10 May 2016

OPEC’s failures: A prisoner’s dilemma

Steve writes:*

The past months have been tough on the OPEC member states’ economies. The oil price has fallen from $100 a barrel in 2014 to $45 a barrel today. The Organization of the Petroleum Exporting Countries (OPEC) has been trying to reverse the fall by decreasing supply, but unwillingness from some OPEC member states has made this a complex issue.

After the failure of the OPEC meeting in Doha, the price of a barrel of Brent crude oil went down to $40, after which it slowly recovered to $43 a barrel. A decrease in supply would drive up the price of oil, but Saudi Arabia, the largest producer, does not want to decrease its production if other member states do not do so either. As Saudi Arabia turned to OPEC to come to an agreement, the Saudis found out that a decrease in production is much harder to accomplish than they had initially hoped.

Ever since the international embargo on Iran has been lifted in January this year, oil production in Iran has been increasing by the day, and the Iranian government – finally able to fully benefit from oil exports – is eager to return to the global market, where it can sell more oil for higher prices than during the embargo.

With Iran not willing to decrease production, despite the fact that it could benefit all OPEC members, we can see that there is a classic prisoner’s dilemma going on. If all OPEC countries were to cooperate and cut production, the price for a barrel of oil would increase, leaving all member states better off in terms of oil revenues. The pay-off of cheating, however, is higher than the pay-off of cooperating if all other member states stick to their promises to cut production. Furthermore, if a country (e.g. Saudi Arabia) suspects that another country (e.g. Iran) might cheat, it is better to also keep production at the same level (i.e. cheat), because cutting production makes no sense if the other country does not do so as well. In short, cheating is always the best response to the other country’s action.

The only way for OPEC to come to a solution would be if the benefits of cooperating would outweigh the benefits of cheating. Imposing a punishment on cheating members could be a way to do this, but because OPEC is a multilateral agreement, there is no whip to enforce punishments. In short, this means that it may take a long time for OPEC to get to an agreement on a decrease in oil production.

Bottom Line Cooperation on decreasing production is a better solution for all OPEC members, but the benefits of not cooperating – if all others do cooperate – are higher, meaning that it will be difficult to get to a common solution.

* Please comment on these posts from my environmental economics students, to help them with unclear analysis, alternative perspectives, better data, etc.