Weekly notes: oil production and game theory

Globally, oil supply is one of the strongest mechanisms of power. In addition to the balance of power in world politics, trend analyses are showing signs of oil producers preparing for a shift of demand away from oil to other fuels. Major oil producers have huge financial interests in the prospects of oil use, so they also keep their eye on the long-term development trends, decades from now. The view that the end of oil will not be a problem has grown stronger in recent years; quite the opposite: burning all fossil fuels is not a safe alternative. The negotiation processes of the international community are aimed at forming a shared situation awareness and making decisions on how to prevent dangerous levels of carbon dioxide concentrations in the Earth’s atmosphere. 

If the slow-moving negotiations on climate change lead to concrete solutions, some of the fossil fuel reserves will be left unused and, after the transition period, the value of these unused reserves will drop to zero. Based on game theory, and given the current situation, oil producers are acting extremely logically.

First, those whose reserves are the easiest and quickest to get out of the ground should try to remove from the markets those who are threatening to increase the amount of oil available on the market beyond a safe limit.

Second, those involved in the industry should strive to create a situation where reaching a global consensus is as difficult as possible and takes the longest possible time.

Third, producers should determine the levels of profitability at which point they will gradually start to liquidate their property with the goal of detaching themselves from the reserves in a controlled manner in order to minimise the amount of worthless reserves they might be stuck with.

In the current situation, maintaining the output of oil production and falling oil prices support all three of these goals. Falling prices are causing problems to those oil producers with the highest costs for getting their oil reserves out of the ground and into further processing. Some of these players may quit the game early, curbing the oil supply.

Many states participating in the negotiations of the Intergovernmental Panel on Climate Change (IPCC) are concerned about their own economic growth. Low oil prices stimulate economies, apart from a few exceptions, and therefore a markdown in oil prices so close to the climate negotiations in Lima and Paris will not make it any easier to take difficult decisions. In addition, considering that the production costs of one of the major players in oil production, Saudi-Arabia, are roughly 5 to 6 US dollars per barrel, its oil production is set to remain profitable at current and even significantly lower prices.

Selling such reserves at significantly lower prices compared to the present is quite tempting when a value crash is looming on the horizon.

The author has an MSc in Systems Analysis

P.S. Saudi-Arabia aims to obtain one third of its power from renewable sources by 2032. ;-)