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Indonesian Oil and Game Theory

From: http://www.thejakartapost.com/news/2011/10/04/turning-petro-dollars-back-a-game-theory-approach.html

An interesting article discussing how the method employed by the Indonesian government to subsidize oil production and exploration is counter productive. As the article states: ” Indonesia uses a system known as Production Sharing Contract (PSC), allowing oil companies to fully recover exploration and development costs before splitting profits with the government.” This results in oil companies focusing less on profitability and more on raw production, often with little consideration for efficiency or cost-effectiveness.

While this certainly seems contrary to the typical operating procedures of most companies, the article suggests an important consideration from Game Theory, specifically that the standard game most of us imagine does not fully capture all the subtleties of reality. We would imagine that the company’s payoff would be negatively effected by incurring additional costs, but this is not in fact the case.  The nature of the PSC allows whatever oil is produced to be used to offset the cost of production first; only when all costs are recouped is the government entitled to a share of the profits.  And, of course, these profits are smaller than they might otherwise have been.

The article goes on to recommend that Indonesia transition to a royalty based system similar to those used in other countries.  This would reformulate the game so that additional costs would indeed reduce the oil company’s payoff.  In this way it would be encouraged to be efficient in its operations, most likely resulting in greater profits for itself, and certainly for the government.

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