OPEC And Game Theory

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Includes: BNO, DBE, DBO, DNO, DTO, DWTI, JJE, OIL, OLEM, OLO, ONG, RJN, SCO, SZO, UBN, UCO, USL, USO, UWTI
by: David Merkel, CFA

Most games in life are cooperative. Many are competitive. A few are perverse.

That's what the crude oil market is like today. It reminds me of the prisoner's dilemma. In the prisoner's dilemma, two parties that would benefit from cooperating together tend not to do so because of other incentives that if both follow, they will both end up in a worse place.

This stems from three problems facing OPEC [Organization of the Petroleum Exporting Countries].

  1. The Saudis and the Iranians don't want to take any action that would benefit the other, even if it would help themselves.
  2. It's virtually impossible to keep member nations in OPEC from cheating, and producing more than their quota.
  3. Thanks to hydraulic fracturing (at least for now) there is enough supply outside of OPEC at inexpensive prices, that if OPEC cut production as a group, it might not gain as much of the benefit as they did in the 70s and early 80s.

Factors 1 and 2 interact, because even if there was a credible deal to cut production on the table, the Saudis likely think that the Iranians might cheat and produce more… leaving the Iranians much better off and the Saudis not that much better off.

We have to remember that the neoclassical model of man as a maximizer of utility or profits is often wrong. People and nations are envious, and will make do with less if it means those that they dislike are even worse off. The Saudis may be burning through their financial reserves quickly, but virtually everyone else in OPEC is worse off. The Saudis might think that they can drive a better deal inside OPEC when almost everyone else is desperate.

What this argues for is crude oil prices staying lower for a longer period of time - my guess is between $30 and $50 per barrel of Brent-type crude. What could change this?

  • Faster economic growth
  • Turmoil in oil producing regions that reduces supply
  • Depletion of short-life low-cost sources of crude (as is common with hydraulic fracturing)
  • Some clever third parties in OPEC find a way to get the Saudis and Iranians to cooperate while saving face, and no one cheats.

On the other side there is:

  • More cheating within OPEC
  • Weaker growth
  • Higher energy taxes
  • Further technological refinements that lower crude oil production costs further
  • Continued improvements in solar, wind, and energy storage (primarily battery) technology.

At present, my guess is that the marginal barrels of crude oil are being extracted in North America, and probably will be out to 2020 or so. As such, I would encourage energy investors to stick with strong companies with a mix of low debt and cheap production costs. Also, look for companies that are misunderstood, that have other businesses away from energy but have been tarred with the low energy price story.

In summary, play it safe while the members of OPEC flounder in a game that they designed for themselves.