By Mark Finley
Fellow in Energy and Global Oil, Center for Energy Studies
There’s a new sheriff in town for the world oil market…or rather, there are TWO sheriffs.
There are also new prisoners.
That means there are more opportunities to enforce the law, but also more opportunities to break it.
Oh, and the two sheriffs don’t talk to each other & have different visions of how the town should work.
Welcome to today’s oil market! Is this a recipe for harmony or chaos? We’re about to find out…
Yesterday’s oil market: A classic version of the prisoner’s dilemma
The “prisoner’s dilemma” is a famous case in the field of game theory…and a key element of the global oil market. Cooperation is the best mutual outcome, but if the other party chooses to cooperate, you can do better by cheating. And if everybody cheats, everybody loses.
Efforts to manage oil production go back to the market’s earliest days under John Rockefeller and the Standard Oil Trust, and continue through OPEC today. Cheating has plagued those efforts for just as long. (In OPEC’s case, for as long as the group has used production quotas to manage the market, going back into the 1980s.)
Maintaining discipline has always been a struggle. When prices are low, countries dependent on oil revenues are scared, and compliance might be pretty good…but as the market recovers, the temptation to cheat creeps in. Discipline fades, and OPEC kingpin Saudi Arabia and its allies lose patience and ramp up supply to give their (theoretical) OPEC allies and other oil producers what Mr. Rockefeller once called a “good sweating”. A familiar cycle sets in: Prices decline; cut quotas; comply; prices increase; cheat…repeat.
The rise in US shale production created an additional and profound challenge to OPEC’s market management. Its rapid growth (which moved the US from the world’s biggest importer to self-sufficient in less than a decade) reduced OPEC’s market share as well as the impact of its supply management efforts. Moreover, US shale operators were able to quickly ramp investment (and therefore production) up and down to match oil price movements. In 2014, OPEC – led by Saudi Arabia – started a price war to give shale producers a “good sweating”. But they were unpleasantly surprised when their US competitors stayed in the game by cutting costs and dramatically improving productivity.
One way to make the quota system more impactful is to expand the number of participating players. OPEC historically recruited new members among countries that were ramping up production. Most recently, Equatorial Guinea joined in 2017 and Congo joined in 2018.
Recruiting US shale producers was out of question. They are not sovereign states that could be recruited into OPEC. The US has anti-trust laws in place. Moreover, the US producer companies (and their host country) were big advocates of free market forces.
With the recovery of US shale production still posing a threat after the 2014-15 price war, in 2016 OPEC tried an alternative strategy: Formal cooperation with other non-members, this time with 10 non-OPEC oil exporting countries including large producers Russia, Mexico, and Kazakhstan. This “OPEC+” group significantly expanded the oil production under active management with quotas.
But more members never solved the cheating problem. Indeed, the more members, the more potential cheaters. The group has always needed an enforcer: usually Saudi Arabia. But the Kingdom often struggled with this role. Previous Saudi leaders generally preferred quiet diplomacy and subtle pressure to outright confrontation. Moreover, their own heavy reliance on oil revenues to fuel the Saudi economy (and state budget) meant that price wars were politically and economically painful at home as well.
COVID helped set the stage for a new game
And then…the COVID pandemic changed everything.
Global oil demand collapsed as governments, businesses and families shut down travel and public activity. When the two biggest OPEC+ producers, Saudi Arabia and Russia, couldn’t agree on an approach, oil prices also collapsed, famously falling below $0 briefly in the US. With a push from then-President Trump, who saw US producers as losers in an oil price collapse, the two countries ended the price war. The OPEC+ group agreed last April to cut production by roughly 10 million barrels per day (Mb/d), the largest coordinated production cuts the world has ever seen. In the US, investment and production also fell sharply, though not because of government-directed cooperation.
Moreover, as my colleague Jim Krane & I have written elsewhere, the new Saudi leadership became much more assertive in its traditional role as the OPEC (now OPEC+) enforcer, pre-emptively employing a variety of carrots and sticks to encourage other participants to obey their quotas. The new-found discipline has been extraordinary, with traditional cheaters in the group even agreeing to additional cuts to compensate for previous over-production.
The new, COVID-induced production cuts worked. As oil demand recovered, so did oil prices. Today, prices are above $70/barrel, and have easily surpassed pre-pandemic levels.
But as world oil demand and prices recovered, OPEC+ producers – in addition to managing their own production – had another worry: Would US producers once again swoop in to take advantage?
Today’s oil market: Two groups of prisoners…and two enforcers
Not this time.
While US producers aren’t members of the OPEC+ group, it turned out that the world oil market had a new sheriff in town: Shale investors.
Scared by the price collapse, but also tired from a decade of chasing breakneck growth (while failing to generate consistently positive cash flow), and nervously watching rapid growth of EVs threaten future oil demand, shale investors pulled the plug in 2020. Starved of capital, US producers have been forced to rein in spending, even as oil prices have recovered. With that discipline, US shale operators are on track for record cash flow this year. Yet the domestic oil rig count remains nearly 50% below the pre-COVID peak.
This is today’s oil market: Not one, but two prisoner’s dilemmas – related, but different. The first “game” is among the traditional OPEC/OPEC+ countries, with Saudi Arabia playing the traditional enforcer role. The new, second game adds US shale producers as “prisoners”/participants, as well as a new enforcer: Their investors.
What does a second game mean for future oil prices?
Financial investor caution essentially expands the traditional market management game by adding the world’s largest oil producer – the US – to the dynamic. More production inside the game expands the opportunity to boost prices by successfully managing production (in the case of the US, by managing investment flows). The failure of US production to respond has pushed oil prices up farther, and faster, than would have been the case with OPEC+ alone managing the market.
But as always in the prisoner’s dilemma, any individual – OPEC+ country or US company – can take advantage of recovering prices and strong group compliance to unilaterally raise production. There are many more potential cheaters with the huge number of shale producers in the US!
Also, as always, the enforcer is watching.
Or rather, “the enforcers” are watching since now two games are being played, each with its own enforcer. The Saudi government and shale investors have different perspectives on the optimal market strategy, and no real means to harmonize those strategies with one another.
History suggests that, as the temptation to cheat rises with prices, the cooperative game breaks down.
In today’s oil market the question is not only when will the cooperative game break, but also which game breaks first?
Will OPEC+ countries fall to the temptation to cheat?
Or will shale producers try to convince investors that they can grow production AND generate cash flow? Some smaller, privately-held companies are already beginning to do so, but most large, publicly-held companies – reined in by their investors – remain cautious.
And a final new wrinkle from adding a second game: which enforcer changes strategy first? Will investors decide there’s money to be made in growing shale drilling? Will Saudi Arabia lead the OPEC+ countries to take market share before shale producers can convince their investors to open their purses?
The introduction of the new game will boost oil prices while it lasts, but it also greatly complicates the task of enforcement, and the uncertainty in the marketplace.
Greater price volatility may become the norm as these two games play out.
Get ready for a wild ride!
This post originally appeared in the Forbes blog on June 28, 2021.