Thursday, August 3, 2017

OPEC's Game-Theory Dilemma

Cartel members are being pushed to seek ever-broader coalitions to secure an orderly influence on oil prices.

By Mohamed A. El-Erian
The Bloomberg View
August 3, 2017

Over the last few years, producers belonging to the Organization of Petroleum Exporting Countries have had mixed success at winning the price-setting "game" for oil. To stand a better chance of regaining durable control, they must do a much better job of working together, and, importantly, they need to do so in a much broader and more institutionalized manner. Otherwise, they risk finding that the calming influence of a good July for the oil market, including a 9 percent price gain, could give way to continuing pressure from nontraditional suppliers, particularly in shale, that are benefiting from cost-cutting innovations.

To win the price-setting game, oil producers need to address two related issues: They must maintain prices at a relatively high level without losing more market share to nontraditional producers, and they need to retain unity amid geopolitical tensions and disparities in domestic economic and financial situations.

The easiest way to achieve this -- absent a major exogenous shock to oil production -- is through a large increase in energy demand. This is unlikely to happen anytime soon. The alternative is better supply management. Here, OPEC members have essentially three types of approaches available, and each comes with implementation challenges.

The first is to try to establish and lead a broad coalition that includes non-OPEC producers and involves some type of understanding with nontraditional suppliers. This is OPEC's best chance of reversing the multi-decade process of transition from a cartel of the many when it comes to share of energy production to the cartel of the fewer.

But this first best approach for OPEC is not just the least likely; it may also be a non-starter, given that nontraditional producers have such a fundamentally different setup. They are much more dispersed and highly decentralized, and they have little experience in self-organizing. Also, many reside in the U.S., a legal jurisdiction that is highly averse to pursuing a government-led approach to oil production.

The second approach is for OPEC to try to strengthen its recent alignment with producers outside the cartel by seeking tighter production curbs and stronger verification and enforcement mechanisms, and adding the incentive of a stabilization fund that would help the more pressured producers through multiple cash crunches. Such a unified approach would provide oil producers with greater short-term influence over oil prices.

Again, implementation is far from straightforward, as it would require a greater level of cooperation among a group that includes increasingly bitter geopolitical rivals. Moreover, a heavy funding burden would need to be carried by the low-cost producers led by Saudi Arabia, and would involve a set of cross-subsidies that are likely to be a lot more permanent than they may wish to -- and should -- commit to.

The third approach would be for OPEC to go all out to meaningfully disrupt the current production of nontraditional suppliers and, simultaneously, cripple the flow of funds for their investment needs. By allowing oil prices to plummet and stay low for a considerable time, this approach would eat into both operating earnings and investable funds in a manner that would render a recovery tricky and a lot more uncertain for these suppliers. It would be a repeat of what was attempted starting in November 2014, but with more duration and structural underpinnings.

In this scenario, and without a meaningful pickup in demand, OPEC members would need to be willing and able to live with a lot lower oil prices. They would have to convince their citizens that the potential longer-term gains are worth what would likely be considerable short-term pain. And to maintain the type of unity that would be required to carry out potential mid-course corrections, they would need to introduce an even larger stabilization fund than required for second option.

Again, this is not an approach that OPEC would readily adopt. But members could risk slipping into a disorderly version of it if the current arrangement with non-OPEC producers does not hold.

This brief survey of the most likely types of supply approaches available to OPEC speaks to a larger notion of game theory. Having experienced a gradual and persistent erosion in its dominance of the oil market, OPEC members are being pushed to play a larger cooperative game that involves ever broader coalitions to secure an orderly influence on oil prices. This explains the step-up in contacts with non-OPEC producers. And it explains why the initial agreement reached already needs some tweaking.

The survey also suggests that, at least for now, the most likely outcome is one in which OPEC seeks to influence a series of range-bound trading bands around what is likely to be a declining secular trend longer-term. Periods of price recoveries within the bands, such as the one in July, should reinforce rather that deter member countries from implementing the fundamental changes at home that would make them more resilient to what is likely to be a trickier future.

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