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OPEC raises the white flag in battle with U.S.

Why OPEC is cutting oil production

That fluttering sound you just heard was OPEC waving the white flag.

After a painful two-year price war against U.S. shale, the Saudi Arabia-led cartel finally blinked this week by agreeing to stop flooding the world with excess supply.

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OPEC’s first production cut since 2008 reflects a recognition that hopes of drowning U.S. producers with cheap oil has failed to kill the American oil boom.

In fact, the price collapse crushed the budgets of Saudi Arabia and other OPEC producers, creating financial stress that was unthinkable just years ago. Moreover, U.S. frackers have emerged from the oil crash stronger and leaner than before. Now they’re positioned to ramp up output at prices that were once too low to survive on.

“OPEC realized they’re facing an impossible battle — and instead has retreated,” said Matt Smith, director of commodity research at Clipper Data.

Ultimately, OPEC decided the financial pain inflicted by the collapse of crude trumped the benefits of continuing to push out producers like the U.S. that tend to need higher prices.

“OPEC hasn’t been able to slay the dragon that is the U.S. shale boom,” Smith said.

Related: Oil prices skyrocket on OPEC deal

Saudi financial stress

While it is true that OPEC’s strategy did slow American oil production, others agree that OPEC’s price war missed its mark.

Saudi Arabia’s market share battle has “turned out to be a failed experiment,” Michael Tran, commodity strategist at RBC Capital markets, wrote in a recent report.

The price war has “left the Kingdom with little to show for its trouble besides burning through a quarter trillion of FX reserves, rising domestic tensions and a deteriorating market share position,” Tran wrote.

Budget stress brought on by cheap oil has forced Saudi Arabia to jack up gas prices and remove other generous subsidies, shelve projects that has cost jobs and contemplate an ambitious diversification of its broader economy.

Another crash in oil prices would have plunged Saudi Arabia further into the red and threatened the IPO of Saudi Aramco, the kingdom’s crown jewel whose debut as a public company could raise $100 billion.

Related: Saudis believe Trump will unleash America’s economy

OPEC sparks oil price spike

Of course, OPEC does have a number of things to be happy about this week.

It’s clear that OPEC proved it still has the ability to influence the markets in a dramatic fashion. It took three days of closed-door negotiations, but OPEC did cobble together a major deal between rival factions, namely Saudi Arabia and Iran.

OPEC should also be happy about the 13% spike in oil prices in the two days since the meeting in Vienna.

“The relevance of OEPC as an organization has strengthened significantly,” JBC Energy wrote in a note, calling the Vienna meeting “well-staged.”

Jason Bordoff, a Columbia University professor and former Obama energy adviser, said OPEC was able to “restrain” U.S. shale and “succeeded in cutting investment” in high-cost supply.

But the latest oil rally helps U.S. producers, too. That’s why shares of U.S. oil companies like Hess (HES) and ConocoPhillips (COP) skyrocketed on Wednesday.

“This was an extremely bullish production decision,” Jason Schenker, president of Prestige Economics, wrote in a report that oil could rise to $60 a barrel soon.

Investors are clearly betting the OPEC agreement, if it’s adhered to by self-interested members, will help fix the epic supply glut that caused prices to collapse in the first place.

Fitch Ratings predicted the deal “should help accelerate” the ongoing rebalancing in the market and raises the odds of a “more rapid” recovery in prices.

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OPEC fails to wipe out U.S. shale

At the end of the day, the U.S. oil boom has fared much better than feared when OPEC launched the price war two years ago. The U.S. pumped 8.6 million barrels per day in September, down by 1 million from the peak of April 2015, yet just shy of the average level of 2014.

In other words, domestic oil output has dropped — but not fallen off a cliff.

“They weren’t able to wipe out shale. OPEC has to face the new reality that shale is going to be there,” said Thomas O’Donnell, a senior energy analyst at Wikistrat.

And many anticipate shale will emerge as one of the biggest winners from the OPEC decision.

Rystad Energy predicted on Thursday that the OPEC deal should allow non-OPEC shale oil production to rise by 1 million barrels per day in 2018.

While dozens of U.S. oil companies have succumbed to bankruptcy, the ones that have survived have been forced to become vastly more efficient. By cutting excess costs and rolling out new technology, these frackers are much more competitive than just a few years ago.

“U.S. producers are now able to pump more for less. That’s saved their bacon,” said ClipperData’s Smith.

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