Why Russia Just Cried Uncle

Over the weekend, Russian Energy Minister Alexander Novak announced that Moscow is ready to meet with both OPEC and other oil producers to address the low price of oil.

For the first time in nearly 11 months, geopolitics is likely to give support to higher crude, and oil prices saw a new push.

Ever since OPEC decided last Thanksgiving to defend market share rather than price, crude has been in a swoon. That has had a major negative impact on countries relying upon the sale of oil to balance their central budgets. All producing countries have been affected as oil declined from the triple digits to around $40 a barrel.

And even U.S. producers have taken it on the chin. The American scene may be accentuated by huge new reserves of shale and tight oil, but these are more expensive to extract, requiring an average price of well above $70-75 a barrel.

But since last year’s OPEC decision, little has been done on a geopolitical scale to correct oil prices. So why has Russia just cried uncle?

Here’s my take on why Russia’s planning to meet with OPEC… and what the outcome will be…

With State-Owned Companies, a Price Decrease Is a National Disaster

Whereas oil production in the U.S. is a private affair, in all other major producing countries the sector is either led or controlled by state companies. So for Russia and all OPEC countries, the dive in prices was more than a private sector bottom-line consideration.

All government programs and expenditures are impacted. To make matters worse, these economies are largely undiversified. Oil is the sole source (or, in the case of Russia, oil and natural gas are the primary sources) of revenue.

Russia also has other concerns. The Western sanctions issuing from the crisis in Ukraine and Moscow’s annexation of Crimea have restricted access to the outside hard currency markets essential to operating hydrocarbon exports (almost all contracts are denominated in U.S. dollars and must be pre-financed).

The double whammy of low prices and sanctions has resulted in a significant reduction in the value of the ruble. That, in turn, has created additional domestic market problems for average Russians.

Somebody Else Must Blink First

On several occasions over the past month, I have discussed here in Oil & Energy Investor the unsustainable OPEC position and the rise of U.S.-Russian combined responses to it.

All OPEC countries (with the exception of Iran – given its own sanction barriers and the dreadful state of is oil industry) have been producing well over their monthly quotas. The OPEC Secretariat determines these each month by first estimating global demand, then non OPEC volume, followed by what is termed the “call on OPEC,” divided into quotas for each cartel member.

Low prices have required that OPEC members flood the market with crude in an increasingly desperate drive to raise needed revenues. And that, of course, has simply driven the overall prices even lower.

Russia and the U.S. have experienced downward pressure as well. But of the two main non OPEC providers, Russia has the most acute (and immediate) problem. And Novak’s statement comes after indications from OPEC sources that an accord is developing.

Nobody yet knows exactly what this will mean or how any agreement will play out. The consensus (which I happen to share) is that the Saudis require some indication that the strategy to maintain market share has been successful.

The clearest way of accomplishing this is to have somebody else blink first.

A Latin American “Spring”?

All OPEC members have faced an acute situation for some time. All – even the Saudis – have been running increasing budget deficits. Riyadh has also begun to withdraw billions from foreign investments as the need to support domestic financial realities has intensified.

Other cartel countries are in more dire shape. Venezuela, Nigeria, Libya, and Iran require oil prices in the high triple digits to have any pretense of stable central government accounts. Any price improvement notwithstanding, this is simply not going to happen.

Perhaps the most serious situation is taking place in Venezuela. The national economy has stopped functioning, there are food and commercial pricing riots in all major cities, and sources within the national oil company (PDVSA) privately acknowledge that reliance on crude revenues to import essential commodities has failed.

A transition of the crisis to the political realm would mark the beginning of a Latin American parallel to the Arab Spring. And with stability crumbling in Brazil and Argentina, economic problems intensifying in Ecuador (the smallest of the OPEC nations), and a stabilization under pressure in Colombia, this could get very nasty very quickly.

How Russian Involvement Will Affect Prices

Rising oil prices will not solve all of the problems, even if that rise were an accelerating one. But it would provide at least one welcome element.

Overproduction has become so bad that even Saudi Arabia has increased both production and exports. The convoluted rationale behind this tactic has strained credibility. The real reason is simple: The Saudis cannot prevent other OPEC nations from rising volume in a desperate attempt to collect revenues. So they need to appear to be leading the effort.

Russia may be the short-term key to allowing OPEC to ease production levels. Moscow will never become a member of OPEC because the Kremlin would never allow an outside organization to dictate how much oil it can produce or trade. But, unlike the U.S., Canada, or Mexico, the Russians have had a high-profile observing delegation at the OPEC headquarters in Vienna for some time.

The stage now seems set for a Russian-Saudi meeting to precede a broader OPEC session. That should be enough for crude prices to find a floor and improve. I’ll keep you posted as this situation plays out.

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