Oil producers and game theory

2008-06-19

in Economics, Politics

Iron railings

We usually think about oil prices from the perspective of consumers, but it can also be useful to think about the incentives faced by producing countries. A country like Kuwait has a fixed amount of total oil, and a level of recoverable oil that varies depending on price and technology. Oil is the most lucrative product the state can provide on a global level. There are thus serious concerns about what would happen if production began to decline terminally.

Expectations are also critical. If I expect oil prices to keep rising, it may make sense for me to pump less. After all, I can earn more per barrel for it later. All the oil that got pumped at $10 a barrel a few years ago could have contributed a lot more to consumption and investment at today’s prices. Conversely, if I expect this to be a short-term shock, my interest is to pump as much as I can and sell it for sky-high prices.

Producer incentives thus create both a positive and a negative feedback. In situations where oil is running short (and producers know it), the incentive is to cut supply even further to take advantage of higher future prices. In situations where producers consider present prices to be an aberration, the incentive is to glut the market and thus depress prices even more when they do start to fall.

Of course, the oil supplying states are probably just as concerned with keeping their real reserves and production potential secret from one another as they are concerned about hiding it from consumer states. As such, states like Russia and Saudi Arabia that might be lying publicly about their reserves cannot be entirely certain whether other parties are lying as well, and to what extent.

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{ 9 comments… read them below or add one }

. June 19, 2008 at 10:11 am

The challenge of exploiting Iraq’s oil

By Marcus George
World Service reporter, BBC News

It’s difficult to imagine today, but 50 years ago the Iraqi oil industry was directed from offices thousands of miles from Baghdad.

In the 1950s, number 214 Oxford Street, London, was the headquarters of the Iraq Petroleum Company.

For three decades, the IPC held a stranglehold over Iraqi oil – a monopoly only broken with nationalisation in the 1960s.

But once again, foreign oil companies are waiting for another opportunity to return to Iraq. With governments eager to see the rocketing price of crude oil kept under control, focus on Iraq is increasing.

. June 19, 2008 at 10:21 am

Commodities are a relatively poor investment
Tuesday, January 29th, 2008

t June 19, 2008 at 3:54 pm

“There are thus serious concerns about what would happen if production began to decline terminally.”

How about instead,

“There are thus serious concerns about what will happen when production begins to decline terminally.”

Milan June 19, 2008 at 4:57 pm

Tristan,

It is certainly true that production will eventually decline, but the question of when and how quickly is huge. It is a lot like the Arctic icecap, actually. It may suffer a fantastic decline in the next few years, or it may linger for a few decades. We don’t have the information necessary to decide which it will be.

. June 20, 2008 at 10:50 am

Asian refiners want increased supplies of the lighter grades of crude to produce more expensive cleaner-burning fuels while Saudi Arabia is offering more of the heavy, high-sulphur grades. . . . . Saudi Aramco is understood to have only more of the heavier grades at its disposal.

. June 25, 2008 at 11:01 am

Barrel Fever

Does anyone know how much oil there is in the world?
By Yves Smith
Posted Wednesday, June 25, 2008, at 6:54 AM ET

For starters, take OPEC, which is estimated to control two-thirds of the oil reserves and to provide 36 percent of oil production and is largely unresponsive with IEA inquiries. And cooperation doesn’t always translate into insight. For instance, Iraq recently claimed it has as much as 350 billion barrels of oil, triple its proven reserves and more than even oil kingpin Saudi Arabia has. Is this claim completely crazy? No one knows for sure; Iraq is underexplored, with only 2,000 oil wells versus more than 1 million in Texas.

Here’s how arcane the oil guessing game can get. Saudi’s Ghawar oil field is the world’s largest; it’s been pumping out oil since 1951 and holds 7 percent of the world’s proven reserves. Overall Saudi production has been falling since 2005, yet the number of rigs in use has tripled since 2004. Why is that? Some analysts believe the increased rigs are intended to compensate for declining production from Gwahar. Others argue that the Saudis are operating strategically, shutting their most productive wells as prices rose and opening smaller wells to better manage supply.

. March 24, 2009 at 4:58 pm

Tuesday, March 24, 2009
The Next Five Years
Peak Lite and the Current Oil Picture

Figure 2 illustrates the case in which demand growth is outstripping supply growth, leading to diminishing spare capacity. This is the mode that we have been in for the past few years. Spare capacity was eroded by several million barrels during the first half of this decade, and as a result the price of oil climbed higher, and became increasingly volatile. This was caused by a combination of stronger demand worldwide, and an oil industry that had not anticipated such strong demand growth. As a result, the global oil industry didn’t invest aggressively enough to meet demand, and while capacity did grow, it didn’t grow quickly enough to keep prices stable.

. September 2, 2009 at 3:30 pm

There has been much discussion of peak oil — the idea that the Saudis have peaked out in their oil supply. If that’s true, then they need to get the maximum price for every barrel produced. It could be argued that keeping prices high even in the face of global depression, if it could be done, would be the optimal long-term strategy for the Saudis. If peak oil is true, then the Saudis need to maximize the total revenue captured, not quarterly or annual revenue.

But the Saudis need to be aware of the third variable: alternative sources of oil and alternative energy supplies. The higher the price of oil goes, the more incentive there is to use previously uneconomic sources of oil and find other energy sources. This is not something the Saudis, or other oil producers, want to see happen. Over the long term, to the extent that they can control prices, the Saudis and others want the highest possible price that precludes significant investment in alternatives. That isn’t easy to calculate or to do, but it is their goal.

Chris June 4, 2012 at 2:11 pm

The Challenge of showing the real value of oil. Oil is and has been overpriced for decades and to even imagine that what we would have to do is invade and remove resources that we already have is absurd. Reality must set in and people have to realize that we have been forced and coerced to drive gasoline driven cars with Rubber made tires so that the governments machine can keep on moving on the road.

Let us start here, America has how many industries? Now Saudi Arabia, Kuwait, Iraq, etc. Iran’s total GDP is the size of Wisconson so for them to even suggest that they can compete against America is a joke. The only country right now that can even come close is China and that is because of their black market and marketing tricks plus the currency manipulation that the rest of the world lets them get away with as long as they pay the price for the high gas prices. India is coming up but it will be at least 10-15 years before it breaks way as a major producer in the world of production because of all the importing that is taking place.

We have allowed OPEC and the oil industry for years to over price in hopes of peace happening in the middle east. With the Arab spring and all treaties being undone it is time to abandon the hopes that letting them do this is acceptable. They are beginning to think that they can do what they want and abolish all peace treaties and we will still have to pay them absurd amounts of money for nothing. First off the United States has more natural gas than it knows what to do with. Second Diesel engines can run of off any thing to keep just using what they are producing and letting them do what they do is stupid and just goes to show the games that politicians play and that these politicians only care about themselves and all there wheeling and dealing has come undone. I pray for the US sake the stupidity of it all stops. You cannot pay there peace but you can teach people a lesson stop the hate or no money.

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