What Will Saudi Arabia and OPEC Do in 2016? - giStrat · whether to limit production or continue...

What Will Saudi Arabia and OPEC Do in 2016? Applying Game Theory and Agent-Based Modeling to Predict OPEC Behavior

FEBRUARY 18 2016

Global Impact StrategiesReport: What Will Saudi Arabia and OPEC Do in 2016?

Global Impact Strategies deploys expertise in predictive analytics and decision science to address some of the world's most pressing challenges.

Contributors

Global Impact Strategies

Amir Bagherpour, PhD, Chief Political Scientist

Shaun Donaldson, Senior Analyst

We deliver forecasts with accuracy and speed,

combining advances in mathematical modeling

with expertise from the fields of political science

and economics.

We work with corporations, governments, andphilanthropies in three main focus areas:

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2 Background

2 Overview of OPEC

3 About the Methods and Forecasting Platforms

4 Possible Outcomes in 2016

7 Projected Outcome

7 Conclusion

8 Appendix A

10 Appendix B

12 Appendix C

1


Overview

The decline of oil prices from $115 per barrel in 2014 to approximately $30 today has

generated fiscal shortfalls for petroleum-producing nations. Saudi Arabia, the largest oil

producer within the Organization of Petroleum Exporting Countries (OPEC), must decide

whether to limit production or continue current levels to maintain market share. Their

decision will have significant impact on producer and consumer economies worldwide.

Findings

• Saudi Arabia will continue status-quo production levels to maintain market share (93%

likelihood).

• OPEC members will not reach an agreement to restrict supply. They will continue to

produce at uncoordinated levels with little deference toward the current price of oil.

• OPEC members will fail to coordinate pricing through quotas. OPEC members will

divide into two camps as Gulf Arab countries attempt to retain market share at the

expense of other member producers (Iran, Venezuela, Nigeria, Libya) who seek

quotas to drive up the price of oil.

• Iran will add to the global oil supply as sanctions are eased. This will bring a

diminished return on oil sales than would have been expected because of current low

prices.

• Barring a significant external shock, the price of oil will remain at historical lows

for the next six to twelve months, with continued pressure on marginal producers,

including the U.S. shale market and petro-states Russia and Venezuela.

2


Background

The decline of oil prices from $115 per barrel in 2014 to approximately $30 today creates concern

about the economic stability of oil-producing states as they continue to suffer fiscal shortfalls. While

analysts attribute the drop in price to global oversupply, market intervention aimed at regulating this

function is the overriding objective of the Organization of the Petroleum Exporting Countries (OPEC).¹

Saudi Arabia historically performs as the cartel’s swing producer mainly due to its high-production

capacity. A critical question for 2016 is whether OPEC members succeed in negotiating a reduction in

production output for short-term increase in prices, or if they continue with uncoordinated production

levels aimed at retaining individual members’ market share.

Overview of OPEC

OPEC accounts for roughly 40 percent of global oil supply. In recent years, it has imposed a quota

system for individual member countries detailing oil production limits. According to its statute, OPEC’s

regulation is intended to “ensure the stabilization of oil markets in order to secure an efficient,

economic and regular supply of petroleum to consumers, a steady income to producers and a fair

return on capital for those investing in the petroleum industry.” While OPEC employs a voting structure

constituting “one member, one vote,” in practice the larger exporters, particularly Saudi Arabia as the

cartel’s swing producer, wield the greatest influence.

While the organization purports to regulate the price of oil primarily through the restricting and easing

of supply amongst member states, OPEC’s true effect on price outside of what would be achievable

unilaterally (through members independently) is questionable. Evidence for this is particularly

compelling when considering the absence of any enforcement mechanism to ensure compliance

with agreed-upon national quotas. While some analyses claim rampant cheating within the scope of

the cartel’s aggregate quota system (96% by one estimate), members find themselves in a perpetual

game of prisoner’s dilemma. In this classic game-theory example, OPEC members fail to maximize

price because of an inherent distrust among its members in coordinating quota levels. Believing that

some members might cheat, they maximize their own output in pursuit of market share and thereby

drive down the price of oil. OPEC members thus engage in non-cooperative bargaining. Saudi Arabia

and other Gulf Arab nations pursue a long-term strategy aimed at driving marginal producers such as

Russian and U.S. firms out of the market. They do this in the hope of maximizing market share despite

other OPEC members’ calls to curb production and restore the price of oil to higher levels.

¹ Hampton, Liz. “Oil market braces for longer downturn as 2020 crude falls to $50.” Reuters January 11, 2016. http://www.reuters.

com/article/us-usa-crude-futures-idUSKCN0UP18R20160111

² Colgan, Jeff. “OPEC, the Phantom Meance.” The Washington Post June 16, 2014. https://www.washingtonpost.com/news/

monkey-cage/wp/2014/06/16/opec-the-phantom-menace/

3


About the Methods and Forecasting Platforms

Game Theory Impact ModelgiStrat estimated the game theory-based

benefits (payoffs) of various OPEC member

and non-member states by ranking their known

preferences on two issues: (1) market share;

and (2) price of oil. giStrat then calculated the

range of combinations for these determinants to

estimate how these members and non-members

would act in 2016 regarding production levels

and potential coordination of quotas.

Senturion Agent-Based ModelThis forecast is conducted using a validated

agent-based game theory model called

Senturion. It incorporates computational

analytics applying proven theories of behavior

from the fields of psychology, political science,

and microeconomics to anticipate political

outcomes. In 2014 the State Department

selected Senturion as the most accurate model

for predicting conflict and crisis outcomes at

90% accuracy level across 200+ cases. Applying

an agent-based game-theoretic approach to

understanding the dynamics of OPEC member

behavior, giStrat modeled OPEC bargaining

amongst stakeholders over the next six to twelve

months using Senturion simulation to assess

the likely outcomes. In modeling stakeholder

preferences, the simulation assumed that a

nation’s bargaining range is a function of its

position, salience, and relative influence

on a given issue.

Modeling Current Member and Non-Member PositionsStates ability to influence each other was

operationalized quantitatively through a formula

that accounted for its proven reserves weighted

by its production levels. The stated position a

nation held on the issue of OPEC quotas and

productions was based on statements over the

past twelve months and quantified using each

member’s expected fiscal breakeven price of

oil for 2016. The salience a state places on the

issue was derived by operationalizing oil rents

as a percentage of GDP weighed against the

absolute deviation of fiscal breakeven price

from the current price of oil. Discounts were

then applied based on additional criteria (i.e.

Iran was granted a positive discount as potential

oil rents were not fully accounted for given

economic sanctions). The values of non-OPEC

members were derived from assumptions based

on a qualitative assessment of geopolitical and

economic factors.

4


Possible Outcomes in 2016

Modelling the range of possible futures in 2016,

giStrat developed a scale of potential outcomes

ranging from least to most coordinated OPEC

member responses:

1. Output Ceiling Eliminated: Members agree

to eliminate the fiction of an aggregate

output ceiling, demoting OPEC’s status

as a cartel to that of a political interest

bloc or multilateral forum.

2. Status Quo: Members continue in the

absence of individual production quotas with

a notional aggregate ceiling where individual

members continue to produce at their most

advantageous levels.

3. Rhetorical Support for Reducing Output:

Members make affirming statements and

promote toothless policies supporting either

or both individual quotas or a reduced ceiling

with no practical consequence.

4. Limited Reduction of Output: Members

cooperatively agree to reduce production

targets marginally, whether through the

re-introduction of individual quotas or

another mechanism.

5. Significant Reduction of Output: Members

cooperatively agree to reduce production

targets significantly, whether through the

re-introduction of individual quotas or

another mechanism.

Impact Model Prediction: Saudi Arabia will continue to produce at current levels

Strategic Preferences Based on the Stated Position

5


Description: giStrat estimated game theory-based benefits (payoffs) of various OPEC member and

non-member states by ranking their known preferences on two issues: (1) market share; and (2) the

price of oil. giStrat calculated the range of combinations for these determinants to estimate how

stakeholders would act in 2016 regarding production levels and potential coordination of quotas.

Impact Model Outcome

The impact model indicates positions of OPEC voting members will continue to divide into two

camps as Gulf Arab countries seek to maintain market share at the expense of other members (Iran,

Venezuela, Nigeria, Libya) who seek quotas to drive the price of oil up. The impact model indicates that

OPEC member states will not coordinate pricing through quotas. Saudi Arabia will continue to produce

at status-quo levels.

Strategic Preferences Based on the Cost and Benefits (Net Payoffs)

6


Agent-Based Model PredictionLandscape of Member and Non-Member Positions (Early 2016)

Projected Landscape of Member and Non-Member Positions (Mid-to-late 2016)

7


Projected Outcome

OPEC members will not reach an agreement

to restrict supply and will continue to produce

at uncoordinated levels. Saudi Arabia is highly

likely to continue status-quo production levels

in order to maintain or gain market share. Iran

is expected to add to the global oil supply

as sanctions are eased but will see a less

enthusiastic return on oil sales because

of low prices.

Conclusion

The price of oil will likely remain at historical

lows the next six to twelve months, implying

continued pressure on marginal producers such

as U.S. shale market and petro-states such as

Russia and Venezuela. With additional global

supply expected in the coming year and continued

“business as usual” at OPEC, we expect global

crude oil benchmarks to remain within recent price

boundaries throughout the course of 2016, barring

a significant external shock.

8


Appendix A: Monte Carlo Simulation and Robustness Testing of the Model

Robustness testing and Monte Carlo simulations were applied using Senturion to estimate the

robustness of the model and the reliability of the outcome. giStrat simulated over 40 alternative futures

with 90% shock probability under a uniform distribution with +/-15% shock and error variance. The

findings are highly robust.

9


Saudi Arabia: In 36 of 40 iterations, Saudi

Arabia’s final negotiated position remained

at the status quo, while testing at the 90%

confidence level, showing little-to-no deviation

outside its stated position to maintain production

output at the current levels of at least ten million

barrels per day.

Iran: In 40 of 40 alternative futures, Iran evinced

a preference to reinstate production quotas and/

or significantly reduce aggregate OPEC output.

Russia: In 37 of 40 alternative futures, Russia

maintained an overriding interest in OPEC

reinstating production quotas and/or significantly

reducing aggregate OPEC output.

United States: In 33 out of 40 iterations, U.S.

oil interests demonstrated a strong preference

to OPEC significantly decreasing output and/or

reinstating production quotas.

Significant Oil-Dependent States: Major oil-

dependent nations (i.e. China, EU Members)

showed a final positon preferring the status quo

over any adjustment in OPEC production targets

in 36 out of 40 alternative futures.

10


Appendix B: Testing Flexibility of Actors at 90% Confidence Interval

Divergent Positions on Key Negotiations:

Outcome: At the 90% confidence interval, Saudi Arabia exhibited no overlap in the range of potential

preferences with either Venezuela or Russia. Accordingly, a negotiated agreement between either

group over the next six-to-twelve months is highly unlikely.

Outcome: At the 90% confidence interval, Saudi Arabia exhibited no overlap in the range of potential

preferences with either Venezuela or Russia. Accordingly, a negotiated agreement between either

group over the next six-to-twelve months is highly unlikely.

11


Saudi Arabia Responding to Demand and Maintaining Share of Global Market:

Outcome: Confidence interval testing shows Saudi Arabia’s preferences strictly aligned with

responding to global demand to maintain market share during the projected six-to-twelve-month

period of 2016.

12


Appendix C: giStrat Impact Model Projection Payoffs and Pathway Outputs

Scenario Pathways Degree of Market Share Price of Oil

Formally Dissolve Output Ceiling / Unrestricted Supply of Oil High Price is Low

Status Quo - - Formal Ceiling but No Quotas Enforced Price is Low Medium

Limited Reduction in Output / Quotas Reinstated Price is Moderate Medium

Individual Quotas Reinstated at Greater Magnitude Low Price is High

Scenario Pathways

Scenario Payoffs

Saudi Arabia

Iran Algeria Angola Ecuador Indonesia Iraq Kuwait Libya Nigeria Qatar UAE Venezuela RussiaUnited States

Other Non-OPEC Oil Exporters

Significant Oil Dependent

Nations

Limited Reduction in Output / Quotas Reinstated

-1.0 3.0 3.0 3.0 3.0 -3.0 1.0 1.0 3.0 3.0 1.0 1.0 3.0 3.0 6.0 6.0 -3.0

Individual Quotas

Reinstated at Greater Magnitude

-5.0 5.0 5.0 5.0 7.0 -7.0 -1.0 -1.0 5.0 5.0 -1.0 -1.0 5.0 7.0 4.0 4.0 -5.0

Formally Dissolve Output Ceiling / Unrestricted Supply of Oil

3.0 1.0 1.0 1.0 2.0 1.0 3.0 3.0 1.0 1.0 3.0 3.0 1.0 -1.0 -1.0 -1.0 1.0

Status Quo - - Formal Ceiling but No Quotas Enforced

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

13


Payoff Based Cost of Friction

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