabia-Russia oil alliance would mean to the market

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Saudi Arabia and Russia have so far failed to reach an agreement to cut oil production even with the COVID-19 epidemic in China expected to significantly hurt energy demand this year, putting the more than three-year-old alliance between the two major oil producers at risk.

Saudi Arabia is weighing a break in its alliance with Russia, The Wall Street Journal reported Friday, citing people familiar with the matter. The Saudis are holding talks with Kuwait and the United Arab Emirates this week to discuss a possible joint production cut of as much as 300,000 barrels a day, the report said.

“If the alliance were to split, the immediate reaction would be a drop in oil prices, but that could be reversed by a strong OPEC cut,” said James Williams, energy economist at WTRG Economics. “I doubt that OPEC is anywhere near a breakup, but the alliance between OPEC and non-OPEC producers is fragile.”

“OPEC for decades wanted to get the Soviet Union and then Russia to become a member,” he explained to MarketWatch. “Since the 80s the Russians avoided it and it took the collapse of oil prices in 2015 and 2016 to bring them to the table. The rising shale production was the prime mover.”

The news Friday of a rift in the alliance followed a technical meeting earlier this month between members of the Organization of the Petroleum Exporting Countries and their allies, known collectively as OPEC+. The committee in Vienna recommended that OPEC+ extend current production adjustments to the end of the year. The current agreement calls for OPEC+ cuts of 1.7 million barrels a day, from the October 2018 baseline, through March.

“The tussle between OPEC and Russia raises substantial doubt about continuation of production cuts and therefore a return to a heavily oversupplied market,” said Manish Raj, chief financial officer at Velandera Energy. “The market is factoring in the possibility of a total breakdown of the OPEC+ alliance, which can boost supplies by [two to three] million daily barrels in an already oversupplied market.”

On Friday, April West Texas Intermediate crude CLJ20, -1.10%  fell by 92 cents, or 1.7%, to $52.96 a barrel on the New York Mercantile Exchange. April Brent crude BRNJ20, -1.77%, the global benchmark, traded at $57.97 a barrel on ICE Futures Europe, down $1.34, or 2.3%.

“In the past, Saudi Arabia has been adamant that all production cuts be shared pro rata between OPEC and Russian alliance members,” said Raj. “The money question is whether OPEC would continue to shoulder all the cuts on its own without pro rata participation from Russia. The market believes it won’t, and this fear is weighing in on the oil price” Friday.

The technical committee in Vienna earlier this month also recommended that the group “proceed with an additional adjustment until the end of the second quarter.”

During that meeting Russia, however, rejected a Saudi push to curb output by an additional 600,000 barrels per day, according to The Wall Street Journal. The Journal reported that Russian officials don’t see a need for reductions as the impact of the virus in oil demand is limited and they expect weaker demand to be offset by reduced supply from an oil shutdown in Libya and new sanctions targeting Venezuela’s crude sales.

If the cuts were to be implemented in the second quarter and demand starts to revive by that time, the OPEC+ alliance “could just lose more market share to unconventional producers,” said Marshall Steeves, energy markets analyst at IHS Markit.

“If the viral outbreak isn’t contained by March 5-6, I would expect the group to adopt the deeper cuts,” he said.

The International Energy Agency recently lowered its view on world oil demand growth to the lowest level since 2011 due to the coronavirus outbreak. The IEA cut its growth forecast for 2020 by 365,000 barrels a day to 825,000 barrel a day.

But “if it does appear that the rate of [coronavirus] infections has peaked, no additional cuts would likely be adopted,” said Steeves. OPEC and OPEC+ will hold their next official meetings on March 5 and March 6 in Vienna.

In the short term, Williams said he expects the Saudis, Kuwait and UAE “to cut even more to shore up the market in the face of the impact of the coronavirus impact on Chinese and global demand.”

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