Saudi-Russia oil war is a game theory masterstroke - Financial Times

Saudi-Russia oil war is a game theory masterstroke - Financial Times

Saudi-Russia oil war is a game theory masterstroke - Financial Times

Posted: 29 Mar 2020 08:03 PM PDT

On the face of it, the idea of Saudi Arabia and Russia starting an oil price war in the middle of a global pandemic is as dumb as it gets. From a game theory perspective, it is a masterstroke.

Analysts have called the breakdown of Opec+ and the lifting of the supply cuts that kept the oil market balanced in the last two years anything from a spectacular blunder to collective suicide.

A new model of the oil market led by the inventors of mean-field game theory, Fields Medal laureate Pierre-Louis Lions and Jean Michel Lasry, suggests otherwise.

To optimise oil revenues, big low-cost producers such as Saudi Arabia — the 'dominant monopoly' in game theory parlance — must balance conflicting price and market-share aspirations, the model shows.

Although Opec often invokes 'price stabilisation' as its mission, in practice this is an elusive goal. Opec's real interest is to let the market cycle from rallies to sell-offs. When prices rise, the 'monopoly' benefits from higher revenue but loses market share to its 'competing fringe' of higher-cost producers that finds themselves incentivised to invest in new capacity.

Their response, however, drives up production costs further and makes their investment increasingly less efficient — thus making them vulnerable to a sell-off. Sooner or later, the dominant monopoly regains control by ramping up his own output and pushing prices off a cliff. The steeper the cliff, the better.

It usually takes some kind of shock to get the dominant monopoly to go into cliff mode. In the late 1990s, the catalyst was the negative demand shock of the Asian financial crisis. During the most recent oil market crash, in 2014, it was the supply shock of US shale oil. For some time, the model shows, the market had been waiting for the right signal. The coronavirus has provided it.

While the cliff is familiar, its steepness is unprecedented. The demand impact of the coronavirus is so devastating that it is giving Russia and Saudi Arabia a unique chance to test global storage capacity limits.

The fuller storage capacity gets, the closer oil prices will get to zero. When and if capacity is maxed out, oil prices will turn negative. On current trends, this could happen within months if not weeks.

Unlike during the oil market crash of 2014, low-priced oil cannot spur demand and economic activities that are restricted for public health reasons but is going straight into storage. Kayrros satellite measurements show global crude stocks surged by more than 100m barrels in the last month alone to 63 per cent of nameplate storage capacity.

The spread of confinement measures is accelerating the builds. No one knows for sure the actual level of maximum operating capacity because it has never been tested — perhaps 80 per cent of nameplate. We may soon find out.

Given the amount of advance planning needed to boost production, one would have expected Saudi stocks to fall as the kingdom increases supply, at least initially. But Saudi inventories have jumped since the start of the price war.

This suggests that the Russian and Saudi oil ministers walked into their fateful meeting earlier this month fully prepared for a supply surge. The fact that Riyadh and Kuwait recently settled an old dispute allowing them to restart shared oilfields that had long been idled further undermines the view that Riyadh's decision was spur-of-the-moment escalation after Russia said "nyet" to production cuts.

The sell-off will hurt producers all around but will bring Riyadh and Moscow longer-term benefits. With their low costs and vast financial reserves, the two can withstand a loss of oil revenue better than most producers. Others are already teetering on the brink of collapse. Sanctions-hit Iran is a case in point.

The real prize for Opec however is the taming of shale oil. It suddenly looks within reach. Long an Opec critic, the US is turning into an unlikely cheerleader.

Only last year, lawmakers were dusting off the old "NOPEC" bill. Now a group of senators from US oil states are begging for cuts.

A member of the Texas Railroad Commission, which used to manage supply before Opec, has been talking with the cartel about joint production targets — reportedly with the blessing of shale companies.

Washington officials are reaching out to Riyadh about a deal. The International Energy Agency, set up in 1974 as an oil importer group but whose extended membership now includes some of the world's top producers, not least the US itself, has chastised Moscow and Riyadh for their "irresponsibility" in lifting production restraints. 

Game theory shows how the 'competing fringe' passively benefits from Opec supply cuts for as long as they last. Since becoming the world's top producer, however, the US is discovering that being a free-rider may no longer be an option. 

Its market interests, game theory suggests, have effectively converged with those of Russia and Saudi Arabia. By threatening to open the floodgates, the latter can compel it to join their club. 

Current prices are unsustainable. When the storm passes, the oil landscape will have shifted. The shale revolution had empowered Washington to wield the oil weapon as a tool of foreign policy. Oil 'dominance,' it now finds out, cuts both ways.

Antoine Halff is the chief analyst at Kayrros and a research scholar at Columbia University's Center on Global Energy Policy

The Commodities Note is an online commentary on the industry from the Financial Times


Dividends Aren't Surviving the Oil Market Meltdown - Nasdaq

Posted: 22 Mar 2020 12:00 AM PDT

Oil prices have nosedived this year. Dual shocks to demand (from the slowdown in the global economy caused by the COVID-19 outbreak) and supply (from the collapse of OPEC's market support agreement) have pushed the price of crude oil down to its lowest level in decades. That's cutting deeply into the cash flow of oil producers, forcing them to slash spending.

The first thing they've cut is their capital expense budgets. However, a growing number of energy companies are also reducing their dividends to conserve cash. That trend is likely to continue as they focus on surviving this turbulent period in global history.

Scissors cutting into a hundred dollar bill.

Image source: Getty Images.

Finally reaching the breaking point

Up until recently, dividends had been on the upswing in the oil patch. Many companies had reset their businesses to run at lower oil prices by selling assets and cutting costs. Those moves enabled them to generate free cash flow as long as oil was around $50 a barrel. However, with crude prices crashing into the $20s, oil companies have had to adjust their plans to run on even lower pricing.

Occidental Petroleum (NYSE: OXY) was among the first oil companies to slash its dividend. The company reduced its payout by 86% one day after its yield spiked to an eye-popping 25%. That move abruptly ended a streak of 17 consecutive years of dividend increases for Occidental, which had grown its payout by more than 500% since 2002. However, it had no choice but to reduce its dividend following the significant deterioration in its financial profile as a result of its debt-fueled acquisition of Anadarko Petroleum last year. 

Apache (NYSE: APA) also recently slashed its dividend, cutting it by 90% to preserve cash during these turbulent times. While Apache hadn't increased its dividend since 2014 -- right before the last oil price crash -- it was also one few that preserved its payout during that downturn. However, with $937 million of bonds maturing between now and January of 2023, Apache opted to retain the $340 million per year it would have paid out in dividends to help it address these upcoming maturities in case oil prices don't recover. 

Midstream company Targa Resources (NYSE: TRGP) also recently announced a substantial dividend reduction. It's slashing its payout by 89% in a move that will save it about $755 million per year. Targa will use those savings to repay debt following a massive expansion program. Targa, like Apache, had managed to preserve its dividend through the last downturn. However, its financial metrics had been on very shaky ground until recently because it continued to pay out most of its cash to support its dividend even as it kept spending money to expand its midstream footprint. 

More cuts are inevitable

More energy companies will likely announce dividend reductions in the coming weeks. One sub-sector where that seems almost certain is master limited partnerships (MLPs) that focus on gathering and processing oil and gas. CNX Midstream Partners (NYSE: CNXM) has already stated that it's reevaluating its capital allocation opportunities. CNX Midstream could opt to slash its distribution -- which spiked to yield more than 30% in recent days -- and reallocate that cash toward debt reduction or buying back its units, which have cratered this year. 

Another likely candidate for a payout reduction is Western Midstream Partners (NYSE: WES). Investors see it as a near certainty as its unit price has cratered, pushing its yield up near an eye-popping 70%. The MLP currently counts Occidental Petroleum as one of its main customers, which is concerning since the reduction in Occidental's activity level this year will likely result in fewer volumes flowing through Western Midstream's systems than it initially anticipated. That will affect the fees it collects, which is coming at an inopportune time for the company, given its already weak financial profile.

Several other MLPs are in similar situations where they risk declining volumes at a time that they have shaky financials. Many have already started making cuts by reducing their capital spending. Noble Midstream (NYSE: NBLX), for example, cut its budget by 35% this year to reflect reduced activity levels by its customers. However, with an already elevated leverage level and a tight coverage ratio, Noble Midstream might also need to reduce its payout to shore up its financial situation. Investors see that as a near certainty, given the spike in its yield, which was over 70% at one point in the past week. 

Income investors can't seem to catch a break

Dividends had just started making a comeback in the oil patch before crude prices collapsed this month. Now, they're crashing down as companies adjust so that they can survive. Most payouts probably won't ever again reach their previous heights because companies will probably put an even higher priority on balance sheet strength in the future. That will keep dividend payments low so that these companies don't ever find themselves in a situation where they'll need to cut them again should there be another crash.

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Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool recommends Targa Resources. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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