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.


Anonymous said...

Dear Student,

I thoroughly enjoyed reading your blogpost. I was wondering why you made the statement that there is no enforcement mechanism in place to punish those who cheat. There is a failsafe in place like those found in any multilateral agreement namely the age of tactic of ganging up on the those who break the rules.

If it is agreed upon in OPEC to lower exports of crude oil and a state does not follow through on their promises then other OPEC states can just influence pressure to make sure that countries fall in line.

While it is not the prettiest its still a method that can be used to whip the house into order!

Let me know what you think

Steven said...

Dear anonymous user,

Because, as you noted, OPEC is based on a multilateral agreement between countries that are not necessarily on good terms (e.g. Iran and Saudi Arabia), there is no "whip" in place to punish specific members (there is no OPEC court of justice). Furthermore, as is specified in the FT article in the link, OPEC did not get to an agreement in Doha. If there are no rules in place meant to cut back on oil production, there are no rules to break. The problem is not about breaking laws, it's about getting to an agreement, and as long as OPEC members suspect each other of breaking such agreements, there will not be an agreement in the first place.

I hope I have answered your question.

Kelly said...

Your blogpost was really interesting to read, and gave a small insight into the troubles that are faced among the oil exporting countries. I thought you outlined the situation through the prisoners dilemma quite clearly.

However, while reading it I was wondering what solutions could be provided to enforce cooperation between countries (even those on bad terms), as it seems like they will continue to 'cheat' rather than cooperate and that OPEC is unable to do anything about it, yet they need to and should. So what suggestions could be provided to encourage cooperation?

Steven said...

Hi Kelly,

That is indeed a really interesting question. Because OPEC is merely a cartel, their impact on the price of oil in the global economy can only be felt if all members cooperate. This game theoretic model is, unfortunately, only a simplification of the problem. While economic incentives could push these countries to sign an agreement that punishes cheating behavior (thereby reducing the benefits of cheating), the political elite in these countries make it difficult to do so. While all countries could be better off economically, some OPEC members get more utility from forcing economic collapse upon their neighbors’ economies (e.g. Iran vs. Saudi Arabia).

As I am not trained in international relations / diplomacy, I do not know a feasible solution to this problem as it is. Maybe other people have suggestions / comments as to how to solve this problem?

Lauke said...

Hi Steven!

My comment ties in with the one just made by Kelly in terms of the political aspect:

By now, it has come to a point that the US is fracking at extraction prices many times higher than the oil price itself, the same goes for Canada and its tar sands and even Russia with its ambitions to start extracting in the Arctic. So my question is: have you, for your paper, considered the more political drive for countries to produce oil? The US, Canada and Russia are obviously not doing it for economic gain, seeing the current price levels, but for political pride as it were, which puts extra pressure on the OPEC countries. One of Saudi- Arabia's main motivations for continuing oil extraction at such a high rate is also not necessarily the bigger revenue (theirs is huge anyway seeing as they can extract at $3 per barrel) but to maintain their position as the world's largest oil producer, which title has recently been taken over by the US. This might have an influence on the incentives of different countries within OPEC for their oil-production.


PS. You probably already know this site, but just in case; it has awesome data and graphs :)

Erkki Piipari said...

Hi Steven,

My comment is in the same line as Lauke's.

After looking at the site posted by Lauke it is clear that there are conflicting data about the cost of oil production. When looking at http://graphics.wsj.com/oil-barrel-breakdown/ the cost of oil barrel for Saudi-Arabia is at 9$/bbl. In contrast, the other site states that the production + transport cost for Saudi-Arabia is 5$/bbl.

These numbers are much lower than the production cost for fracking, which is around 25$/bbl. Saudi-Arabia can still extract a profit of 500-1000%/bbl with the current oil price compared to the production costs. Therefore, there might be only little incentive for it to reduce production, as Lauke said, because they might just want to kill off competition from fracking.

This argument becomes also more substantiated when we consider the huge reserves of oil shale. The higher the price for oil, the lower the treshold for oil companies to start innovating on oil shale extracting techniques. Keeping the price low could actually be seen as increasing the barrier of entry for alternative methods of fossil fuel extraction. After all, because Saudi-Arabia is the largest producer of oil (and its economy completely dependent on it), it has the most to lose if more cheap alternatives for fossil fuel extracton become available.

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