The latest OPEC+ gathering saw Saudi Arabia pledge to cut production by 1 million barrels per day (1mn b/d) in July. Channelling his inner Kojak, Prince Abdulaziz (Saudi Energy Minister) described this as a ‘Saudi lollipop’ for members of OPEC+. All he had to do was to say ‘Who loves you, baby’ to complete the picture.
This will lower Saudi production to 9mn b/d (including the 500,000 b/d April cut) and in their thinking, should show their OPEC+ chums that they are willing to bear some pain in order to bolster prices, which is their common cause. Keep in mind that OPEC and OPEC+ are a cartel, and as such ‘should have’ folded some time ago as cartels are very difficult to keep together given the incentive to cheat. Game theory economists have been fascinated by how behavioural tendencies, incentives to cooperate, collude, conspire and cheat all work in real life. A relatively useful summary can be found here in a Stanford paper. Some game theory concepts were brought to life in 2020 as toilet paper became worth its weight in gold (well…) due to pandemic hoarding, with a Cornell University article serving as a reminder of those dark days.
What does this have to do with the latest production cut? In theory, OPEC+ members should note the Saudi sacrifice and cooperate with their own production quotas for the common good. In reality, with oil prices on a slide and a global recession looming, producers may need to think about selling as much as they can above $65/bbl. whilst bracing for the risk of sub-$45/bbl. over the coming years. This is on the view that consumption will be pressured during a recession, many Western economies are doing their best to wean themselves off oil in order to meet green targets, and Russia, a top producer, has a war to pay for so can’t really cut production much further.
The OPEC cartel has been kept together for so long because Saudi Arabia has been a capable enforcer. The prisoners dilemma game theory example is made very simple if both prisoners believe in the mantra that ‘snitches get stitches’ (or wind up in ditches). In the oil cartel, if the Saudis thought that others were not playing ball, they used to be able to turn the taps on or lower the price of oil from them. This would see the global oil price fall, crushing other producers who couldn’t match their low production cost. The latest example was the Saudi discount in 2020 which was aimed at getting Russia to play ball on pricing and production targets.
How OPEC, as a cartel with friends, deals with the potential demand slide ahead of them will be interesting. They got the ‘Asian crisis’ in the mid-90’s wrong, sending oil below $10/bbl. at one stage. We don’t expect a hard global recession over the next few years, but we do see a slower growth environment in the US, Europe and China. We also note that in most gaming scenarios, cheating on production and pricing is very tempting, especially when the only enforcement mechanism is to send prices lower. With Russia funnelling oil to China and India (and taking market share) the latest Saudi production cuts could be a good example of pushing on a string. True, there are plenty of ‘peak oil’ analysts and fund managers out there looking for $200/bbl. and higher. High prices cure high prices in the commodity world though.
The monthly chart below shows that the 5-yr moving average is under pressure at the moment. A break of this line should see $65/bbl. and then $45/bbl. approached. It will be interesting to see what Russia does if the market price of crude nears their production cost – odds are they will bear the loss and keep pumping and hope for the best.
Gerry Celaya
Chief Strategist
Keywords: OPEC Oil Saudi Arabia Game Theory
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