OPEC cuts and Game Theory

Recently President Trump has been vocal on OPEC and not cutting production to boost oil prices. Well, OPEC today stood by the cuts which will last until June 2019.

Oil companies took on a lot of debt when Oil prices crashed in 2014, and recently as oil prices began to fall again, a lot of these Oil companies had to take more debt just to pay off the interest on the debt they took out 5 years ago. Again, it shows you how delicate the world is. Even oil prices need to be managed to ensure these oil companies do not go bust, because it is the banks that will lose out (who lent the money) and then this has repercussions for real estate and the domino’s continue to fall.

On the opposite side, this hurts the consumer. You would think President Trump would want lower gas prices…because if we get higher gas prices, the money the US consumers have saved through Trump’s tax cuts, are just used to pay for higher fuel costs. At a time when the consumer is burdened by debt and living costs get more expensive.

(By the way, US retail sales for December 2018 got revised down to -1% for both retail and online…for Christmas time).

Prices of Oil were up over 1% today, and we remain in our range we discussed in the weekly review, awaiting for a break in either direction.

I wanted to speak about why OPEC price cuts work only temporarily. This is where game theory on cartels/oligopoly comes into play. Where what happens, is that players in the cartel get enticed by making extra profits, and stealing potential market share.

When OPEC cuts production which is agreed upon by its members, price does rise. However, if demand in countries such as China, Japan, South Korea, Germany etc still stays the same, they need extra barrels.

What happens, is that there is an incentive for OPEC nations to cheat on the production cut deal, by producing the amount of barrels they used to produce before the cut, and to sell them at CURRENT prices to these nations for extra profit.

Once one nation does this, and other nations find out, they all join in and price returns back to pre production cut prices as the supply is made up again.

The Saudi’s are wary of two nations: Iran and Venezuela. They see both of these nations as a threat to take their market share. When production cuts are agreed upon, and China, Japan, Germany etc require more oil, they will buy it from Iran or Venezuela, who have a history of breaking OPEC production cut deals, thereby stealing market share from the Saudi’s.

Both Venezuela and Iran need to pump out high numbers because their governments rely on oil revenue greatly to stay afloat. The Iranians have just got their production now available to Europeans so they do not want to cut. Venezuela needs oil revenues.

The Saudi’s cannot do much to Iran, since both Iran and Saudi Arabia have very low costs of production, some say below $10 a barrel. As Iran starts to accept other currencies besides the dollar for their oil (as well as the Chinese and Russians), the Saudi’s, who are crucial to the petro US dollar system, feel like they are missing out and losing out on market share.

If they ever decide to ditch the US dollar and join the Russian sphere, there will be huge affects on the global system. This is not out of the question, quite recently, OPEC has been getting close with the Russians and have even worked with them. The ties between Saudi Arabia and Russia are also increasing through President Putin and Crown Prince Mohammed Bin Salman (MBS). Perhaps this is why there have been rumours that the US are unhappy with MBS having a major role and being the next King of Saudi Arabia.

However, Saudi Arabia has a sweet deal here. They can pretty much demand anything from the global hegemon, the US. The US has guaranteed to protect Saudi Arabia…but I believe the Saudi’s have asked the Americans to deal with Iran, who threaten Saudi Arabia’s market share…plus the whole Sunni vs Shia conflict in the Middle East.

On to Venezuela.

In 2014 when oil prices crashed to below $30 a barrel, many analysts said that this was a way to destroy American shale production, whose costs were $65 a barrel at the time.

However, I believe it was a way to actually punish/destroy Venezuela, who would cheat on OPEC production cuts, and remove them from the list of nations attempting to take Saudi market share. Venezuela costs are around $40 a barrel, and the country was never the same after 2014. In the years after 2014, Venezuela was NOT making any money from oil revenues, which the government and its welfare state really depended on. All these things are now having a massive toll as Venezuela becomes a failed state with a confidence crisis looming.

I must say, as time goes on, OPEC will be slowly losing its power over the oil markets. Russia, is a top three producer, and the Saudi’s are slowly making an alliance with them…which may help save OPEC’s power.

But the big one to watch is the United States. They are on the verge of becoming the largest producer of oil, and soon an exporter of oil. By the way, this will have a huge impact on Canada, and this is why we are trying to develop new pipelines so we can send oil overseas. Interesting times ahead which will change the energy markets.

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