Oil Rigmarole: OPEC’s Production Cut




OPEC announced that it would cut oil production by 1.2 million barrels per day to 32.5 million. This is the cartel’s first cut in eight years and will take place by January. The agreement exempted Nigeria and Libya, but included Iraq. The agreement did allow Iran to raise its output as it recovers from US sanctions. In addition to OPEC, Russia also agreed to cut output.

Over the past two years, OPEC countries’ profits have dropped due to higher supply and lower demand. Wealthier members like Saudi Arabia have been able weather the storm. But the less wealthy, like Venezuela and Nigeria have struggled. OPEC has kept production levels stable because Saudi Arabia and Iran wanted to keep market share. But prices continued to drop – until this week’s cut.

Market Realist

Oil (USO) (BNO) and energy stocks (GUSH) (XLE) have been problem children for markets for some time now. It has been a wild ride for investors interested in the sector over the past couple of years. The latest development in the saga has come in the form of OPEC’s production cut announcement. It’s the cartel’s first production cut in almost eight years. Let’s do a quick recap of what forced the cartel to take this step.

Several factors led to a precipitous fall in oil prices. Oil prices fell to a low of $27.1 per barrel at the beginning of 2016—its lowest level since November of 2003. The oil price slump added debt woes to energy stocks. It caused many projects to be shelved and jobs to be eliminated in order to cope with the onslaught of falling oil prices. According to data from Bloomberg, oil and energy companies (ERX) (ERY) around the world lost $720 billion in value in 2014 and a whopping $850 billion in value in 2015 (Source: Financial Post).

Several factors caused the oil price slump. The Chinese (YINN) economic slowdown dampened the demand for oil. Demand was also restricted by the slowing pace of global growth and the growing strength of the US dollar (UUP). While demand growth for oil tapered off due to economic weakness in countries such as China (YANG), Japan (JPNL), and the Eurozone (EURL), the oil supply has been rising. It threw the balance out of whack. It caused excess oil supply (XOP) and a steep fall in oil prices. The US fracking revolution elicited a boom for shale oil–rich regions. The shale boom transformation increased the production of US crude oil manifold and propelled it to multiyear highs. It’s one of the major reasons behind the oil supply glut. The previous graph shows the gap between production and consumption of liquid fuels.

Despite the large drop in oil prices, OPEC members continued to operate near full capacity. They made sure that the supply never dwindled. It exacerbated the problem. The previous graph shows how OPEC members have been operating near maximum capacity over the past few months.

OPEC’s production cut announcement provided some hope for energy sector investors. We’ll discuss the ins and outs of the deal later in this series.

More From Market Realist