Game theory perfectly explains why OPEC members are going to cheat

Saudi Arabia's Oil Minister Khalid al-Falih (R) sits next to Russian Energy Minister Alexander Novak as he addresses a news conference after an OPEC meeting in Vienna, Austria.

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Saudi Arabia’s Oil Minister Khalid al-Falih (R) sits next to Russian Energy Minister Alexander Novak as he addresses a news conference after an OPEC meeting in Vienna, Austria.
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Reuters/Heinz-Peter Bader

  • OPEC members have a deal to cap production levels until December.
  • Oil prices are rising.
  • When prices are higher, there is less incentive to cooperate with production caps.

With oil prices rising, Organization of Petroleum Exporting Countries members are facing a dilemma.

Extending output caps means making more room in the market for non-member competitors, and coordinating a higher amount of output means lowering prices. So they might not do either, and game theory could help explain why.

“Game theory suggests that higher oil prices increase the pay-off from cheating on the deal, which means that compliance could fall in 2018,” Thomas Pugh and Liam Peach, economists at Capital Economics, wrote in a note to clients this week.

West Texas Intermediate crude oil has stayed above $60 a barrel most of this year, only falling during a major market selloff in February. And as prices rise, non-OPEC production is increasing. In November, US shale producers hit a record high for production, pumping more than 10 billion barrels a day.

For an individual country focused on maximizing revenue, producing as much oil as possible is usually the dominant strategy – what players should do regardless of the actions of other players.

But when everyone amps up production, it puts downward pressure on prices. In game theory, this is an example of the prisoner’s dilemma. Because everyone acts out of self-interest, players end up in a worse scenario than if they collaborated.

This is where OPEC collusion comes in. Member countries – Algeria, Angola, Ecuador, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia and the United Arab Emirates – act as a single supplier.

But as prices rise, it creates more incentive for members to cheat and produce more. Because marginal revenue is higher than at lower prices, there is greater payoff from raising output – even in the face of production caps.

At the same time, the opportunity cost of complying also becomes greater.

“Cutting output to counter the effect of rising non-OPEC production would require giving up increasing amounts of market share and revenue,” Pugh and Peach added.