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Game Theory of OPEC Production Cuts

https://seekingalpha.com/article/4055294-opec-production-cut-failure-next-oil?page=1

Earlier this year OPEC (Organization of Petroleum Exporting Countries) agreed to cut oil production in hopes that cutting supply would raise prices favorably for the supplier. The countries that OPEC is comprised of control a large enough amount of global petroleum production that there is merit to their effort, and they have succeeded with a similar strategy in the past. The projected yield on the strategy has not met fruition however, and halfway through the deal we are instead seeing oil prices dropping. This is a product of a changing oil market, with new production occurring in Alaska, Canada, and Brazil that was largely underestimated by OPEC. With new players in the market dropping pushing prices down, individual countries within OPEC are ramping production back up in hopes to get there slice of an increasingly competitive market.

Applying a lens of game theory to OPEC’s struggle to control the market sheds light on the situation at hand. Initially, the game is defined by the 12 oil producing nations that comprise OPEC, and the decision of each individual country on how much oil to produce. In an unrestricted market, each of the 12 countries produces at maximum volume and compete against one another to sell petroleum which creates downward pressure on oil prices and cuts into the producer’s margins. This issue can be amended, however, if the countries agree to cut production volume collectively and benefit from the rise in prices that follows supply shortage. The game theory issue lies here in that if production gets cut and prices rise, it is in every individual countries best interest to undermine the rest of the group and produce at maximum volume, resulting in full production at increased sales prices. When every country takes advantage of this opportunity, supply returns to the previous volume and prices lower back to equilibrium.

While this issue of incentive is sometimes addressed by having a stronger centralized OPEC, the members of OPEC need to understand that the rules of the game they are playing in are changing. With massive shale production from Alaska and Canada feeding North American fuel needs and Brazilian oil help South America, in conjunction with oil flows from Russia, we are seeing OPEC’s share in the market place and overall purchasing power weaken severely. When they are no longer able to control prices in the market, there unity and strategic production stops are going to have little impact on the market and instead only put downward pressure on their own profit, as exemplified by this year’s round of production cuts. The only way to adapt and maintain their strategy would be to increase the number of players in their organization so that they can control enough of the petroleum market to once again drive the supply.

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