Game theory and oil prices
2015 has been a win for American consumers. With oil prices the cheapest they have been in 7 years, the average American is saving $800 dollars on gas this year. While a weak global economy is fueling some of the decrease, behind the low oil prices lies a deep standoff between OPEC, an organization whose members include many of the richest oil nations in the world, and American shale producers. However, basic economics would suggest that low oil prices, combined with a supply glut, would cause oil producers, such as OPEC, to cut back on supply in a bid to raise prices. This suggests that there could be a simple game theory model to explain why neither OPEC nor shale companies have budged on oil supplies in the past year.
Game theory involves analyzing economic decision-making primarily at the micro level. In this case, we will be looking at the strategy OPEC and shale producers are pursuing in the short term. Ideally, shale producers would want to obtain the highest price and supply the most oil as possible to obtain the greatest amount of revenues. However, their counterparts abroad want to do the same. Evidently, they both cannot follow the same strategy to succeed. In November of last year, Venezuela failed at convincing other OPEC countries to cut oil supplies. In this year’s meeting in June, Venezuela did not make any more objections. It is clear which strategy OPEC is taking. OPEC, nevertheless, has the advantage once we add one important consideration to the game theory model: cost. Shale oil is much more expensive, roughly $55 per barrel, to extract from the ground as conventional oil near the Persian Gulf, only $25 per barrel. With oil prices at $45 dollars, many Shale oil fields are now unprofitable. This naturally disincentives new oil wells, such that as oil wells dry up, they will not be replaced. Indeed, Citibank estimates that US oil production falling by 500,000 barrels per day by the end of the year. Will OPEC end up winning in this model? Yes.
http://www.economist.com/news/leaders/21635472-economics-oil-have-changed-some-businesses-will-go-bust-market-will-be
http://money.cnn.com/2014/11/27/investing/oil-prices-opec-crude/
http://www.reuters.com/article/2015/06/04/us-opec-meeting-idUSKBN0OJ0MK20150604
http://fuelfix.com/blog/2015/09/09/citigroup-sees-u-s-oil-production-falling-500000-barrels-per-day-by-end-of-2015/#26983101=0