Oil prices stop making sense

For the past few years, the expanded group of oil producers known as OPEC+ have tried collectively to stabilize crude prices by lowering production in order to dampen price volatility to the downside. But because several members of the wider cartel have different and conflicting fiscal and external financing priorities, efforts to limit output have not only failed, current production has increased. This would be newsworthy by itself, but is even more puzzling considering the potential impact of tariffs on global demand.

OPEC+ operates in a world where the US is the largest crude producer, and other non-OPEC countries, Canada, China and Brazil are among the top 10. The crude price per barrel (ppb) has varied between about $32 and $112 in the 5 years since May 2020, but is around $63 as of mid-May. However, many oil-producing countries have been just “getting by” at current prices. Traditionally, as prices fall, members “cooperate” to limit production. But as uncertainty about tariff impacts escalates, cooperation is devolving into chaos.

Saudi Arabia, the largest OPEC producer, typically has the power and influence to keep the membership in line. They consider the complexities of global politics and supply/demand from an advantageous position, proving they can afford to cut production (receiving less revenue) and also tolerate much lower prices due to falling demand, when necessary. During Covid, for example, they were able to raise VAT from 5% to 15% to compensate.

This time it’s been different. Other OPEC+ members, such as Kazakhstan and Nigeria, don’t have that luxury, and are “cheating” by not cooperating with Saudi-driven OPEC production policy, exceeding agreed to production quotas in order to generate enough revenue to cover income needs and infrastructure costs. To demonstrate this huge gap in price tolerance, Russia, the largest OPEC+ producer, and third after the US and Saudi Arabia in output, considers $70 a practical price per barrel (ppb) while Saudi Arabia via Aramco, has a reported $10 breakeven price threshold and can tolerate prices at half of current levels.

Recent abrupt changes in production have been challenging to keep up with. OPEC+ unexpectedly increased supply for May and June by 411,000 barrel per day (bpd) while Saudi Arabia inexplicably raised prices for Asia in the face of weakening demand, proving that not only are the various OPEC and OPEC+ members not on the same page, but the traditional pricing/demand dynamic is not operating.

And even assuming the Saudis aim to do what’s right for OPEC members to support prices, they are hosting President Trump and US business leaders who will expect support on the inflation front as tariff negotiations play out over an extended period. The Saudis need a steady USD supply to manage their pegged exchange rate and the US administration wants them as a trade and investment partner to help buffer losses elsewhere.

Ultimately, Saudi Arabia has to protect its market share by pricing out competitors who need $70 oil, and also maintain political support and ties, all while the future of oil prices looks grim and OPEC’s ability to dictate production policy appears to be weakening.

In the current environment, higher market volatility and falling oil prices are the major headwinds for emerging market assets. At the same time, with strong fiscal positions, many EM countries have the flexibility to address further global economic weakness, and many idiosyncratic countries remain attractive and can help the overall performance of the asset class. While demand for oil and other commodities is important to many emerging market countries, and China remains the elephant in the room, there is also potential there for government stimulus and improved trade with local partners as well as a global emphasis on multi-nationalism as banks will need to cooperate and trade in USD.