Applying Game Theory On the Global Oil Industry

Saudi Arabia has approximately 17% of the world’s oil reserves(Barros, Gil-Alana &Payne, 2011). It enjoys low production cost in extracting and refining petroleum. Venezuela, on the other hand, is a very poor country. Even though it is also an oil-rich country, it lacks the require capital and technology to process huge oil reserves. The reason why Saudi Arabia still chooses to form a cartel with Venezuela can be explained by Game theory as shown in the Table 1 below.

In the first scenario, when both Saudi Arabia and Venezuela decide to follow a cartel, the quantity of supply will drop and the oil price will increase. It is because the cartel aims to restrict the output of OPEC countries and thus drive the oil price. It can increase the profits and meanwhile save the non-renewable oil resource for both countries.

In the second scenario, if Saudi Arabia does not want to join OPEC but Venezuela chooses to follow the cartel, Saudi Arabia may choose to increase the oil put but it is predicable that the oil price in Saudi Arabia will goes down accordingly. But other OPEC members still choose to restrict output and enjoy a high oil price as the oil reserves of the rest OPEC countries are much higher than Saudi Arabia. In other words, OPEC has more market power and monopolistic power to set the price. OPEC can persuade oil-importing countries to stay away from Saudi Arabian oil products or otherwise threaten to cut the oil supply. Saudi Arabia will also suffer from tremendous profit loss due to low oil price.

In the third scenario, when Saudi Arabia follows but Venezuela does not follow, the consequence is even more disastrous. Venezuela has to increase its oil production in order to gain more market share (largely impossible due to poor technology and lack of required capital) but meanwhile the oil price of Venezuela will drop accordingly. It leads to significant profit loss.

In the fourth Scenario, both countries will suffer from profit loss due to low oil price as other OPEC countries still have higher market power. Venezuela and Saudi Arabia have to produce more oil products and meanwhile earn much less due to the decrease in oil prices.

From Table 1, even though the ideal case is that Saudi Arabia increases its output and drives out other members such as Venezuela through low oil price by declaring price war, it is literally impossible as it has only 17% of the world’s oil reserve. It does not have enough monopolistic power to set the price and oil output in the global oil market. As such, the nash equilibrium occurs when both Saudi Arabia and Venezuela agrees to follow the cartel. OPEC countries accounts for 70% of the petroleum production in the global oil industry ( Barros, Gil-Alana &Payne, 2011). They can enjoy higher profits by restricting the oil output (barrels per day) and increase the price per barrel.

Table 1: Game Theory in explaining Cartel between Saudi Arabia and Venezuela

Reference

Barros, C. P., Gil-Alana, L. A., & Payne, J. E. (2011). An analysis of oil production by OPEC countries: Persistence, breaks, and outliers. Energy Policy, 39(1), 442-453.