The oil supply market is a complex system with complex rules and multiple interactions among the petroleum exporting countries [OPEC (Organization of the Petroleum Exporting Countries)] and non-OPEC countries such as Guyana, which makes the modelling and forecasting of market behaviour a challenging task. The high complexity of the oil supply system is enhanced by the game strategies played by all the producers involved (Campbell 1999). The conflict and cooperation between these multiple agents can be modelled using game theory (Myerson 1991).
Two Types of Game Relationships Concerning Oil Supply
- The first kind is the game relationship between OPEC and other oil-producing countries that has a big share of the world oil supplies.
- The second kind is the game relationship between OPEC and non-OPEC producers.
These relationships are complex and can be influenced by many factors. However, one of the most common factors is the relationship between OPEC and non-OPEC partners. The high increase in oil price leads to a win-win strategy for oil-producing countries. [Which does not form a Nash equilibrium (Zhao and Pu 2010)]. A Nash equilibrium is possible only if all oil-producing countries maintain a lower supply when the price is higher. However, they all have the motive to produce more supplies because higher price with higher supplies will result in more profits. Obviously, the best strategy for one oil-producing country is to increase its own supply while trying to keep other oil-producing countries to keep a low supply. As all the gaming partners are rational and all try to maximise their profits, therefore, their best strategies are to increase their oil production when the price is high, which leads to the well-known scenario of Prisoner’s dilemma.
Clearly, one of the main objectives for OPEC producers is the determination of the best strategies for safeguarding their organisation’s own interests, both individually and collectively (Liang and Qi 2009). In this sense, OPEC is the price maker, which can affect the oil price in the oil market via their supply strategies, while the non-OPEC producers such as Guyana are the price taker, which has little impact on the actual oil price and thus has a disadvantage compared with OPEC. Therefore, non-OPEC’s behaviour can be assumed to be competitive, but their competitiveness is subject to geological and economic constraints (Dees et al. 2007).
Adaptive Strategies in Oil Supply Market
As a complex system, the oil supply market can maintain some balance by itself. Oil-producing countries can decide their supplies, constrained by their economic and geological factors, while the oil supply market can adjust and adapt in terms of complex game relationships. There are many models and studies, but most models have not considered this important issue, thus leading to inappropriate conclusions. When the oil market loses its balance between oil supply and oil demand, the OPEC may have to adapt by changing their supply strategies to maintain a balance.
OPEC and non-OPEC have different strategies. OPEC can adjust their supplies so as to influence the oil price, while non-OPEC producers such as Guyana as price takers can have different strategies. Hence, the supplies of both OPEC and non-OPEC can lead to a high price scenario. In the high-price situation, the supply of non-OPEC can shrink under the influence of OPEC’s behaviour. A consideration for economies like Guyana as they continue to increase production.
The diverse nature in OPEC and the supplies of the non-OPEC fringe often creates strong incentives against collusion. More specifically, OPEC’s supply strategy, although observed to be substantially more restrictive than that of a [Cournot–Nash] oligopoly, is found to still be more accommodative than that of a perfect cartel. The strategy involves allocating larger than proportionate quotas to smaller and relatively costlier producers as if to bribe their participation in the cartel. This is in contrast to predictions of the standard cartel model that such producers should be allocated relatively more stringent quotas. Furthermore, cartel collusion is more likely to be sustained for elastic than for inelastic demand. Since global oil demand is well known to be inelastic, this observation provides another structural explanation for why OPEC behaviour is inconsistent with that of a perfect cartel (Okullo and Reynès 2016).
OPEC is not and should not be regarded as a perfectly colluding (i.e., standard) cartel. Indeed, concessions made when bargaining for quotas may engender production allocations that vastly diverge from those of a perfect cartel. While economic theory prescribes that perfect cartels must assign quotas so that marginal ( incremental ) revenue (alternatively, full marginal costs – full marginal costs constitute the marginal cost of lifting the resource out of the ground, plus all rents associated with the extraction of the resource) are equalized across members (Schmalensee 1987), OPEC’s actual quota allocation scheme plausibly diverges from this rule.
Technically, equalization of these revenues requires that the least efficient (i.e., high cost and low reserve) producers cut their production, so as to accommodate for relatively higher production shares from more efficient (i.e., low cost and large reserve) producers. For OPEC, this means that Saudi Arabia would frontload its production, while high-cost producers, such as Venezuela, would postpone theirs to a time when their (full) marginal costs of extraction are in line with those of Saudi Arabia. Full marginal costs constitute the marginal cost of lifting the resource out of the ground, plus the scarcity rent of depleting the resource. The reverse, however, has been observed for OPEC and some other cartels such as the Railroad Commission of Texas (RCT) where, the less efficient (i.e., the small and generally high cost) producers tend to acquire larger than proportionate production shares (Griffin and Xiong 1997). These less efficient producers are given unproportionally larger quotas as if to bribe their participation in the cartel. Such a quota allocation scheme conforms more to non-cooperative oligopoly behaviour than perfect cartelization.
The production scheme, where smaller producers in cartels get unproportionally larger quotas, can be explained by concessions at the bargaining stage. There is a consideration for a two-stage model of global oil production where, in the first stage, OPEC producers negotiate overproduction allocations, i.e., quotas. These quotas must be enforceable. In the second stage, each OPEC member chooses its optimal production plan, subject to its quota restriction, while making independent judgments about investments in capacity and resource development.
Non-OPEC decision making for new economies such as Guyana, by contrast, are confined to the second stage where optimal levels for production, investments in capacity, and resource development are all chosen. OPEC producers know the form of the demand function and therefore act as prices setters. Non-OPEC producers, on the other hand, know only the time path for the global oil price. They act as a competitive fringe.
It must be noted that a country like Guyana should be able to assess how different attributes, such as reserve holdings, extraction cost, production capacity, etc., might affect a member’s bargaining power in the cartel and its incentive to collude. This will assist in the evolution of OPEC’s ability to deploy an effective mark-up pricing strategy.
OPEC enjoys moderate to substantial gains from cartelizing. More specifically, whilst there are adequate incentives for OPEC to cartelize, these, unfortunately, do not tell us much about OPEC’s degree of collusiveness. Understanding the distribution of collusion gains across OPEC members and over the different collusion possibilities is key to understanding the effectiveness of the OPEC collusion arrangement and hence the extent to which OPEC can mark up the global oil price(Berg et al. 1997).
OPEC enjoys positive gains from perfect cartelization (estimated to be 25%), and thus has positive incentives to cartelize. Heterogeneity within the cartel is, however, an important factor that impedes full cooperation since, for plausible demand elasticity estimates, most members’ profits are observed to be non-monotonic in the degree of cartelization. For most producers, individual profits initially increase because of collusion, but then begin to decline as cooperation approaches perfect cartelization. This decline is strengthened by the presence of a non-OPEC fringe that increases its production whenever the cartel further withholds. In fact, non-OPEC producers such as Guyana can be one of the biggest gainers from OPEC’s attempts at stronger collusion. As a result of the non-OPEC “free rider” problem and heterogeneity between OPEC members, the perfect cartelization approach seems inadequate for capturing the intricacies of OPEC behaviour. Instead, OPEC plausibly sets production where it can ensure the highest gains for most of its members, while at the same time crowding out non-OPEC production. Such an equilibrium point does not have to correspond with perfect cartelization.
Thus, the more elastic the demand curve, the more likely OPEC producers are to perfectly cartelize. This result is not specific to OPEC but is a general result. Organisational factors such as the number of producers in the cartel, the size of the cartel relative to the fringe, and the level of demand will influence cooperation in a cartel (Hyndman 2008). Additionally, market factor such as the demand elasticity also influences cooperation in a cartel. It is generally perceived that cartels are more likely to form in cases where demand is inelastic. While this may appear to be the case because of the high profits that low (absolute) elasticities induce when producers collude, it is not necessarily the case that the cartel will be a perfectly colluding one. The intuition behind the effect is that since gains from collusion are more (less) substantial with inelastic (elastic) demand, cartel members need to make minimal (deep) cuts in production, thus colluding less (more) stringently in order to raise prices and hence profits.