After intense negotiations which have been underway for the entire year, OPEC has finally announced a decision to cut by 1.2 million barrels a day (roughly 4.5% of current production).

The biggest production cut is to be carried out by Saudi Arabia, which has agreed to cut its production by 486,000 barrels per day. In addition, Iraq will cut production by 209,000 barrels per day, and Kuwait by 130,000 barrels per day.

One major producer, Indonesia, has refused to cut its production, and is suspending its OPEC membership. Another oil producer, Iran, is being allowed to increase its production to 200,000 barrels per day from the current 3.7 million.

Non-OPEC producers are expected to cut their production by 600,000 barrels per day, the biggest cut being by Russia, which is to cut its production by 300,000 barrels per day.

The production cut agreement is to last for 6 months.

The oil price has immediately recovered on the news, with oil prices surging by 8% to over $50 a barrel.

This agreement represents a reverse by both Saudi Arabia and Russia.

Both of these two major oil producers refused to cut production in response to the oil price crash in 2014. Both have since been producing oil at record levels, in the case of Russia 11.2 million barrels per day in October (a post-Soviet record) whilst Saudi production hit record levels in July at 10.67 million barrels a day.

Officially Saudi policy until the start of this year was to allow the oil price to rebalance naturally. What caused the policy to change?

As I previously discussed in September, the first proposal for a production cut actually came at the start of the year from the Venezuelan Oil Minister, who toured the major oil exporting states to lobby for one. Protracted discussions for an oil production freeze then followed, only to be held up by bitter disputes between Saudi Arabia and Iran, with Iran insisting on increasing its production after returning to the oil market at the start of this year following the easing of sanctions.

The latest agreement however goes beyond a production freeze, as was discussed as recently as September, and envisages an actual production cut.

The explanation for the Saudi reversal is undoubtedly the growing strains on Saudi Arabia’s budget caused by the oil price remaining lower for longer than the Saudis expected. Almost certainly the Saudis were also spooked by the brief collapse of the oil price to $25 a barrel at the start of the year, which led to concerns that the oil price might fall through the floor.

Though Saudi Arabia has great capacity to borrow money on the capital markets, its fixed exchange rate means that because of the oil price fall its budget deficit has yawned to astronomic levels, and forcing the Saudis to undertake politically sensitive budget cuts to maintain the confidence of the international financial community. These budget cuts have however been causing serious problems, and it seems that the Saudis have grudgingly accepted that they simply cannot afford to continue with their present course.

As for the Russians, with their oil production at a record high and their budget under control, they probably reckon that they have called the Saudis’ bluff and can afford what is for them a minor production cut.

It remains to be seen whether the oil price cut will be sufficient to rebalance the oil market. Most commentators suspect not, but with the Saudis now reversing course and cutting production it is not impossible that if oil prices fall back more production cuts will follow.

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