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In a Surprise Move, More Oil Cuts Are on the Way

In an astonishing move, Saudi Arabia has signaled that more oil production cuts are on the way. This certainly bodes well for higher oil prices in a market that is depressed by persistent oversupply and growing oil inventories. It also means that concerns about whether or not OPEC can deliver on its promised production cuts are now allayed, boding well for Canada’s energy patch. 

Now what?

The surprise deal between OPEC and non-OPEC oil-producing nations, which encompasses 60% of the world’s total crude production, has buoyed hopes of a balanced oil market going into 2017. Non-OPEC nations have committed to cut oil output by 558,000 barrels daily, which comes on top of OPEC’s agreement to reduce its output by 1.2 million barrels daily.

Then there is the shock move by Saudi Arabia, which has vowed to make even deeper cuts by reducing their oil production to below 10 million barrels daily. This is good news for beaten-down energy stocks. It signals a marked change in strategy by the Saudis, who, in the recent past, were committed to boosting market share by making it uneconomical for U.S. shale oil producers to continue operating.

As a result, the price of crude in recent weeks has surged. West Texas Intermediate, or WTI, which is the North American benchmark price, is up by 23% over the last month, whereas the international benchmark Brent has spiked by 27%.

There are signs that higher prices are here to stay for at least the foreseeable future, despite fears of U.S. shale oil producers seeking to significantly ramp up oil production in response to rising oil prices.

You see, even though the U.S. rig count continues to rise, the current level of drilling activity is considered by many analysts to only be sufficient to replace output lost because of natural production declines. This certainly appears to be the case with shale oil wells experiencing decline rates that are more than double those of conventional wells.

Furthermore, the U.S. rig count still remains well below where it was a year ago, meaning that it will be some time before there is a noticeable increase in U.S. oil output.

This is tremendously good news for Canada’s beaten-down energy patch.

A number of companies, including Baytex Energy Corp. (TSX:BTE)(NYSE:BTE), have been battling to sustain operations because of the twin impacts of weak oil prices and considerable piles of debt. Now, with WTI moving to over US$55 per barrel and expected by many analysts to break US$60 per barrel, Baytex will become free cash flow positive.

This will not only support increased profitability, but will allow it to boost expenditures on exploration and well development that will help to offset declining production from existing wells. Such a move is particularly important for Baytex because it would allow the company to finally start boosting production so as to benefit from higher prices.

The additional free cash flow generated will also be used by Baytex to pay down that tremendous pile of debt, which, by the end of third quarter, came to $1.9 billion.

The optimism that now surrounds the outlook for crude and the future of companies such as Baytex is reflected in the staggering bounce in their share prices. Over the last month, Baytex is up by almost 41%, and for as long as crude continues to rise, Baytex’s share price will do the same. 

So what?

The surprise backdown by the Saudis means that, finally, oil markets should rebalance and prices for oil will rise, at least for the foreseeable future. This is extremely good news for the energy patch and beaten-down energy stocks such as Baytex, which is one of the best-levered plays on higher crude.

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Fool contributor Matt Smith has no position in any stocks mentioned.

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