OPEC: The Prisoner’s Dilemma

OPEC

 

As long as oil markets have existed, producers have tried to control them. From John Rockefeller’s Standard Oil in 1890 to the Railroad Commission of Texas in 1930 to OPEC since 1960, participants have attempted to stabilize the price of oil through controlling supply. Nevertheless this is much harder said than done as basic human tendencies, revealed through the prisoner’s dilemma, can easily undermine carefully designed production quotas.

Prisoner’s dilemma highlights the psychological motivation for individuals and organizations to cheat in the presence of rewards, despite a greater reward if they cooperate. To clearly highlight the influence of this phenomenon within OPEC’s production, we will divide OPEC into 2 main players, Saudi Arabia, which produces 40% of OPEC’s total daily output, and the 11 other member countries. The rules are for each member to stick to its production quotas, set during a conference of all members at their Vienna headquarters, usually twice a year. The nature is that OPEC members have been blessed with substantial oil reserves, comprising 81% of world crude oil reserves by their estimates.

Just as two partners in crime locked in separate jail cells think about ratting each other out for a lighter prison sentence, OPEC members ponder over abiding by OPEC’s production quotas for the integrity of the cartel and its pricing power, or cheating and producing more oil for the benefit of their own economy. Given the relative inelasticity of demand for oil, OPEC’s manipulates prices through supply, wrestling pricing power away from the free-market. This monopolistic control enables member countries to take part of the consumer surplus through higher prices, disadvantaging global consumers and creating a deadweight loss.

OPEC is only as good as its control over production, and herein lies the dilemma. If all members produce accordingly and OPEC adheres to last years (and most recently scrapped) quota of 30 million barrels per day, the price of oil would increase and all members would profit. However member nations are motivated to cheat by increasing production, reaping the higher oil prices that other members have sacrificed to achieve. If everyone cheats then oil prices will drop from the increased supply: a return to free market economics as prices fall to producer’s marginal costs. This results in lower oil prices, no deadweight loss, and cost savings for consumers worldwide: the socially optimal outcome. These incentives are illustrated in the following payoff matrix.

Assumptions

Price: $ Million USDQuantity: Million Barrels/Day (mbl/d) OPEC (ex-Saudi Arabia)
QL QH
Saudi Arabia QL Price $100 Price $95
SA:15 mbl/d OPEC-SA: 15 mbl/d SA:15 mbl/d OPEC-SA: 16 mbl/d
QH Price $95 Price $90
SA:16 mbl/d OPEC-SA: 15 mbl/d SA:16 mbl/d OPEC-SA: 16 mbl/d

Payoff Matrix

Revenues in $ Million USD OPEC (ex-Saudi Arabia)
QL QH
Saudi Arabia QL $1500, $1500 $1425, $1520
QH $1520, $1425 $1440, $1440

A recent QERI LLC report put the current global oversupply of oil at 1 million barrels per day, an imbalance that a 5% production cut from the top 3 producers in OPEC could rectify. While traders have noted that oil could jump to $50 if such production quotas were introduced, we will assume a more simple example where 1 million barrels /day production cut creates a 5$ increase in the price of oil, and visa-versa. Similarly we will assume Saudi Arabia comprises 50% of OPEC’s output, and both Saudi Arabia, as well as the rest of OPEC’s members cumulatively, are capable of increasing production by 1 million barrels /day.

Clearly all members gain the most by adhering to their production quotas, shown by the larger revenues ($1,500) in the upper left box. They sell less oil and get more revenue for it. However both players are aware that overproduction could bring even greater revenues, and like everyone in life, they want more. Overproduction, while detrimental to the cartel, is each member’s dominant strategy because regardless of what the other player does, this will lead to greater revenue (either $1,520 versus $1,500 or $1,440 versus $1,425). Such self-interest will lead production to the lower right box, its Nash Equilibrium.

While rich countries like Saudi Arabia could theoretically forego greater reward for OPEC’s integrity, smaller and poorer members like Algeria have no choice, constrained by inadequate foreign reserves and large social welfare programs. Nevertheless this dilemma does not have to be a lose-lose situation. There are solutions to get members to cooperate, overcoming the usual suspects of communication, detection of cheating and game repetition that have plagued OPEC.

The first option requires all OPEC members to sign a binding agreement, including punishment for overproduction. A second option entails creating a clearinghouse to collect and redistribute all OPEC oil revenues based on their quotas. This would immediately change the incentives and hinder overproduction, as revenues from overproduction would now be distributed to all OPEC members rather than just the suspect country.

As OPEC struggles internally, the nature of the game is also changing. The US’s Energy Information Administration reported last year that oil consumption per unit of economic output in the developed world is declining. At the same time Saudi Arabia’s public spending has swelled as the country tries to maintain a loyal citizenry and counter radicalism. Government spending has quadrupled since 2003, raising the breakeven price for oil to $106. Declining demand for oil coupled with larger government budget outlays have stressed OPEC members, as nearly all members depend heavily on oil for a large percentage of their GDP, including Saudi Arabia (44%), Kuwait (59%), Qatar (31%), Venezuela (23%), Nigeria (17%) and Ecuador (15%).

 

The nature has also changed as new forms of drilling and fracking unleash previously unknown supply from the US. This new non-OPEC production threatens to diminish the cartel’s market share and potential payoffs, bringing oil to a 12-year low as recently as last week. Despite this, Saudi Arabia has staying power, with $650 billion in foreign reserves and the world’s lowest debt-to-GDP ratio (1.6%, 2014). Meaning the battle is far from over, both within OPEC and with its global competitors.

 

The Crude Truth

Oil’s effect on US growth has been debated heavily, and this week’s Barons suggests that while the initial effect of boosting consumption will help the economy, the ripples of less shale production will eventually drag on economic growth.  This will effect the numerous energy beneficiaries including railroads and truck driving.  Nevertheless JP Morgan is more positive, estimating every 10% drop in oil contributes .25 to GDP over time.

Oil prices have so far declined 30% from their late June peak as US production increases,  jumping past 9 million barrels a day last week for the first time since 1986 (EIA).  This narrows the gap between the US and #2 producer Saudi Arabia (producing at 9.7 million barrels/day) while Russia remains the leader (10.1 million barrels/day).

Domestic production has jumped 60% over the last 5 years due to breakthroughs in hydraulic fracking and horizontal drilling.  The industry directly employs 213,500 people as of October, doubling over the past decade.  This incredible leap in US production has weighed heavily on net oil imports, averaging 5.2 million barrels of oil a day so far this year (through August) compared to 12.6 million over the same period in 2006 (a reduction the size of Iran & Kuwait’s daily production).

On a shorter term basis, petroleum imports are down 7.5% this year (compared to the same period last year, through September) while petroleum exports are 15.4% higher.  The US exported an average of 2.7 mm barrels of oil a day (June) just shy of its record 3.1mm barrels last December (export ban?).

Nevertheless cheaper energy will continue to stimulate lower income households and energy intensive industries such as airlines, chemical companies and utilities, creating a far greater net benefit for the economy over the long term.  Capital spending from the oil and gas industry totaled 0.8% of GDP last year up from just 0.3% in 2013.  This marks the highest level since the oil boom in the early 1980s even though cap ex will fall back next year due to lower oil prices.

Cheaper energy can solve the world’s problems, from effectively sanctioning Russia to alleviating income equality as oil companies lose profits and low income households gain discretionary income.  Not to mention bankrupting the numerous oil-cursed, economically and politically stagnant countries dependent on the commodity for income.  Lower oil can literally do it all.

Northern Trust’s Million Charts

NT_Chart_Library_-_02052013  A fantastic presentation with charts on every aspect of the  global economy, from the breakdown of the CPI and dollar weighted index, central bank policy rate charts, US household & government spending, global GDP and inflation, China’s economy & growth, fixed income yield curves. spreads, option adjusted spreads, high yield metrics, default rates, global equities returns and fundamentals, commodities, demographics.

Northern forecasts an average rate of GDP of 1.85% for 2013, with just over 2% growth in the second half.  Slightly conservative compared to the street’s average 2.4% estimate.