Streetwise Professor

Oil is crashing, with WTI trading at a 33 handle, down 20+ percent since Friday.

The first leg down in oil prices was caused by the coronavirus demand shock in China. This most recent free-fall is a response to Russia’s refusal to agree with OPEC to extend the existing OPEC+ cuts, and deepen them in response to the demand decline; and the Saudis’ reaction to the Russians, specifically, to put the output pedal to the metal.

The Saudi reaction to the Russians is a classic cartel defector punishment strategy. The Russian demurral is more difficult to understand. One story circulating is that Putin wants to punish US shale. If so, he’s a fool. And worse, a fool who fails to learn from the foolishness of others, e.g., the Saudis whose predatory pricing strategy in 2014-2016 failed miserably.

Yes, cratering the price of oil will inflict pain on US shale producers. They will suffer financial losses, and will curtail drilling and output. But US pain does not equate to Russian gain. Russia will incur substantial losses from prices in the 30s–and more pain if prices go into the 20s, as is possible. But Russia will not recoup this pain with future gains. If and when they (and OPEC) decide they’ve had enough, and curtail output to raise prices, US output will respond accordingly.

US rocks can outwait Putin. Yes, reduced activity will damage the shale supply chain, and it will take some time to recover, but as the Saudis found out in 2016, the flexibility of the US oil sector allowed it to rebound extremely rapidly when prices rose. The resource remained. The human capital remained. When OPEC+ went into effect, US oil output soon exceeded the pre-2014 price crash levels, which sharply limited the upside for the Saudis and Russians.

I am currently putting finishing touches on a paper which, among other things, demonstrates the futility of the Saudi strategy in 2014–and the Russian strategy (if that’s what it is) today. I document learning-by-doing economies in the US shale sector. If these economies are big enough, lost output today due to predatory Saudi or Russian behavior translates into lower US productivity in the future. That means that Saudi/Russian price cutting today raises their rivals’ costs in the future, which could lead to higher future Saudi/Russian profits then.

But the empirical estimates show that the US productivity losses due to foregone learning are very small, and hardly allow the predators to recoup the huge costs they incur from their predatory strategies. Putting the Saudis and Russians together, $10/bbl price cuts today cost them on the order of $230 million/day: $20/bbl cuts cost them around $460 million/day. There is no way that the higher future cost of US oil production due to lost learning opportunities will allow the predators to recoup these losses in the future by raising the ceiling that US shale puts on world oil prices.

Predatory pricing strategies are almost always futile. They are definitely futile with regards to the US shale sector. If Putin is indeed pursuing a predatory path, he is cutting off his own nose to spite his face.

So go ahead, Vova. Knock yourself out.