OPEC and Game Theory

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OPEC and Game Theory

Most games in life are cooperative. Many are competitive. A few are perverse.

That’s what the crude oil market is like today. It reminds me of the prisoner’s dilemma. In the prisoner’s dilemma, two parties that would benefit from cooperating together tend not to do so because of other incentives that if both follow, they will both end up in a worse place.

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This stems from three problems facing OPEC [Organization of the Petroleum Exporting Countries].

  1. The Saudis and the Iranians don’t want to take any action that would benefit the other, even if it would help themselves.
  2. It’s virtually impossible to keep member nations in OPEC from cheating, and producing more than their quota.
  3. Thanks to hydraulic fracturing (at least for now) there is enough supply outside of OPEC at inexpensive prices, that if OPEC cut production as a group, it might not gain as much of the benefit as they did in the ’70s and early ’80s.

Factors 1 and 2 interact, because even if there was a credible deal to cut production on the table, the Saudis likely think that the Iranians might cheat and produce more… leaving the Iranians much better off and the Saudis not that much better off.

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We have to remember that the neoclassical model of man as a maximizer of utility or profits is often wrong. People and nations are envious, and will make do with less if it means those that they dislike are even worse off. The Saudis may be burning through their financial reserves quickly, but virtually everyone else in OPEC is worse off. The Saudis might think that they can drive a better deal inside OPEC when almost everyone else is desperate.

What this argues for is crude oil prices staying lower for a longer period of time — my guess is between $30 and $50 per barrel of Brent-type crude. What could change this?

  • Faster economic growth
  • Turmoil in oil producing regions that reduces supply
  • Depletion of short-life low-cost sources of crude (as is common with hydraulic fracturing)
  • Some clever third parties in OPEC find a way to get the Saudis and Iranians to cooperate while saving face, and no one cheats.

On the other side there is:

  • More cheating within OPEC
  • Weaker growth
  • Higher energy taxes
  • Further technological refinements that lower crude oil production costs further
  • Continued improvements in solar, wind, and energy storage (primarily battery) technology.

At present, my guess is that the marginal barrels of crude oil are being extracted in North America, and probably will be out to 2020 or so. As such, I would encourage energy investors to stick with strong companies with a mix of low debt and cheap production costs. Also, look for companies that are misunderstood, that have other businesses away from energy but have been tarred with the low energy price story.

In summary, play it safe while the members of OPEC flounder in a game that they designed for themselves.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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