The global oil and gas industry is in a state of utter distress and uncertainty at the moment. At a time where the coronavirus pandemic is decimating oil demand, the last thing that the oil world needed was an OPEC+ row that threatens to open the oil spigots in the world. Instead of taking measures to temporarily slash supply to keep up with the demand drop, Saudi Arabia and Russia are going head to head to increase supplies. It is nigh impossible to model the current abnormal situation, as it is both temporary and unsustainable. While it is difficult to remain clear-eyed during all the confusion, one must imagine a pandemic-free world to model medium to longer term scenarios. In this case, one could appreciate the OPEC+ dilemma, which Figure-1 describes:
Figure-1: Market-share tailspin
Thus, from the traditional oil producers’ view, the above scenario is a tailspin that doesn’t have a happy ending. This is made worse by the fact that, to varying degrees, all of OPEC+ members’ fiscal balances depend on oil revenues. So this isn’t a matter of just economy, but of survival.
On the other side, as long as US producers don’t run out of shale rocks to crack, they are neither incentivized nor can they formally enter into any sort of production agreements, which would certainly run afoul of anti-trust laws. It would be prudent to mention that competition laws in the US and Europe are quite merciless and could run a company into the ground if it runs a significant breach. And it’s not only companies, but individuals (such as executive and board members) who can face personal liability for breaching such laws. Thus, the only way for production cuts to materialize in the US would be for independent company action based on the basis of economics.
This backdrop is ideal for the use of game theory in order to guide the action of two competing parties on the oil supply side: The first party, OPEC+ (just call it Saudi+Russia S+R), and the second party, US producers. One can observe that the two players don’t have a lot of chemistry within their respective parties. However, broadly speaking, the interests of party members of the two above groups are more aligned with each other than the other party. Thus, we may be able to apply the concept of game theory to analyze the choices these two teams will make. Related: Russia’s Plan To Bankrupt U.S. Shale Could Send Oil To $60 What is game theory? The theory was pioneered by mathematicians, most famously John Nash, and assumes that players within any game must be rational and will strive to maximize their individual payoffs. The game is played in sequence and "both players maximize their payout while being affected by each other, ultimately leading to “Nash Equilibrium”.
Figure 2 above illustrates the game set-up. The numbers used here for calculation are approximations and the key is conceptualizing the game theory aspects.
Team Saudi+Russia (Team S+R) can produce anywhere from 19 million barrels per day (mbpd) to 23mpbd, with the bottom range being close to what Saudi Arabia was proposing as the new cut level in the last OPEC meeting. A level of 21mpbd would be close to 2019 production levels and 23mbpd is what S+R have announced they will reach. Team USA reached between 12-13mpbd before the current crisis. Projections for potential USA cuts under a low price environment range from 2-5mbpd, assumed in this exercise at 3mpbd or production levels of 10mbpd.
The biggest challenge in this exercise was to estimate oil supply price elasticity. In a constantly evolving demand environment, a simple price versus supply calculation would not yield useful information. Instead an evaluation of demand-supply balance versus spot Brent price (using publicly-available data) was considered. Since both supply and demand changes aren’t instantaneous, 6-month rolling averages were used, and finally, the price was shifted off forward in order to account for “reaction time” to supply-demand balance shifts. The correlation, while not perfect, is reasonable enough to employ for our illustrative game theory exercise, and shown in Figure 3a below. Figure 3b then uses the achieved correlation to reflect Saudi+Russia+USA oil supply and corresponding price points.
Finally, using the price and production levels, one can arrive at revenues (pay-outs) for each team under each scenario. The following scenarios reflect the decisions both teams have to take:
For all practical purposes, we are currently in a hyper state of Scenario-1 (with plummeting demand exacerbating supply length). With Team 1’s oil spigots open and USA production still at high levels, price-points have plummeted below $20, and even sub-$10 for many physical crude deliveries. The correlation suggests a price point of $15 for this exercise (even in a non-COVID world). The red circle indicates this state. By the end of 2020, it is expected that Team-USA may have already played out this scenario and had production shut-ins. Even though this would be involuntary for the most part (production costs higher than the price of oil for most production plays), it would also be the rational choice as payouts would be higher even with lower production, moving to the yellow circle.
The question then is what do the teams do after the coronavirus conditions subside? There will be no incentive or financial appetite for Team USA to restart any production at oil around the $33 mark. The ball is now firmly in Team S+R’s court.
Scenario-2 (Team S+R agree to cuts)
The local optimum (yellow circle) reached in Scenario-1 is not sustainable. Considering the breakeven prices for fiscal balances, this price level would decimate the economies of most of the oil-exporting world. And as can be seen in Figure 4, Saudi Arabia has far more to lose than Russia (see: “Why Saudi Arabia’s oil price war is doomed to fail: Fuel for Thought”).
Figure -4 Fiscal breakeven oil prices
Assume now that Team S+R agree to cut to 2019 levels and move to the left, corresponding to a reduction of 2mpbd, which along with the 3mpbd of shale oil for a total of 5mpbd would be enormous. Oil prices then move up into the $50-60 range. Now it is Team-USA’s turn. It could maintain low production or ramp up, as this price level would support most shale plays. But should it do so, the price shift would bite again, and in fact the payouts would fall.
So, for both players, the payouts would indicate to stay put. This is where Nash equilibrium is reached and the game ends. Considering Team USA’s rational action, both teams’ highest payout also occurs under this scenario. Any way one plays this game; the payout answer remains the same.
What happens with additional demand? Who supplies it? Team S+R will remain in the strongest position to dictate terms, because it can always take the game to Scenario-1 and destroy the financials of non-government USA enterprises. However, with power comes responsibility. It will be up to OPEC+ to permit US producers to make reasonable returns. While players cannot collude, the government can act in the best interest of the industry as a whole.
Bottom-line, game theory appears to vindicate Russia’s action to disagree with Saudi production cut demands, although one could argue that now may not have been the right time. In the long-run, OPEC+ will have to fundamentally and structurally alter the shale industry’s economic choices by making its own clear: it will not give up more market share. Another way would be to alter the rules of the game by OPEC+ buying up American shale assets that may be coming due for a fire-sale and then letting the shale rocks be - silent and untouched.
By Amad Shaikh for Oilprice.com
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