There Will Be Blood: Persistent Competition Among Oil Producers
Earlier this week at the G20 summit in Hangzhou, China, one major topic of discussion was the collapse of oil prices that has occurred over the past 1-2 years. Going into the summit, Russia and Saudi Arabia, the world’s two largest producers of crude oil, had expressed interest in making an agreement to freeze or limit oil production. As the de facto leader of OPEC, Saudi Arabia’s participation in such a deal would also influence other OPEC members to reduce oil production. Based on the principles of supply and demand, reducing output would increase the price of oil, and because the demand for oil is relatively inelastic in the short run, the quantity of oil demanded would not show much change.
However, despite much anticipation of a pact to freeze oil output, Russia and Saudi Arabia once again left the table without a signed agreement, instead holding a joint press conference to emphasize their commitment to making a deal. Representatives of the two countries will meet again this fall for further discussions.
Why is it so difficult for these countries to come to an agreement? After all, lowering output could increase prices and improve profitability for everyone. Unfortunately for major oil-producing nations, it’s not that simple. This situation can be modeled with game theory, and as we’ll see, it’s a classic case of the Prisoner’s Dilemma.
I made a few assumptions to simplify the analysis, including the following:
- Assume that Russia and Saudi Arabia have the same oil-producing capacity and power. Both produce about 13% of the world’s oil, so this is a reasonable assumption.
- The demand for oil is close to inelastic, so I will assume that changing the supply of oil will not change the amount of oil demanded. The price, however, will indeed change.
- As a country’s oil production increases, its market share increases.
The values in the payoff matrix are representative of money made; only the difference between the values is significant. In this game, both Russia and Saudi Arabia have 2 options: low output, and high output.
|
Saudi Arabia |
|||
| Low | High | ||
|
Russia |
Low | 5, 5 | 1, 8 |
| High | 8, 1 | 2, 2 | |
With a quick analysis of best responses, we can see that the Nash equilibrium of this game is for both countries to produce large amounts of oil, even though if they both chose to reduce output, they would both benefit with decent profits.
In the real world, these results translate into difficulty signing a binding agreement to lower oil production, since there is such a large incentive to deviate and produce more. Of course, in cartels such as OPEC, you have the ability to force countries to obey certain production limits. But when non-OPEC nations such as Russia and the US enter the fray, controlling output becomes a lot easier said than done.
For more information on oil production negotiations at the G20 summit, check out the article that I consulted for this post: http://www.bloomberg.com/news/articles/2016-09-05/saudi-russia-discuss-actions-to-bolster-oil-including-freeze.