For the past few years, the strategy of OPEC has been to do nothing while Saudi Arabia pumps oil as fast as it can into the market. The idea was to cripple, or drive out of business, various U.S. oil businesses that depend on more expensive extraction methods such as fracking. With prices low, many of those businesses did indeed go into hibernation and most new drilling was curtailed. However, that still leaves tons of capacity sitting idle, waiting for higher prices before flipping the switch back on.
It has become apparent that overproduction will not drive out U.S. oil businesses. It seems a strong U.S. economy, plus a more disciplined approach to lending and spending has left most American producers able to hold out for higher prices for longer than the cartel may have hoped. As a result, the cheap oil is actually causing more trouble for oil producing countries like Saudi Arabia that depend on oil production to fund their government.
So, for the first time in over 7 years, the 14 OPEC countries have reached a deal to reduce production. The new deal calls for a reduction of 1.2 million barrels of oil per day, with a ceiling of 32.5 million barrels per day. That works out to about a 4.5 percent cut in production. Russia also agreed to reduce its output, although it is not a member of OPEC.
Oil prices had already been rising for the last several days as traders anticipated that there would be some kind of deal at the meeting. Prices are up from the mid-40s to near $50 per barrel. If OPEC and the assorted non-member countries stick to their commitments (not always a given), then oil prices should stay closer to $50 than $40.
The question becomes, at this price point, how much U.S. production is worth turning back on? And, with President Elect Trump saying that he wants to open more American oil production, and reduce, or eliminate, various restrictions on certain types of drilling, can American production temper the reduction in supply?
Where this gets really interesting is that the whole point of Saudi Arabia’s multi-year refusal to cut production was to prevent giving any sort of market share over to the U.S. at the expense of the Kingdom. If U.S. production ramps back up, it will be doing just that. Will they, and other countries, be willing to accept that, or will this agreement be one of the ones that falls apart quickly?
U.S. Stocks and OPEC
While cheaper oil benefits many U.S. companies, particularly those in transportation and certain manufacturing, the reality is that a lot of the biggest stocks on the U.S. stock market are oil-related companies. Obviously, higher prices are better for them, and their large size is moving stocks up with them. This continues a recent run-up in the markets that continues to push indexes to record levels.
Higher gas prices will show up in some inflation statistics as well potentially giving even more cover to a Fed chomping at the bit to make a rate hike. Unfortunately, those numbers will likely come too late to affect any inflation adjusted numbers for 2017, such as various tax brackets, or other inflation-indexed numbers.