Falling oil prices can be a double-edged sword in terms of economic impact: welcomed by consumers, but not by producers. Franklin Templeton Emerging Markets Equity’s Bassel Khatoun shares his thoughts on the impact of lower oil prices on emerging market economies and some considerations for investors.

OPEC+ Divorce

The collapse in OPEC+1 negotiations over the weekend of March 7 and Saudi Arabia’s subsequent, aggressive undercutting of its official selling prices signals a break from four years of cohesion and co-ordination in oil strategy. Once again, Saudi Arabia has effectively abandoned its role as swing producer, sparking a price war which has the potential to inflict major costs if sustained for a prolonged period. This compounded the impact on oil markets of slowing demand amid a dip in global economic growth due to the spreading coronavirus. The result was a March 9 plunge in oil prices—the largest one-day oil price decline since the 1991 Gulf war.

Russian Roulette?

Saudi Arabia’s foreign reserves of over US$500 billion (73% of gross domestic product [GDP]) and significant further debt-raising capacity (given debt-to-GDP of merely 25%) means the country has enough financial capacity to withstand oil prices in the US$30-$40 per barrel (bbl) range for several quarters.2

In our view, Russia likely has the greater ability to sustain lower oil prices, having substantially raised reserves in recent years, with US$436 billion in foreign exchange (see chart below) and zero net public debt, while conservative budget assumptions were made regarding both the oil price and exchange rate. However, the added geopolitical dimension to Russia’s behavior, involving retaliation against recently imposed US sanctions and more generally countering the rising market share of shale, adds to uncertainty.

Saudi Arabia and Russia compete at the very bottom of the cost curve in terms of lifting costs (i.e., from existing wells) as well as full-cycle costs (which capture all costs of production). However, at current production levels, Saudi Arabia’s fiscal breakeven oil price stands at US$83/bbl, which is roughly double the US$42/bbl of Russia (see chart below). Moreover, Saudi domestic political sensitivity to economic stress is much higher than that of Russia given the importance of public project spending and welfare provision, suggesting this move is a high-stakes gamble by the Saudis.