OPEC supply squeeze causes prices to surge

The oil producer cartel OPEC has agreed their first output cut in eight years causing the global price of crude oil to surge by around 9%.

OPEC has opted to cut 1.2 million barrels a day from its output to 32.5 million barrels, effective from January 2017.

This is the biggest coordinated action by OPEC for many years, but the world energy market has changed radically since 2008 not least because of the scale of US shale oil and gas production. American producers will be able to take advantage of a higher world price for crude and enjoy increased producer surplus as will other non-OPEC suppliers. Advances in technology and the benefits of economies of scale have reduced the long-run marginal and average costs of supply for USA shale oil and gas businesses.

That said, Russia (a non-OPEC member) has chosen to join in with the OPEC supply squeeze.

It is worth remembering that a formal agreement to lower daily crude oil production is not always the same as sticking to the quota!

Game theory tells us that each individual nation might have an incentive to over-produce and take advantage of higher world prices. OPEC outproduced its quota by an average of 883 thousand barrels per day from 2000- 2008.

Market watchers will be keeping a keen eye on the actual production figures to see if the supply squeeze is real. According to Goldman Sachs, looking at the last 17 OPEC production cuts, observed oil production cuts have typically come in at 60% of the announced reductions.

The world's largest producer of crude oil is Saudi Arabia and the recent slump in crude prices has dealt a significant blow to both their trade surplus and government finances.

The outlook for global oil prices depends just as much on conditions of demand especially with the Chinese economy weakening through 2017.

The Bank of England may have to revisit their macro forecasts for next year if the increase in world oil prices sticks through the New Year. They expect consumer price inflation to climb above the two per cent target and a fresh burst of cost-posh inflation from rising energy prices could increase the risks of "stagflation-lite" in 2017.