Did Russian President Vladimir Putin just screw up in a spectacular fashion? Russia pulled out of the OPEC+ production cut deal on March 6, baulking at increasing its cut from 300,000 barrels a day to support prices to 500,000 bpd under the terms of that deal. Many said at the time that the decision was made on purpose to cause the price of oil to fall and so destroy the US shale oil industry that needs prices of oil to be at least $40 per barrel to be economically viable.

The problem is the plan worked too well. First the Saudis flooded European refineries with crude at a steep $8 discount. That effectively locked Russian producers out of the their traditional export market and the price of the Russian Ural’s blend of oil, which normally trades at a roughly $2 discount to the benchmark Brent blend, collapsed completely, briefly going negative a full two weeks before the same thing happened to the US WTI blend, where prices fell to below zero on April 20 for the first time in history due to the lack of storage space for May contracts.

The price of a barrel of Urals blend subsequently recovered to $24.55 in the next few weeks, but now there is a lot of confusion over how much a barrel costs. Part of the problem is that while Urals futures can be traded on the St Petersburg international commodity exchange, there are in fact no deals and so no pricing mechanism for futures. The only market is a spot market, but here too the information on the prices used in deals is not transparent. There have been reports that the price of Urals fell into negative territory again in the last few days to -$3 and other reports that say the price is somewhere around $17 – still a deep discount to Brent which is trading at about $25 at the time of writing. Confusion reigns.

But whatever the price really is, all the possible prices for Urals are below the $25 that the Kremlin seemed to be assuming if its motive really was to crush the US shale industry. Finance Minister Anton Siluanov came out just ahead of the flash crash of WTI prices to boast that the RUB12 trillion ($161bn, 11% of GDP) in the National Welfare Fund (NWF), Russia’s sovereign wealth fund, was enough to cover the budget deficit for a decade, assuming average oil prices as low as $25. This year the Ministry of Finance is expecting there to be a RUB3 trillion hole in the budget (a third bigger than the RUB2 trillion hole it had in 2014 during the last oil shock) but that there was no need to cut spending, as the missing money could be sourced from the NWF. At that burn rate there is enough in the NWF for four years – and that is before the Kremlin starts cutting spending or raises the very low tax rates on companies and citizens.

But this plan doesn't work if average oil prices are zero, or even if they are, and stay at, $15. In the days after the crash of WTI prices Siluanov was out in public again to manage expectations and dramatically walked back his previous confidence, saying that Russia would have to spend half of the money in the NWF just this year (6.8% of GDP) to cushion the shock from the double whammy of the oil price collapse and the stop-shock caused by the coronavirus (COVID-19) pandemic.

“Demand for oil in April and May could be down by as much as 20 or 30 per cent, while the overall decline in 2020 will be 5–7 per cent, according to various estimates. This means that in six to eight weeks, storage facilities could be full, pushing oil prices even lower than the record lows seen recently, when the price of Urals crude fell to about $10 a barrel,” says Marcel Salikhov, an analyst with the Carnegie Moscow Centre. “Oil prices at a twenty-year low and a dawning realisation of the scale of the fall in demand helped all the key producers to see that any agreement is better right now than no agreement at all.”

If the MinFin really does need RUB7 trillion years of budget deficit cover and stimulus spending then the NWF will be exhausted before the end of 2021. Given the government’s previous form in prior crises it is very clear that the Kremlin will not run down its reserves because they play a key strategic role, as they make Russia Inc. sanctions proof. If Russia has to go into the international debt market to raise significant amount of cash to fund deficits is becomes vulnerable to sanctions and Putin simply won’t go there.

In this light it was no surprise that the Kremlin decided to eat humble pie and signed off on a new OPEC++ production cut deal that will reduce production of oil by 9.7mn bpd on April 13. Under the terms of the new deal Russia will cut 1.8mn bpd, which is significantly more than before. All in all, the Russian cut is 18% of the total OPEC++ cut, which is the same share as it had before under the old deal.

“The main risk is that after being temporarily shut down, the oil wells may not be able to return to their previous operating capacity, or will require a major overhaul to do so. As a result, there may be irreversible production capacity losses, and some deposits may simply not be viable at current prices,” says Salikhov. “This is by no means inevitable, and much will depend on how well the oil companies prepare for the new regime.”

Moreover, Russia now cuts a million barrels a day more than the Saudis do, a reversal from the previous deal. And despite Russian calls for the US to finally join the OPEC+ structure, Putin only managed to get vague commitments from US President Donald Trump, who claims to have brokered the deal. From the Russian perspective the new deal was a humiliating climbdown.

The terms of the tussle between the US, Russia and Saudi have changed and it appears the Kremlin has badly miscalculated. Going into the OPEC+ meeting on March 6 the key elements to a clash between the players was a combination of the cost of lifting a barrel of oil, the amount of money a country has in reserve to deal with deficits, and the breakeven cost of oil needed to balance a budget.

The Kremlin was calculating that it was in a strong position, as its lifting costs are much lower than those in the US and only slightly higher than those in Saudi Arabia. As Siluanov said, the Kremlin believed it had enough reserves to survive low oil prices for a decade, but then the circa $500bn Saudi Arabia has in reserves is also enough to cover deficits for at least five years. But in a long fight the Kremlin believed that Russia’s budget breakeven price of circa $40 vs the $80 Saudi Arabia needs gave it the upper hand.

That all works with oil at around $25, but it doesn't work with oil at around $0 or even in the teens. Now the terms of the conflict are simply who can most easily turn oil wells on or off and control the flow of production. Here Saudi Arabia has a big advantage over Russia, where most of the fields are mature and have become technically more difficult to work. With many Russian fields, if you turn off the production it is not clear if you can turn it on again later.

“Russia’s geological conditions are inherently worse than Saudi Arabia’s, but even measures that could have helped in the current standoff were not taken in advance. For example, Russia has very limited capacity for storing oil and petrochemicals, which means it is unable to fully balance current demand against production. It needs to offload virtually all the oil it produces,” says Salikhov. “After the oil crisis of 2014–2015, the Energy Ministry discussed the creation of strategic oil reserves and the construction of storage capacity, but no action was taken.”

However, if the goal was to destroy the US shale industry, or at least significantly reduce US production, that much has probably been achieved. The US will reduce output by 500,000 bpd this year and 700,000 bpd next year, according to the latest IEA estimates, and the first big US shale producers are already going bust and the number of operational rigs is falling fast.

If the calculation was Russia’s economy would take a hit after oil prices fell, but it would not be as bad as the hit everyone else would take, then that calculation has also gone badly wrong. Initially well respected economists like Bank of Finland Institute for Economies in Transition (BOFIT) and the Institute of International Finance (IIF) were predicting the Russian economy would only contract by about 1% in 2020 due to the falling oil prices, but as the coronavirus pandemic has gathered steam the predicted contraction has increased to somewhere between 5% and 8%. In the 2008-09 crisis the economy contracted by 7.5%.

Even if the intended victims were US shale oil producers, amongst the collateral damage is Russia’s own oil industry. The plunge in crude prices puts significant pressure on Russian oil producers, says Sberbank CIB. The problem is the decision to collapse oil prices at the start of March has destabilised the entire market, indeed, coming on top of the pandemic, the entire global economy has been destabilised, and Russia has lost what little control it had of the situation.

“The collapse in WTI May futures has led to significantly increased volatility in other global benchmarks. Brent front-month futures dropped to $16/bbl, Brent spot prices to $14/bbl and ESPO spot prices to $11/bbl, according to Bloomberg data in the days after WTI fell to -$37 on April 20. The Urals price has fallen below $9/bbl, according to Reuters Refinitiy,” Andrey Gromadin and Anna Kotelnikova, analysts from Sberbank CIB, wrote in a note.

The combination of the supply-side shock thanks to the Saudi dumping of crude in Europe plus the demand side shock of a pan-Continental lockdown is unprecedented and has crushed the market, which was already suffering from a glut of oil.

“Given that the market remains very oversupplied and that the OPEC+ deal will only take effect in May, Sberbank had assumed that April would be the most challenging month for Russian oil companies. However, the situation only continues to deteriorate, and at a rapid pace. Operating costs in the crude upstream are mainly in rubles, and the ruble has remained fairly resilient versus the dollar, which has resulted in upstream crude cash costs of $8-10/bbl, according to the bank’s estimates,” say Gromadin and Kotelnikova.

The average realised price in the industry will be substantially higher than the Urals price, as Urals exports account for less than 30% of total Russian output, says Sberbank, while the remainder is oil products (linked to Brent) and mainly lighter benchmarks.

“So, in normalised tax terms (i.e. without the lag in export duties) companies' margins should still be positive. However, April is particularly challenging due to the lag in the export duty, which is now around $7/bbl (based on a $50/bbl oil price) but should drop below $1/bbl in May,” the Sberbank analysts add.

Individual companies will be harder hit. The drop in ESPO spot prices has eroded most of Rosneft's tax-free margin for crude oil supplied via eastern routes (previously $3.3bn annually). While Sberbank had highlighted this risk earlier, the magnitude of the contraction is much more severe than the bank had anticipated. Indeed, the whole crisis has rapidly escalated faster than anyone was expecting.

“All in all, while the plunge in oil prices is quite painful for Russian oil companies, it is even more so for most other producers globally. The entire sector has entered into survival mode,” say Gromadin and Kotelnikova. “We believe that the crude production cuts are likely to accelerate in a major way across the globe and in OPEC+ countries in particular. The magnitude of the cuts could be far greater than what countries have agreed to.”