Gaming the Saudis
OPEC members have a long history of breaching production quotas, which contributes to scepticism about current cuts. Game theory explains why this pattern persists and also why the Saudis often act, as cartel leader, if it becomes too widespread.
Concerns over how long OPEC members and Russia will comply with production quotas have been accentuated by poorer compliance of 95% in June, down from over 100% compliance the last three months. In addition, Ecuador has announced that it cannot comply with the agreed cuts for fiscal reasons.
These types of concerns are nothing new and are justified given the historic pattern of over-production by members, as illustrated (excluding Iraq) below.
Game theory involves mathematical modelling of conflict and cooperation between intelligent rational decision makers. It can be used to explain why small OPEC producers over-produce, providing the big players largely comply.
For example, a small OPEC country with relatively high costs producing 0.5mbd is incentivised to over-produce, because the price impact of them doing so will be very small given limited impact on overall supply. Meanwhile, as outlined in Calling OPEC, Saudi Arabia and other large producers are heavily incentivised to raise prices by limiting production, ignoring small over-productions elsewhere.
However, as the number of countries over-producing rises it erodes the benefits for Saudi Arabia as the price falls on their reduced volume. At some point, then the benefits to Saudi Arabia are insufficient for them to comply and they’re incentivised to punish other producers and improve future compliance. This is what we saw in November 2014 when, led by the Saudis, OPEC switched away from quotas temporarily.
In the first example, the potential pay-offs are shown for Saudi Arabia and a small group of high-cost OPEC countries. The non-Saudi pay-offs are shown in red. The highlighted cell shows the 'Nash equilibrium', where neither party has an incentive to switch option given how the other would rationally respond; it shows that Saudi Arabia should comply but small OPEC countries will over-produce.
However, if over-production becomes widespread and the Saudis are left balancing the market on their own, the economics may not justify their compliance. In the second example, over 2mbd of combined cuts are agreed, targeting an oil price of c.$55, but half of other low cost OPEC countries over-produce by over 1mbd.
In this instance, there isn’t a single Nash equilibrium. For example, starting at the previous Nash equilibrium, with Saudi Arabia complying but all other over-producing, the Saudis are now incentivised to over-produce too, raising their pay-off marginally from $370m a day to $380m. But that’s not a new equilibrium as if Saudi Arabia over-produces, the other low cost producers are then incentivised to comply, raising their own pay-off from $220m to $240m a day due to higher prices. In turn Saudi Arabia is then incentivised to comply too, raising their own revenue to $470m a day which finally leads those low cost countries to over-produce and increase their own profits to $300m.
So instead there’s a mixed strategy where around 80% of the time some of the other countries over-produce, but 20% of the time they comply, reflecting that the Saudis can also switch between the two and in doing so cost the other producers when both over-produce.
These two simple examples, based on our actual revenue estimates from current oil prices in different scenarios, illustrate that partial over-production is a logical conclusion of the complex game being played between OPEC members. In reality, the Saudis have levers to try to improve compliance, including third party verification of production and threats of future action against those who transgress.
Unfortunately for Saudi Arabia, the incentive for smaller countries to over-produce is always there, so compliance tends to fall over time. For example, Ecuador is the first to formally quit. Eventually Saudi Arabia might have to flood the market again to restore discipline.