Imagine that you and your accomplice have been arrested for a crime that you did commit. The cops lock you in separate interrogation rooms for hours. While nervously awaiting the interrogator, you fixate on your accomplice in the other room, realizing that he might try to strike a deal to save his own skin. You think to yourself, "What is he saying? Is he sticking to the prearranged story? What should I do?"
After a bit of time, the interrogator enters and explains your options; as he talks, the consequences of your options become clear. You can betray your friend and cooperate with the police, and as long your accomplice stays quiet, you will go free. But if your accomplice cooperates with the police independently, you both will go to prison for a few years. Alternatively, you can remain silent, and as long as your accomplice also stays silent, you both will get a slap on the wrist. But if your accomplice cooperates while you stay silent, you will end up in prison for many years.
In the game to control oil prices, it appears that cheating is the dominant strategy."
Most readers will recognize this situation as the classic "Prisoner's Dilemma" in which the group is better off when each individual is worse off than he could be. What's particularly interesting about it is that regardless of what your accomplice does, you're always better off if you betray your friend and cooperate with the police. In game-theory parlance, betrayal is the dominant strategy.
Variations on this clichéd example have been influential in economic theory as they suggest that completely free markets with all actors working to maximize their own utility might not--after all--produce the maximum total utility. Right now, in fact, a real-life prisoner's dilemma is unfolding in the global oil market.
Thus, picture your interrogation room again. But this time imagine that you have three accomplices who are all waiting in their own interrogation rooms. Furthermore, imagine that your accomplices are Libyan leader Muammar Qaddafi, Venezuelan President Hugo Chavez, and Iranian President Mahmoud Ahmadinejad. Now that's a dilemma.
Can you really trust those individuals to choose against their individual interests and sacrifice for the good of the group?
That hypothetical situation is similar to what's currently controlling global oil dynamics, and it will be on display next week when OPEC ministers meet in Algeria.
The current dilemma started about six years ago as the Chinese and Indian economies accelerated. Year after year, the demand for transportation fuels in these and other developing countries grew at astonishingly high rates. During that time, however, geologic constraints and time lags in developing new oil fields prevented supply from rising as fast as demand. The result was a nonlinear growth in the price of oil from $24 in 2003 to $147 in July, and since the average cost of extraction in oil-exporting countries barely increased, those countries accumulated vast foreign-currency reserves.
That wealth transfer from mostly democratic oil-importing countries to mostly autocratic oil-exporting countries has been bad for freedom. (See my July column, "Breaking the Tyranny of Oil.") As frequently happens during commodity booms, the leaders of geologically lucky countries such as Russia and Venezuela have been able to tighten their grip on power with their newfound wealth. Russian Prime Minister Vladimir Putin, for example, was able to transform his country's nascent democracy into a de facto dictatorship primarily because of the oil jackpot. He--as well as other petro-dictators--funneled oil money into government services, military defense, and bribery; in doing so he built his fortress on the foundation of high oil prices. It has been estimated that Venezuela's government will break even when oil is at $100 per barrel, while Iran's budget requires about $90 per barrel. So, last July, with prices nearing $150 per barrel, the dictators were doing well.
But then, Wall Street collapsed.
Since mid-summer, demand for oil has plummeted with the same stunning abruptness as equity values. The oil boom was fueled by the combination of economic growth in the developing world and the difficulty of increasing supply in the short term. The very high oil prices, however, did stimulate significant investments in new oil-extraction capacity, which has started to come on line. Therefore, supply has been near boom levels, while demand has been drying up across the globe.
That combination of forces has caused oil to drop from $147 per barrel in July to $45 per barrel at the beginning of December, spelling near disaster for Russia, Venezuela, and especially Iran. Indeed, Ahmadinejad recently admitted that the dramatic drop in oil revenues has been severely damaging the Iranian economy. Similarly, Russia's debt was just downgraded for the first time in nine years due to its rapidly draining foreign-currency reserves caused by the plunging price of oil.
That brings us to the dictator's dilemma. If the OPEC countries plus Russia--who collectively account for nearly 50 percent of global crude extraction--were to act in unison by simultaneously decreasing their oil-extraction rates, then the total supply of oil will decline significantly and the price will rise. But there are 13 different actors, and each actor is best off if the other 12 cooperate while they cheat. That is to say, if all of the other countries cooperate, oil prices will increase and the country that cheats is better off selling as much oil as it can at the new high price. Conversely, if a country complies while all of the other countries cheat, then the price of oil won't move but the compliant country's output--and revenues--will drop. So, it appears that cheating is the dominant strategy in the game to control oil prices.
Let's say, for example, that all of the countries decided to cut oil output by 2 million barrels per day in an effort to get the price back to around $75 per barrel. In this case, Iran would be obligated to cut its extraction rate by about 250,000 barrels per day. But the global price is likely to rise almost as much if the total cut were 1.75 million barrels per day (if Iran cheats and doesn't cut its extraction rate), instead of the full 2 million. Therefore, by cheating while the rest of the group complies, Iran would collect an additional $7 billion over the next year. Given Iran's economic frailty, the temptation to cheat will be strong.
So what will happen?
OPEC plus Russia has a sufficiently dominant market position to control prices by cutting output; and if all the actors avoid the free-rider temptation, then oil supply will drop and oil prices will start to rise. But given the degree to which many dictators have been relying on oil revenues to consolidate power, the temptation to cheat coupled with the realization that others are likely to cheat suggests that oil supply won't drop very much. Indeed, there's evidence that the dominant strategy is being applied by some actors as only Saudi Arabia has clearly met its most recent obligation to cut oil production.
The run-up in oil prices was primarily demand driven, and with demand collapsing, it's hard to envision very high oil prices in the next year or so. On other hand, the fundamentals that caused demand to accelerate are real, and they will appear again. There is about one car for every American, while there is about one car for every 100 Chinese people. Over the next decade, the global economy will recover and many Indians and Chinese will buy their first car. In the short term, the dictators of oil-exporting countries have a serious dilemma, but the long-term macroeconomic trends are in their favor. Therefore, oil-importing countries should take advantage of this period of relatively cheap fuel to decrease their own oil consumption.
