Apr 17, 2020

# Economic Analysis of the Oil Price Drop Using Game Theory

The current situation of the globally dropping oil prices has reached the news, but to understand the reasons behind it we’ll have to dive into a little bit of game theory and analyze the situation with the help of payoff matrices.

Superficially, game theory is the science of strategy. It attempts to determine mathematically and logically the actions that players should take to secure the best outcomes for themselves in a wide array of games.

In the "game" of this oil price drop, the "players" are the Russian Federation and the Kingdom of Saudi Arabia.

As far as oil prices are concerned, countries are expected to act in mutual interests and ideally reach an optimal solution that is mutually beneficial.

However, such ideal situations are rare. When we look from a rational point of view, collusion is ideal for both sides, but competition has a higher rate of profit if one of the countries decide to collude. Now such a situation arises the fear of countries acting in their selfish interest and risking a much worse decision, i.e if both countries compete, their profits reduce radically than if they had decided to collude.

This sounds confusing, so let’s try to visually understand this through a payoff matrix.

For further simplicity, let’s fill in some numbers.

As we can see above, the Socially Optimal Solution is to collude and raise prices artificially.

However, both Saudi Arabia and Russia’s dominant strategy is to lower prices and betray the other. Therefore, when Russia decides to lower its price, a situation arises in which no participant can gain by a unilateral change of strategy if the strategies of the others remain unchanged, in game theory we call this a situation of Nash equilibrium.

Nash equilibrium is a concept within game theory where the optimal outcome of a game is where there is no incentive to deviate from their initial strategy. More specifically, the Nash equilibrium is a concept of game theory where the optimal outcome of a game is one where no player has an incentive to deviate from his chosen strategy after considering an opponent's choice.

But how did we arrive in this situation? Couldn’t the countries just decide to mutually collude? Let’s go back to 1960.

Initially, the market for Oil was a competitive market, but in 1960 an Oligopoly was formed called “the Organisation of Petroleum Exporting Countries” (OPEC). Nations had settled on the Socially Optimal Solution, causing the Oil market in the western world and other oil-importing nations to crash, especially the US. There were 5 founding members of OPEC, namely, Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela.

Currently, there are 15 states in OPEC- Algeria, Angola, Congo, Ecuador, Equatorial Guinea, Gabon, IR Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates (UAE), and Venezuela.

This Oligopoly, however, developed cracks and ended with the Russia-Saudi oil price war. Russia was the first to switch over to its dominant strategy (lower prices and compete), which forced Saudi Arabia to switch to its dominant strategy too, reaching the Nash Equilibrium.

But why now, in the middle of a coronavirus pandemic? Well, the answer is actually “because” of the coronavirus pandemic.

Let’s understand the Coronavirus’s impact on the global oil market.

The oil sector of the Russian Federation accounts for 16% of its GDP, 52% of federal budget revenues, and over 70% of total exports, so it is safe to declare that Russia’s economy is heavily dependent on oil, and due to coronavirus, governments around the world have been declaring ‘shutdowns’.

People are in quarantines and industries are collapsing, and since the primary source of energy, almost universally, is oil, are experiencing a huge decline in the demand for oil.

Now that other countries want less oil, the equilibrium quantity and price don’t hold anymore, impacting all oil-exporting countries, especially Russia.

Therefore, Russia lowered its oil prices to make up for the decrease in demand. By selling oil at cheaper prices but in much larger quantities, this idea would minimize the shock the Russian economy would face otherwise.

However, since now importers would prioritize buying from Russia, this also enticed the Russian-Saudi oil price war. After Russia lowered its prices, other countries had to follow, including Saudi Arabia. So, in conclusion, Russia has decided to quit the oligopoly causing the oil price to go for a free fall. This has helped oil importers, like India, and the US, but troubled oil exporters, like Venezuela and some US-based oil companies.

It seems to be a short-term, emergency move made by Russia to make sure that its economy doesn’t crumble in this epidemic, but it has definitely hurt its diplomatic relations with the rest of the cartel members.