A Game Theoretic Approach to Oil Markets
Overview
The following provides a game theoretic framework to rationalize the recent oversupply in the oil markets and the so called “prisoner’s dilemma” that marginal oil producers face. Highly simplified, my analysis focuses on U.S. shale producers and their decision to produce or not produce as global crude oil prices remain at historically depressed levels.
A History of the Game
From the start of last year until mid-2014, the price of a barrel of crude oil hovered at around $100. Today, the price of crude oil sits at less than $50 per barrel. Much of this decline is attributed to simply supply-demand dynamics. Slowing economic growth in China, accompanied by increased supply from the U.S. and Canadian shale markets, has lead to a glut in global oil markets. In addition, Saudi Arabia’s decision last year to keep production stable in the face of falling oil prices, since it can produce oil relatively cheaply and withstand tough market conditions, further prevents the likelihood of a near-term increase in prices.
The Players
In the context of global oil supply markets, and as evidenced by Saudi Arabia’s decision to continue to prop up the global oil supply, the firms that produce oil at the margin (i.e. those that produce when prices increases and are the first to halt production when prices decrease) are those that are most sensitive to changes in oil prices, or those that produce oil most expensively. The below oilprice.com piece by Kurt Cobb provides a rather intuitive explanation of identifying marginal producers in the global crude oil market—U.S. oil drillers. Intuitively this makes sense, as they were the later set of producers who chose only to ramp up production when oil reached all time high.
The Dilemma
Suppose this game is played with 2 U.S. producers, for whom it is only economical to produce when prices reach a high threshold level, say $70 per barrel. As prices initially fall below this level, both of these firms are faced with 2 possible strategies—to continue producing or decrease production. Suppose the hypothetical payouts are such that if both firms were to continue producing, the excess demand would continue to depress prices, harming both firms in the long-run. If both firms were to slightly decrease production, both would be better off, as prices could stabilize to a more economical level. However, if one firm produces while the other decreases production, the firm that chooses to produce increases market share, further bolstering the long-term market position. Although simplified, this game represents the dilemma marginal oil producers face when oil prices dip below a breakeven level. Although all marginal oil producers would be better off coordinating and slightly decreasing production, such collusion is illegal in the United States. Thus, as in the classic Prisoner’s Dilemma, for many of these producers, acting rationally results in a suboptimal equilibrium outcome for all players.
Sources:
http://www.wsj.com/articles/oil-companies-predicament-who-should-cut-production-1419358086
http://oilprice.com/Energy/Energy-General/U.S.-Shale-A-Marginal-Not-Swing-Producer.html
http://www.investopedia.com/ask/answers/030315/why-did-oil-prices-drop-so-much-2014.asp
http://www.wsj.com/articles/tracing-oil-price-plunge-back-to-texas-1418404579