The oil price has taken a beating over the last year.
Brent crude oil – used to set the price of about two-thirds of the world’s internationally traded oil supply – hit a cycle peak of $122 per barrel in June 2022. And is now $76.
That’s a roughly 36% decline in one year.
But I’m not surprised.
In fact, I’ve argued for months that oil would sink lower amid weaker global demand and fading momentum.
There’s simply too much supply relative to demand (especially with China’s lackluster ‘reopening’).
And most importantly, no matter how many times pundits claim that Saudi Arabia and OPEC (Organization of Petroleum Exporting Countries) oil cuts will bolster prices, it hasn’t worked.
In fact, oil prices have drifted even lower.
Why?
Because each time Saudi Arabia announces cuts, they’re essentially subsidizing global oil producers at their own expense.
Remember, this isn’t the 1970s when Saudi Arabia and OPEC supplied ~60% of the global oil market (which has declined to 38% as of late-2021). And will further decline after these recent oil supply cuts.
Thus, they’re now stuck in what’s known as the “prisoner’s dilemma”.
And I believe this is a very underrated way of looking at oil markets.
Because – according to history – once the Saudis stop trying to support oil prices at their own expense, a glut will potentially hit the market.
Let me explain. . .
It’s All About The Prisoner’s Dilemma When Dealing With Conflicting Self Interests
So, what exactly is the prisoner’s dilemma?
Put simply, it’s a game theory concept coined by mathematicians Merrill Flood and Melvin Dresher during the cold war in 1950 as a way to help make strategic decisions.
It’s essentially a situation where individual decision-makers always have the incentive to choose in a way that creates a less-than-optimal outcome for the group.
Meaning an individual has to choose between self-interest and mutual interest. And since individuals receive the greatest payoffs if they betray the group rather than cooperate, they often ‘cheat’.
Here’s an example. . .
Imagine two men are arrested on suspicion of the same crime. And they’re taken to separate rooms for questioning.
To convict them, the police need at least one of them to confess or give testimony against the other.
Now – assuming the suspects are rational – they most likely value their own freedom above others.
Thus they each have two options: confess or remain silent.
If both remain silent due to the lack of a non-confession, the police will sentence both to much less jail time (a win-win scenario).
But how do the suspects know what the other one is saying – or not saying?
If Suspect A talks, then he will go free while Suspect B does the full-time. Or the other way around (a win-lose scenario).
Meanwhile, if both end up confessing, trying to save themselves, they will each serve more time (a lose-lose).
To put this into perspective, the below chart shows this dilemma.
Thus the prisoner’s dilemma illustrates the challenges of cooperating when individuals or groups face conflicting interests.
Sometimes, choosing self-interest might not be of any value to you if others too think for only their own gain.
And on the other hand, if you think of the best interest of the group, but the other members of the group think of only their self-interests, you’ll end up bearing all the loss.
And this prisoner’s dilemma gives us a great framework when looking at Saudi Arabia and OPEC oil cuts.
Because they’re the real losers here. . .
As History Shows Us, Every Time Saudi Arabia And OPEC Announce Oil Cuts – It’s Subsidizing Global Producers At Their Expense
So, now that we covered the basics of the prisoner’s dilemma, how does it relate to Saudi Arabia and OPEC?
First, a little context:
OPEC was founded in Baghdad, Iraq, with the signing of an agreement in September 1960 by five countries. Namely the Islamic Republic of Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. They were to become the Founder Members of the Organization.
These countries later joined – Qatar (1961), Indonesia (1962), Libya (1962), the United Arab Emirates (1967), Algeria (1969), Nigeria (1971), Ecuador (1973), Gabon (1975), Angola (2007), Equatorial Guinea (2017) and Congo (2018).
And by the end of 2016 – once the shale oil boom drove the U.S. to become one of the largest oil producers in the world – Russia (the third largest oil-producing country in the world) informally joined. As did Kazakhstan and Azerbaijan.
And while Russia is a major oil producer, they have their own agenda (they certainly won’t abide by Saudi Arabia’s policies as we’ve seen).
But this new ‘informal’ group is called OPEC+.
Now, make no mistake – OPEC+ is essentially an oil cartel (or tries to be).
It was deliberately formed to make sure they kept oil prices where they wanted (higher) while maintaining market share.
The problem? Saudi Arabia and OPEC don’t have as much pricing power as they once did.
See, a cartel only works when the group has almost full pricing power in a market, and they all play ball.
But Saudi Arabia and OPEC have seen their market share diminish over the last 50 years. So their influence isn’t what it once was.
Countries like the U.S., Canada, Mexico, Brazil, Russia, and China all saw a dramatic rise in oil production over the last 15 years.
And this became extremely evident after 2010.
To give you some brief context: between late-2010 and mid-2014 – the price of Brent crude oil hovered over $100 per barrel.
And U.S. shale was the biggest winner in this.
See, OPEC had a policy to moderate supply to keep prices artificially higher.
But in order to keep prices higher, one must cut back output (decrease supply relative to demand).
The problem? As one cuts back, others can come in and soak up that market share.
For example – if global demand is 100 million barrels a day, and let’s say Saudi Arabia and OPEC cut back 2 million barrels a day.
That extra demand relative to supply keeps prices higher. Allowing another country to increase production by 2 million barrels and gain that market share (all else equal).
So each time Saudi Arabia and OPEC were cutting production – or keeping it flat – to keep prices higher, they were essentially losing market share. While subsidizing U.S. shale (Western) and Russian producers.
After realizing they were losing enough market share – Saudi Arabia and OPEC, in late-2014 decided to stop cutting. And instead, ramp up oil output to try and drown out U.S. shale.
This meant they were oversupplying into a global oil glut. Causing brent crude prices to plunge 70% over 18 months (from $110 a barrel in June 2014 to $33 by January 2016).
Did it work?
Well. not really.
In fact, Saudi Arabia has lost more market share since other oil producers kept increasing. And U.S. shale proved to be far more resilient long-term.
But even Saudi Arabia and OPEC+ members have issues with one another.
For instance, not too long ago, Saudi Arabia and Russia had their own little price war.
To give you some context: after the COVID shock roiled markets in early-2020, OPEC+ met in Vienna to discuss production cuts as oil prices plunged.
OPEC agreed to cut oil production by an additional 1.5 million barrels per day through the second quarter of the year. And OPEC called on Russia and other non-OPEC members of OPEC+ to abide by their decision.
But the very next day (March 6th), Russia rejected the production cuts and walked out. Marking the end of the unofficial alliance.
Neither side relented until a month later – in April 2020 – when oil futures went negative $37 per barrel.
Now, of course, there’s more to it. But I just want to point out how important it is to understand these conflicting agendas of oil producers. And how one move affects another’s.
And that brings us to the issues in 2023. . .
It’s Not Just The West: Saudi Arabia And OPEC Are Stuck In A Prisoner’s Dilemma Of Their Own
There are two fundamental issues with OPEC – and even OPEC+.
First – oil revenues make up most of the income for several oil-producing countries. Thus their government budgets and dollar reserves depend on oil output.
Second – most of these countries have nationalized oil producers. Hence the state can choose oil output targets arbitrarily (whereas, for example, in the U.S. and Canada there is no mandated control of oil output).
So in this context of OPEC, member countries face a dilemma when deciding on oil production levels.
Each country has an incentive to maximize its own oil output to increase its own revenue and gain a larger market share.
OPEC tries to address this dilemma through cooperation and collective decision-making.
The organization – under the heel of Saudi Arabia – sets production quotas for member countries, aiming to stabilize oil prices and maintain a balanced market. By limiting production, OPEC attempts to manage supply levels and support higher oil prices (a win-win).
However, the prisoner’s dilemma dynamics come into play when individual countries consider their own self-interests. . .
For instance, if one country decides to exceed its production quota (let’s say Russia or Iraq) and increase output, it can benefit by capturing a larger market share. And potentially earning more revenue at the group’s expense.
But if they all ‘cheat’ (because they don’t know if others are abiding by production cuts) – it can flood the market with oil (a lose-lose).
This creates tension within OPEC, as each member tries to strike a balance between maximizing their own gains and maintaining stability in the oil market.
And this cheating aspect happens much more often than many realize.
To put this into perspective, economist Deer Point Macro told me, “So with the prisoner’s dilemma, everyone’s incentivized to cheat [in OPEC]. If we look at the present situation with the Russians and everyone else undercutting their production quotas. This is now leading to Saudi (the largest and pretty much king of OPEC) losing market share.
All these nations will do what is best for them. And holding nations to their word to abide by the rules of the game is a fool’s error. The nations will do what is best for themselves first and leave others out to dry. As Friedman says everyone is greedy. . . “
Thus Saudi Arabia and OPEC often face challenges in enforcing production quotas and preventing free-riding behavior, where some countries exceed their limits while others adhere to them (win-lose).
And we’re already seeing the tension and resentment in OPEC build. . .
For instance, a few days ago, Saudi Arabia announced further ‘voluntary’ oil supply cuts of about 1 million barrels per day and to extend them into 2024 (starting in July).
But other OPEC+ countries didn’t exactly want to cut oil output since they depend on these revenues.
Thus after “one of the most contentious production meetings in recent years” – according to the Wall Street Journal – some countries were actually allowed to increase output.
Nigeria, Congo, Angola, and the UAE (United Arab Emirates) saw production quotas raised.
Meanwhile, Russian crude oil exports have been rising when they should’ve been declining from “promised” 2023 cuts.
In fact – according to Bloomberg – Russian crude flows to international markets remain elevated and are still more than 1.4 million barrels a day higher than they were at the end of last year. And 270,000 barrels a day up since February, the baseline month for the pledged cuts.
And this hasn’t gone unnoticed. . .
According to the Wall Street Journal – Saudi Arabia is growing “annoyed” and increasingly frustrated with Russia as it continues to exceed its supply quotas. Which is putting pressure on the oil price and eating away at Saudi Arabia’s market share in Asia.
But looking at it from the prisoner’s dilemma angle – this makes sense.
The Russians can let the Saudis and OPEC cut production – thus pushing prices higher in the paper markets – and they reap the reward (higher margins).
Russia’s fighting a war in Ukraine and dealing with an anemic domestic economy. Meaning they depend on oil revenues very heavily (their largest export is petroleum products).
Making matters worse, Russian oil (Ural crude) is trading at a steep discount (roughly $20 below Brent crude) because of sanctions. Thus they must produce more to make up for weaker prices (amplifying output).
And this is becoming the biggest problem for Saudi Arabia.
Because with each oil cut OPEC tries to do, it’s subsidizing U.S., Russian, Canadian, and Brazilian oil production (which have all risen steadily over the last two years) at their own expense.
No wonder there’s tension building in OPEC.
These countries don’t want to lose oil market share – and the revenues they depend on for state budgets – to prop up other producers.
And if history means anything here – I expect further ‘cheating’ by OPEC members and discontent.
Thus the prisoner’s dilemma highlights the complexities faced by OPEC in maintaining cooperation and managing oil production.
It underscores the need for trust, effective communication, and a collective commitment to shared goals to avoid a “race to the bottom” scenario where everyone suffers from declining oil prices.
But as we’ve seen – these three things don’t really exist in the real world. As each country has its own interests and is always looking for an advantage.
Eventually, I believe they will flood the market with oil to try and price out marginal producers and regain market share.
We’ve seen it happen before. . .
*PS – I’m aware there’re many variables in global energy markets. But I am just highlighting one view of it that I believe’s underrated in market analysis. And one aspect that should be considered more closely.