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The oil price has taken a beating over the last year.
Brent crude oil – which is used to set the price of about two-thirds of the world’s internationally traded oil supply – hit a cycle peak1 of $128 per barrel in March 2022.
And is now – as of November 30th 2023 – at roughly $81.
That’s a roughly 37% decline.
But I’m not surprised.
I’ve argued for months that oil could sink lower amid weaker global demand and fading momentum.
There’s simply too much supply relative to demand (especially with China’s lackluster ‘reopening’).
And most importantly, no matter how many times pundits claimed that Saudi Arabia and OPEC (Organization of Petroleum Exporting Countries) would cut oil output to bolster oil prices, it hasn’t worked with much effect.
In fact, oil prices have drifted even lower.
Because each time Saudi Arabia announces cuts, they’re essentially subsidizing global oil producers at their own expense.
Remember, this isn’t the 1970s when Saudi Arabia and OPEC supplied ~60% of the global oil market2 (which has declined to 30% as of late 2022). And will likely decline further after these recent oil supply cuts.
Thus, they’re now stuck in what’s known as the “prisoner’s dilemma”.
I believe this is a very underrated way of looking at oil markets.
Because – according to history – once the Saudis stop trying to support oil prices at their own expense, a glut may potentially hit the market.
Let me explain. . .
It’s All About The Prisoner’s Dilemma When Dealing With Conflicting Self-interests
So, what exactly is the prisoner’s dilemma?
Put simply, it’s a game theory concept coined by mathematicians Merrill Flood and Melvin Dresher during the Cold War in 1950 to help make strategic decisions.
It’s essentially a situation where individual decision-makers always have the incentive to choose in a way that creates a less-than-optimal outcome for the group.
Meaning an individual must choose between self-interest and mutual interest. And since individuals receive the greatest payoffs if they betray the group rather than cooperate, they often ‘cheat’.
Here’s an example. . .
Imagine two men are arrested on suspicion of the same crime. And they’re taken to separate rooms for questioning.
To convict them, the police need at least one of them to confess or give testimony against the other.
Now – assuming the suspects are rational – they most likely value their freedom above others.
Thus, they each have two options: confess or remain silent.
If both remain silent, due to the lack of a non-confession, the police will sentence both to much less jail time (a win-win scenario).
But making matters more complicated is that each suspect doesn't know what the other is saying in the next room.
"If we remain silent, it's best," suspect A may think to himself. "But, how do I know if he is thinking the same thing? What if he throws me under the bus to save himself? Should I just blame him first?"
Of course, suspect B is thinking the same thing in the next room. . .
Now, if both end up confessing, trying to save themselves, they will each serve more time (a lose-lose).
To put this into perspective, the below chart3 shows this dilemma.
Thus, the prisoner’s dilemma illustrates the challenges of cooperating when individuals or groups face conflicting interests.
Sometimes, choosing self-interest might not be of any value to you if others think only of their own gain.
For instance, if you think of the best interest of the group, but the other members of the group think of only their self-interests, you’ll end up bearing all the loss (just like the suspect who stays silent while the other blames him).
This prisoner’s dilemma gives us a great framework when looking at Saudi Arabia and OPEC oil cuts.
Because they’re looking like the real losers here. . .
Saudi Arabia And OPEC Are Stuck In Their Own Prisoner’s Dilemma
The biggest problem with the OPEC oil cuts is that each time they limit output (in an attempt to raise oil prices), other producers benefit – such as the U.S., Brazil, and Canada.
For instance, U.S. oil production just hit a record high 13.05 million barrels per day in August 2023.
This is a thorn in the side of OPEC as they’re losing market share (reducing output) to try and keep prices higher while others – like the U.S. - come in and soak it up.
But let’s discuss OPEC itself here. . .
I believe there are two fundamental issues within OPEC – and even OPEC+ (aka including Russian and the Caucasus oil producers).
First – oil revenues make up most of the income for several oil-producing countries. Thus, their government budgets and dollar reserves depend on oil output.
Second – most of these countries have nationalized oil producers. Hence the state can choose oil output targets arbitrarily (whereas, for example, in the U.S. and Canada there is no mandated control of oil output).
So, in this context of OPEC, member countries face a dilemma when deciding on oil production levels.
Each country has an incentive to maximize its oil output to increase its revenue and gain a larger market share.
OPEC tries to address this dilemma through cooperation and collective decision-making.
The organization – under the heel of Saudi Arabia – sets production quotas for member countries, aiming to stabilize oil prices and maintain a balanced market. By limiting production, OPEC attempts to manage supply levels and support higher oil prices (a win-win).
However, the prisoner’s dilemma dynamics come into play when individual countries consider their own self-interests. . .
· For instance, if one country decides to exceed its production quota (let’s say Russia or Iran) and increase output, it can benefit by capturing a larger market share, potentially earning more revenue at the group’s expense.
· But if they all ‘cheat’ (because they don’t know if others are abiding by production cuts) – it can flood the market with oil (a lose-lose).
This creates tension within OPEC, as each member tries to strike a balance between maximizing their own gains and maintaining stability in the oil market.
And this “cheating” aspect happens much more often than many realize.
To put this into perspective, look at Iran's oil output (which was a founding member of OPEC) over the last few months. It’s risen roughly 600,000 barrels per day since this time last year – an over 20% increase.
It's important to note that Iran, Libya, and Venezuela are exempt from OPEC production quotas (meaning they don’t have set production limits).
Still, this is an awkward situation4 for Saudi Arabia – the main entity in OPEC – as they’re cutting while Iran (a geopolitical rival) increases output.
Or said another way – Iran is gaining at Saudi Arabia’s expense.
Saudi Arabia and OPEC often face challenges in enforcing production quotas and preventing free-riding behavior, where some countries exceed their limits while others adhere to them (win-lose).
And we’re already seeing the tension and resentment build in OPEC. . .
For instance, a few days ago Saudi Arabia announced5 that they were delaying the OPEC+ meeting because it was “dissatisfied” with other members’ output levels – specifically the African producers and Iran.
Saudi Arabia is having difficulty with other OPEC+ countries that don’t exactly want to cut oil output since they depend on these revenues. Instead, these countries want to have their quotas increased (allowing more output).
In fact, after the meeting today, Angola – the second largest African oil producer in the cartel – said6 that they outright rejected the OPEC quota and will pump more oil than the quota dictates – which is a rare challenge to the Saudis.
Meanwhile, Russian crude oil exports have been rising when they should’ve been declining from “promised” 2023 cuts.
In fact – according to Bloomberg7 – Russian crude flows to international markets through seaborne shipments have been rising since August – and remain elevated at more than 500,000 barrels a day higher than they were at the end of 2022.
Russia appears to be losing its appetite to help prop up oil prices by cutting supply alongside OPEC+ ally Saudi Arabia.
Exports of Russian crude have steadily risen since August lows, even as the two countries reaffirmed their close “cooperation” in the oil market.
But looking at it from the prisoner’s dilemma angle – this makes sense.
The Russians can let Saudi Arabia and OPEC cut oil production further – thus pushing prices higher in the paper markets - while they reap the reward (higher margins).
Keep in mind that Russia is fighting a war in Ukraine and dealing with a weak domestic economy - forcing them to depend on oil revenues very heavily (their largest export is petroleum products).
And this is just Russia I'm talking about. . .
There are currently 13 OPEC member countries, and 23 if we include OPEC+.
All these competing actors trying to fulfill their own best interests are becoming the biggest problem for Saudi Arabia.
Because with each oil cut OPEC tries to do, it’s subsidizing U.S., Russian, Canadian, African, and Brazilian oil production (which have all risen steadily over the last two years) at their own expense.
Saudi Arabia is already expected to run a $21 billion deficit in 2023 (over 1.9% of GDP). How long will they continue doing so while others benefit?
No wonder there’s tension building within OPEC.
These countries don’t want to lose oil market share and the revenues they depend on for state budgets all to prop up other producers.
And if history means anything here – I expect further ‘cheating’ by OPEC members and further infighting.
Thus, the prisoner’s dilemma highlights the complexities faced by OPEC in maintaining cooperation and managing oil production.
It underscores the need for trust, effective communication, and a collective commitment to shared goals to avoid a “race to the bottom” scenario where everyone suffers from declining oil prices.
But as we’ve seen – these three things don’t really exist in the real world. As each country has its interests and is always looking for an advantage.
Eventually, I believe Saudi Arabia may flood the market with oil to try and price out marginal producers and regain market share.
We’ve seen it happen before. . .
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