All the recent talk of an OPEC deal to push up the price of oil is nonsense. Here is a hypothetical supply and demand chart of oil.
In this hypothetical example, equilibrium is set where the supply and demand curves cross at a price of $40 a barrel at 75 MMbpd.
Shifting the Supply Curve
Saudi Arabia controls 25% of the global supply of oil. What Saudi Arabia wants to do is to shift the supply curve up (raise the price of oil) by reducing the global oil supply.
After pushing the supply curve down by flooding US markets with cheap oil to put shale producers out of business, Saudi Arabia now wants to push the supply curve back up by reducing the global supply of oil.
US Shale Oil Production
Saudi Arabia wants to push the supply curve up just enough to keep most US and Canada shale oil production offline. Think about it. Why would Saudi Arabia push the supply curve up so that US shale oil production could surge again? Saudi Arabia would only lose market share again to the US.
Below is the global oil cost curve from Goldman.
Around $55 to $60 a barrel is the price that the Gulf of Mexico (GOM) output begins surging again, so it’s a pretty sure bet that Saudi Arabia wants oil to stay below $55 a barrel.
The purpose of the OPEC cartel is to create a monopoly and to control the price of oil at will, but history has shown that OPEC has only had limited success at doing that because cartel members cheat.
Game Theory and OPEC
In the Prisoner’s Dilemma example, let’s assume there are just two parties, both cannot communicate, and they are separated in two individual rooms. The normal game is shown below:
Here, regardless of what the other decides, each prisoner gets a higher reward by betraying the other (“defecting”). Jack will either cooperate or defect. If Jack cooperates, Jose should defect, because going free is better than serving one year. If Jack defects, Jose should also defect, because serving two years is better than serving three years. So either way, Jose should defect. Parallel reasoning will show that Jack should defect. Game theory shows that the outcome is that Jose will betray Jack. The game is symmetric, so Jack should act the same way. Since both “rationally” decide to defect, each receives a lower reward than if both were to stay quiet. Traditional game theory results in both players being worse off than if each chose to lessen the sentence of his accomplice at the cost of spending more time in jail himself.
Jack and Jose both swore to each other several days before that they’d never rat on each other, but what happens when push comes to shove? It’s every man for himself.
Typically, both men go with their dominant strategy and betray the other. But because both separately decide to confess, they each end up getting two years in prison — a worse outcome than if they had both kept their promise to each other to remain silent. If they had both kept their promise, they each would’ve gone to jail for only one year. The logic of the dominant strategy is so compelling, though, that they each break the agreement and end up going to prison for two years rather than one.
This example of the Prisoner’s Dilemma is set up for just two people, but mathematicians have developed far more advanced models that can analyze the behavior of many participants. These models are invaluable for understanding cartels.
The basic conclusion of these multi-player models is that the dominant strategy is usually to cheat on cartel agreements. This result goes a long way toward explaining why the OPEC oil cartel has a hard time raising oil prices and then holding them there for a lengthy period. Quite simply, cheating on OPEC cartel agreements is a dominant strategy for OPEC member countries. The cheater is better off producing more than its quota because it can sell lots of oil at a higher price if the other countries are obeying their quotas. Overproducing is a dominant strategy and is simply too tempting to resist given the rewards.
OPEC could more effectively manipulate the supply curve up or down if it had some way of threatening its members if they violated their quotas. Because the member countries are sovereign nations, it’s hard to threaten members. Saudi Arabia controls 25% of the world’s oil and so they sometimes threaten to flood the market with oil and create very low oil prices as they did recently against the U.S. I have little doubt that Saudi Arabia threatened the Obama Administration to curtail shale oil production or face the consequences of super low oil. I think it’s clear that the Obama Administration allowed Saudi Arabia to flood US markets with cheap oil to drive shale oil producers into bankruptcy. I think the Obama Administration was more than happy to go along with Saudi Arabia’s attack against shale producers because of its own environmental concerns regarding fracking.