How Nash Equilibrium Explains OPEC Efforts To Cut Oil Production

by: Artem Perminov

Summary

Nash equilibrium is a useful concept for understanding economic agents' behavior.

This concept could be applied to the oil market.

Any efforts to cut oil production will be useless, as the theory predicts.

The notable fact behind the game theory is that it can explain people's behavior by pure mathematical constructions. The main assumption laying behind it is that people make decisions rationally and maximize their rewards or utility. This assumption fails sometimes, however, empirical facts say that, generally, rationality is the key driver of people's decision-making. The goal of the game theory is to show how people would behave and interact under certain circumstances and initial inputs. The key concept of the game theory is the famous Nash equilibrium. Named after the great mathematician John Forbes Nash, the Nash equilibrium is the situation where no player in the game can benefit from changing his strategy unless some other player changes his first. The theorem proven by Nash states that given certain initial conditions, non-cooperative games - which are games where players cannot form coalitions and coordinate their actions - possess the Nash equilibrium.

Things become clear when an example is considered. The most simple and famous example is the prisoner's dilemma. Assume there are two arrested members of a criminal gang. They know each other but have no means to communicate. The prosecutor conducts an interrogation but he does not have enough evidence to convict either one of them on the principal charge. If both prisoners stay silent, they each can expect to be sentenced to, say, a year in prison. However, the prosecutor offers each prisoner a bargain - to betray the other by testifying that the other has committed the crime and to be freed, or to keep silent. Alternatives are summarized in the following table.

Prisoner

In each of the alternatives, except number 4, for one of the prisoners there is an opportunity to increase his reward (to decrease his sentence). For example, in the alternative number 1, Prisoner 1 can expect to be freed if he betrays his accomplice. The Nash equilibrium concept states both prisoners will choose to betray since it is the only alternative where neither of them can reduce their sentences. Notably, this alternative is worse for both than the alternative number 1 where each gets one year in prison.

Interestingly, this concept can explain the reason behind OPEC's inability to negotiate oil production cuts. Consider two fictional countries; say Oilland and United Oil Emirates. They are oil exporters facing an oil price and export revenues slump. Each one has two alternatives - to keep oil production or to cut it in an effort to try to increase the price. However, the price will increase only if both countries cut their respective productions. If only one country decides to cut production, the other can seize its market share. The alternatives are summarized in the following table.

Oil market nash equilibrium

One can notice that this game is exactly the prisoner's dilemma with other names of players, alternatives, and rewards. As game theory predicts, alternative number 4 will be dominant since in each of the other alternatives one of the countries can increase its reward. In the equilibrium, both sides will be worse off than if they have chosen alternative number 1. This model is fairly rough; however, it provides intuitive insight to the way real oil market participants cooperate.

The reasonable question is why countries cannot negotiate to cut production simultaneously. After all, they are not prisoners sitting in the different rooms. The theory works if both sides cannot cooperate, however, as the 1973 oil crisis has demonstrated, this assumption may fail. In 1973, the Israeli-Arab conflict was a strong political reason for such cooperation. The OPEC was more homogeneous, the oil market was less competitive and alternative energy was less developed than today. Nowadays the situation is completely different with a more dynamic oil market and diverse political environment. Here are some reasons why oil producers are locked in the prisoner's dilemma game.

Political mistrust and hidden rivalry. Russia and Saudi Arabia are great examples of political mistrust. Both countries have a collision of interests in Syria; both countries have a long history of cool relations, and neither of them have reason to believe that the other will follow any oil production cut agreements without cheating by increasing their market share. Such mistrust exists even within OPEC - Saudi Arabia and Iran are the classical examples. Not only do these countries mistrust each other, but they are hidden adversaries in the region.

Completely different oil production environment. Some countries, like Saudi Arabia, have very low oil production costs, while other, like Venezuela and Nigeria, have high costs. Moreover, different countries have different assessments about what a comfortable oil price is. Saudi Arabia, according to Economy and Planning Minister Adel Fakieh, could live comfortably with oil prices as low as they were in late 2015 while Iran and Venezuela have stated that $90-$100 is a suitable price. Such diversity and differences in the oil producers' economies results in the impossibility of the oil production cut agreement since there will always be someone displeased with it.

The rise of independent producers. Shale oil producers in the USA are new key players in the oil market. Any oil price increase will make them more profitable and the oil market more competitive.

To sum it all up, the next time there will be OPEC meetings or oil production cut speculations, one needs to keep in mind that the oil market has completely changed. There are a lot of new players now and many different interests. The demand for oil will determine its price in the near future, since there are many suppliers ready to satisfy needs of the market. Therefore, the impact of such meetings and speculations on the oil price will be very short-lived and limited.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.