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Is Oil Crash 2.0 About to Begin?

WTI oil prices slipped 2% March 2 after data came out showing that Russia’s oil production held steady in February.

Why is this important?

OPEC, Russia, and a handful of other producers announced a pact late last year that would see members collectively reduce oil production by 1.8 million barrels per day (bpd) through June. Russia alone has offered to reduce production by 300,000 bpd.

The objective is to bring global supplies more in line with demand and provide support for higher prices.

What triggered the pact?

Countries that rely on oil revenues to prop up their economies took a major hit when WTI oil fell below US$30 per barrel last year. The sell-off prompted major producers to find a way to stabilize the market.

Negotiations dragged on for most of 2016, but OPEC and its partners finally came up with an agreement at the end of November.

Oil prices recovered through 2016, largely on hopes of the deal coming to fruition, and the announcement provided an additional boost, driving WTI oil to a high of US$55 in December.

The market has struggled to extend the gains in 2017, despite reports through January that OPEC and Russia were delivering on their promises.

Rising U.S. production is widely viewed as the reason oil hasn’t moved higher.

What happens next?

The fact that Russian production was flat in February after a 100,000 bpd cut in January suggests the country might have put the brakes on its reduction program. This is important, because up until this point, the market has more or less believed the agreement would hold and members wouldn’t cheat or drag their feet.

OPEC has a history of coming up short on these types of agreements, so it shouldn’t be a surprise if the deal starts to crumble.

Policing members is nearly impossible, relying on data from each country is tricky, and as soon as one of the countries suspects another is not holding up its end of the bargain, the entire pact can quickly fall apart.

OPEC says its members delivered 94% of the agreed cuts in February, so there is still a chance the agreement can survive.

If Russian comes out and says its pause was simply a one-off, the market could quickly rebound, but any indication out of Moscow that Russia has changed its mind on its reduction commitment could send oil into another tailspin.

In that situation, a full-blown meltdown in the OPEC deal could follow, which would be bad news for the oil patch.

What should investors do?

Oil prices could quickly slide back down to US$45 per barrel or lower on any further indications the pact is not being respected, especially when rising U.S. production is taken into consideration.

Big producers with strong balance sheets should be able to ride out another downturn and could take advantage of a pullback to acquire more assets. Suncor Energy Inc. (TSX:SU)(NYSE:SU) would fall in that category.

If you own those stocks and believe in the oil story over the long term, it might be worthwhile to hold the positions or even add to them on a pullback. The stock prices would fall, but companies with low debt and solid cash positions are not at risk of going bust.

Highly leveraged producers, however, could get hammered again, and if oil tanks back toward the 2016 low, some might not make it through the next downturn.

As such, I would avoid the popular names that still have large debt positions, regardless of how cheap they look today.

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Fool contributor Andrew Walker has no position in any stocks mentioned.

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