The only logical end to the oil war


The global oil and gas industry is currently in a state of distress and total uncertainty. At a time when the coronavirus pandemic is decimating the demand for oil, the last thing the oil world needed was an OPEC + row that threatens to turn on the world’s oil. Rather than taking steps to temporarily reduce supply to meet declining demand, Saudi Arabia and Russia will compete to increase supply. It is almost impossible to model the current abnormal situation because it is both temporary and unsustainable. If it is difficult to remain lucid during all the confusion, you have to imagine a world without a pandemic to model medium and long-term scenarios. In this case, we could appreciate the OPEP + dilemma, which Figure 1 describes:


Figure 1: fall in market share

So, from the perspective of traditional oil producers, the above scenario is a tailspin that has no happy ending. This is compounded by the fact that, to varying degrees, all budget balances for OPEC + members depend on oil revenues. So it’s not just about the economy, it’s about survival.

On the other hand, as long as American producers do not lack shale rocks to crack, they are not encouraged or cannot formally enter into production agreements, which would certainly run counter to antitrust laws. It would be safe to mention that the competition laws in the United States and in Europe are completely unforgiving and could throw a company into the ground if it commits a material breach. And it’s not just businesses, but individuals (such as members of the executive and the board of directors) who can face personal responsibility for breaking these laws. Thus, the only way for production reductions to materialize in the United States would be business-independent action based on economic considerations.

This backdrop is ideal for using game theory to guide the action of two competing parties on the oil supply side: the first part, OPEC + (just call it Arabia + Russia S + R), and the second part, American producers. . We can observe that the two players do not have much chemistry within their respective parties. In general, however, the interests of the members of the two groups mentioned above are more aligned with one another. Thus, we may be able to apply the concept of game theory to analyze the choices that these two teams will make. Related: Russia’s Plan To Bankrupt American Shale Could Send $ 60 Oil What is game theory? The theory was launched by mathematicians, notably John Nash, and assumes that players in any game must be rational and strive to maximize their individual winnings. The game is played in sequence and “the two players maximize their payout while being affected by each other, ultimately leading to” Nash Equilibrium “.

Game theory

Figure 2 above illustrates the configuration of the game. The numbers used here for the calculation are approximations and the key is to conceptualize aspects of game theory.

The Saudi + Russian team (S + R team) can produce from 19 million barrels per day (mbpd) to 23 mpd, the lower range being close to what Saudi Arabia proposed as a new level of cut during the last OPEC meeting. A level of 21mpbd would be close to production levels of 2019 and 23mbpd is what S + R has announced it will reach. Team USA reached between 12-13mpbd before the current crisis. Projections of potential reductions in the United States in a low price environment vary from 2 to 5 Mbpd, assumed in this exercise at 3mpbd or at production levels of 10mbpd.

The biggest challenge of this exercise was to estimate the price elasticity of oil supply. In a constantly changing demand environment, a simple calculation of the price in relation to the supply would not provide useful information. Instead, an assessment of the supply-demand balance against the Brent spot price (using publicly available data) was considered. Since changes in supply and demand are not instantaneous, 6 month moving averages were used, and ultimately the price was shifted forward to account for “reaction time” changes in the supply-demand balance. The correlation, although not perfect, is reasonable enough to be used for our illustrative exercise in game theory, and illustrated in Figure 3a below. Figure 3b then uses the correlation obtained to reflect the supply of Saudi + Russian + American oil and the corresponding prices.



Finally, using price and production levels, we can arrive at revenues (disbursements) for each team in each scenario. The following scenarios reflect the decisions that the two teams must make:

Scenario-1 (current)

For all practical purposes, we are currently in a hyper state of scenario 1 (the fall in demand exacerbating the length of supply). With Team 1’s oil valves turned on and production in the United States still at high levels, prices fell below $ 20, and even below $ 10 for many deliveries of physical crude. The correlation suggests a price of $ 15 for this exercise (even in a world without COVID). The red circle indicates this state. By the end of 2020, Team-USA is expected to have already played this scenario and had production stoppages. Even if it would be unintentional for the most part (production costs higher than the price of oil for most production parts), it would also be the rational choice because the payments would be higher even with lower production, going to the circle yellow.

The question is then what do the teams do after the disappearance of the coronavirus conditions? There will be no incentive or financial appetite for Team USA to restart all oil production around the $ 33 mark. The ball is now firmly in the court of Team S + R.

Scenario-2 (the S + R team agrees to cut)

The local optimum (yellow circle) reached in scenario 1 is not sustainable. Given the breakeven budget balances, this price level would decimate the economies of most oil-exporting countries. And as Figure 4 shows, Saudi Arabia has much more to lose than Russia (see: “Why Saudi Arabia’s oil price war is doomed: fuel for thought”).


Figure -4 Fiscal equilibrium price of oil

Suppose now that the S + R team agrees to reduce to 2019 levels and move to the left, which corresponds to a reduction of 2mpbd, which, with the 3mpbd of shale oil for a total of 5mpbd, would be huge. Oil prices then rise in the range of $ 50 to $ 60. Now it’s Team-USA’s turn. It could keep production low or increase, as this price level would support most shale deposits. But if he did, the price change would sting again and, in fact, the payments would drop.

Related: Unprecedented Destruction Of Demand Marks The Return Of The Super Contango

So, for both players, the winnings would indicate staying put. This is where Nash’s balance is reached and the game ends. Given Team USA’s rational action, the higher payout of the two teams also occurs in this scenario. Anyway we play this game; the payment response remains the same.


What happens with an additional request? Who provides it? The S + R team will remain in the strongest position to dictate the conditions, as they can still bring the game to Scenario 1 and destroy the finances of US non-government corporations. However, with power comes responsibility. It will be up to OPEC + to allow US producers to make reasonable returns. While the players cannot get along, the government can act in the best interests of the industry as a whole.

Ultimately, game theory seems to justify Russia’s action to disagree with demands to cut Saudi production, although it could be said that it may not be the good moment. In the long term, OPEC + will have to fundamentally and structurally change the economic choices of the shale industry by clarifying its own: it will not give up more market share. Another way would be to change the rules of the game by OPEC + by buying American shale assets that could mature for a fire sale and then leaving the shale rocks – silent and intact.

By Amad Shaikh for

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