Oil Price Rallies as OPEC Agrees to Cut Production

Back in 2010 it seemed like there was not enough oil to go around. Political and military conflicts in places such as Libya and Iraq were creating supply constraints for oil in the middle east. Many countries had to use up their stockpiles and some were even nearly depleted. The price of crude skyrocketed to around $100 per barrel. Many people thought that oil would continue to be expensive for a very long time. But that has not been the case. As with all things in economics, the oil market is always searching for an equilibrium. The high prices spurred oil drilling companies in the U.S. to use innovative hydraulic fracturing (fracking) and horizontal drilling techniques to unlock large quantities of oil from shale rock formations in areas like North Dakota and Texas. This fracking boom caused US crude oil production to almost double from 2010 until now.

So it wasn’t long before the reverse problem started to occur. There was too much supply and not enough demand. Two years ago in 2014 the price of crude fell dramatically. It went from $100 per barrel down to only $40 per barrel, and completely upended the worldwide economy. It also cost oil producing countries like the U.S. and Saudi Arabia billions of dollars in lost revenue.

The world’s largest organization for controlling the production of oil is OPEC, which is made up of 14 nations which collectively decides on how much oil they should produce. Together they control an estimated 43% of global oil production. After months of talks it appears that they may finally be willing to cut their production to help balance the equilibrium of crude back to a higher price.

Earlier this week on Wednesday, sources told Reuters that OPEC has hashed out an agreement to reduce its production by 0.7 million barrels a day, from it’s current output of 33.2 million barrels a day down to 32.5 million barrels a day. This marks the first agreement to reduce production since the 2008 financial crisis eight years ago. Perhaps more importantly is the fact that the story comes two years after Saudi Arabia lead OPEC on a production binge in an effort to gain market share from the U.S. fracking companies and try to push them out of business. While the strategy worked to put pressure on the U.S. shale industry, OPEC producers themselves have also suffered as a result of the overproduction policy. But now it seems that OPEC has recognized the plan will not work so it has it has decided to taper production in an attempt to mitigate the pain of low oil prices for its own member states. The 14 countries that form OPEC are desperate to put a floor under the price of crude because they depend on oil revenues to finance government spending. So the lower the price goes, the harder it is for them to budget.

WTI crude price jumped by about 6% on the news. But we have to remember that this only a preliminary agreement and is not the final deal quite yet. The completed agreement won’t be ratified until OPEC’s next formal meeting which is in November. Of course a lot can happen between now and then. But beyond that there’s also some skepticism over the effectiveness of the plan. The International Energy Agency mentioned earlier this month that supply will outstrip demand well into next year.

Nevertheless, assuming OPEC goes through with the plan to cut its crude production, it will probably not have a dramatic effect on the price of oil. We are not likely to see crude ramp back up to the $100 per barrel level any time in the next few years at least.

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