Oil Games

The blood bath in the stock markets across the world are an outcome of the Russia-Saudi oil games as much as of the fears of COVID-19. Given the headwinds attributed to US-China trade war, US-Iran tension, tensions in Turkey and Asia Minor etc. this perhaps was the last thing the world would have wanted. Yet these oil games were far from unexpected. The immediate provocation was the Russian decision not to renew the production agreement it has with OPEC member countries that was to expire at the end of March 2020.  

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The post “Re-reading Prisoner’s Dilemma” captured the game theoretic approach to real world problems. The current round of games between Russia and Saudi Arabia too are rooted in games played in the mind and in the field. An analysis of the roots of the current battles and the likely directions would be valid.  The very fact, countries play these games with geo-political and geo-economic implications gyrate around the very nature of the product.

Oil is just not critical but captures the topographies that would fit into what resource-based theorists might term the VRUN phenomena. Oil without doubt is valuable. It is relatively rare given few countries have oil reserves and according to some estimates the world has already crossed peak oil. Implied is the reserves are diminishing and the society might run out of oil sooner than expected. Oil in unimitable and non-substitutable. Though natural gas has emerged as an alternative to oil, yet oil remains indispensable for many a functions. An old but relevant analysis for the future of natural gas is available here.  The above characteristics enable those who possess oil reserves naturally gain an advantage. Furthermore, the last hundred and twenty years or so, oil has emerged as indispensable input thus commanding high degree of price inelasticity of demand. In fact during certain times, even a one percent cut in production used to cause a rise in an eight percent increase in price. The alternatives by and large were non-existent, non-scalable or unaffordable.

The discovery of the high degree of inelasticity of oil happened perhaps partly by accident and partly by design in 1973. By the early 1970s, given the low fuel prices, everyone was virtually addicted to oil. US highways resulted in automobile boom thus large number of cars on road. Subconsciously, the people were getting locked-in an oil trap with zero degree of freedom to manoeuvre and circumvent. In 1973, the Arabs attacked Israel in what became known as Yom Kippur war. The Israelis taken by surprise retaliated with one of the most daring tank battles and manoeuvres to outflank and defeat the Arabs.  To the Arabs it was the second defeat in six years. US had supported Israel and Arabs believed it was time to show US its place. By then, the cartel of oil producers called Organization of Petroleum Exporting Countries (OPEC) was in place. Saudi Arabia and others used OPEC to cut down the production. As the oil production shrank, the impact was severe across the world. Ironically more than the US, it was Europe and countries like India that took the brunt. These countries were sympathetic and in fact like India were vocal supporters of the Arab cause. Five years down the line, in the Iranian crisis, the oil games were played once again causing consternation in the West.

In economic history, cartels are generally believed to fail than succeed. The success of the cartel depends on the degree of elasticity or inelasticity of the product and secondly, the ability to monitor the terms of the agreement. Two or more players can come and form a cartel to regulate the production decisions. Having set high prices, they can capture equal share in the market. Yet there is somewhere down the mind, that a firm is desirous of capturing a larger share in the market at higher prices. Therefore they resort to what economists call as chiselling. They slowly increase the output more than what they had agreed for. Increase in small quantities by one player might not be noticeable. Since every player is likely to engage in chiselling, the small quantities scale up and become voluminous thus reducing the price without a corresponding increase in market share. In the pursuit to be individually better off, they end up as collectively worse off. The reason for this predicament has to do with the ability or rather lack of it to monitor cheating and consequently punish the cheaters.it would appear ironical given the logic behind the cartel itself is illegal.

While quite many cartels from tin to zinc fell by the wayside, the oil survived partly due to nature of the good and partly due to geopolitical significance of OPEC. Moreover, the structure of OPEC was designed to deem Saudi Arabia as swing producer. Once the OPEC sets quota for the total output and apportioned it among various countries, the balance production was to be handled by Saudi Arabia. In case any country engaged in chiselling, Saudi would increasing drastically their production thus resulting in collapse of oil prices. The prices would collapse to point where they were less than the marginal cost of production for the country engaged in ‘cheating’. To the Arab countries, the marginal cost of production being low gave them the added advantage.

Russia was non-OPEC country, entered the game late but over a period of time they have engaged both competition and conflict. At the height of Cold War in 1986, encourage by Regan administration, Saudis decided to drastically increase their production thus bringing down the oil prices below the marginal cost of production for Russia. To quite a number of analysts, the drop in prices ensued Russia could not maintain social peace thus spiralling towards a collapse some five years later. US for most part imported oil despite possessing reserves. Their original reserves in Texas were running out of oil or had dried out and few others like in Alaska were held up on environmental concerns.

The contemporary oil industry is shaped by three differing forces each with their own motivations. There is a strong oil industry in Russia which it sees as a means to regain its lost glory. As a matter of fact, Russia has used its reserves and production of natural gas to arm twist Ukraine and East European countries in the recent past. To Saudi Arabia, its monopoly in oil and thus its geopolitical significance seems diminishing. Meanwhile, the discovery of fracking has created new Wild West in the US. Numerous small and big wild-catters are engaged in oil exploration at lower costs across the US. Within a short time of less than ten years, through a sheer learning curve, their marginal cost of production has dropped from $60 to $40 almost by a third which seems remarkable. Low oil prices will hit each of them yet there seems no hurry to settle for a solution. China and India are major importers who might be happy with a windfall gain.

To each country, the levels of the output is determined by the equalising their marginal revenue with their marginal cost. At a given marginal cost, they seek to maximise their revenues which is anchored in the price elasticity of the good. What seems to be happening is the game of chicken.  In the game, if neither of the parties yield, the outcome could be the worst case scenario. Yet there is individual pride that prevents them from yielding. To Saudi Arabia, it is at a cusp of geopolitical positioning. Crown Prince MBS is consolidating his power through palace intrigues and want to retain a position at the high table. His position in the Islamic high table is challenged by revisionists like Erdogan of Turkey. Saudi is also engaged in cold and indirect hot war with Iran. Russia is out to rediscover and recapture its place in the high table of global power calculus and might use oil production increase to place US in the corner in an election year. To the US, low prices, bankruptcies, bond market collapse in an election year might be the last thing that President Trump would want. Russia might be sympathetic to Iran but hostile to Turkey. Saudi is in good books with US but Saudi-Russian turf battles might impair US oil industry. Thus the cost benefit analysis are shades of grey at the least on the first glance. Digging deeper, the shades too get deeper.

To Iran struggling with COVID-19, it has come at worse time and might generate an upheaval which might be music both to Saudi and US. The Arab countries too will face an impact but their lower population might see them escape worse effects. From Morocco to Algeria to Saudi to Iran to Baharain to Qatar to UAE, all countries have functioned on similar modus operandi. The high oil revenues generate high fiscal and current account surplus. This surplus is transferred to the people in exchange for social peace. Thus prima facie, the hold on power by the reigning rulers is a subject of the ability to transfer oil surplus to its population. The low population in GCC countries might thus necesssiate smaller quantum of transfer, yet for countries like Iran the volume of transfer might be larger. Therefore, it seemingly looks Iran hitting an air pocket if the deal is not reached soon.

US has sufficient monetary reserves which they might use to support their domestic industry at least for some time till the matters cool of. To countries like India, low oil prices might increase the production, profits and thus the GDP, the prospect of expatriates returning from the Gulf and finding jobs for them in India might prove to be a vexed question. China while benefiting from tailwinds as consumers, might too have to face some hurdles in it creeping imperialism.

As oil prices remain low, there is possibility of one more subconscious lock in emerging that would be realised once the prices begin to move northward. The shift to electric vehicles might be hampered or face roadblocks as there would be little incentive for the same. At very high oil prices, there would be a lot on incentive in play for developing alternative fuels. At low prices, the same disappears.

Russia and Saudi are engaged in a game of chicken at least prima facie seems very difficult to come out. Rhetoric abounds on both sides. In fact, in April, Saudi Arabia wants to pump in excess of 12 million barrels per day higher than the maximum sustainable capacity of Aramco. For a comparison its production was around 9 million barrels in March. Saudi thus has signalled its willingness to dip into its inventories to pump Russia out of the market. While Russia might not have the shock and awe capabilities, Putin is no stranger to these games. He too is past master at strategy and intrigue. Trump sits on the side-lines planning his own moves which often are known for dramatic hyperbole accompanies by a degree of self-adulation.

Yet while they play out these games, the externalities would perhaps be quite negative to some countries. Iran might be the foremost victim of the same. Yet in the analysis, it does look the very reasons that pull down the cartels as per the text book are in full play offering it as a case study in practice. The game might be over in short period or at least Saudi seemingly wants it so. If the brinkmanship does not end, there are sufficient reasons to apprehend a period of  long attrition, that while might benefit consumers yet paradoxically might not be economically conducive in the mid to long run.