OPEC Should Let Oil Prices Rebalance the Market

Released in 1983, the movie blended new concerns about home computers and hacking with older concerns about the accidental start of nuclear conflict and mutually assured destruction.

In the film, the U.S. Air Force's new war-planning computer, which displays an early form of artificial intelligence called Joshua, runs simulations for global thermonuclear war, trying to find a way to win.

But the game becomes deadly serious when the computer seizes control of the U.S. nuclear arsenal and attempts to launch a real missile attack against the Soviet Union.

The film's hero, a young hacker, eventually teaches the computer a lesson in futility, forcing it to play tic-tac-toe, a game that has no winning strategy and always ends in a draw.

The computer then applies the same lesson to its nuclear war simulations, realising there is no winner, only losers.

The computer concludes global thermonuclear war is “A strange game. The only winning move is not to play” and stands down the missiles.

In many ways, the renewed battle between OPEC and U.S. shale producers is similar to the self-defeating conflict portrayed in “WarGames”.

If all oil producers try to maximise their output, the result is a glut of crude that depresses prices and proves ruinous for everyone.

If one producer acts as swing producer and restricts output unilaterally, others increase their production to fill the gap, and the only result is a loss of market share.

The only rational strategy is to avoid trying to manage production and allow prices to adjust to rebalance the market.

Swing Producer?
“I personally believe (the oil price) where we are right now is not sustainable,” Tim Dove, chief executive of Pioneer Resources, told a conference in New York on Tuesday.

“It comes in the form of two words: Saudi Arabia. They cannot have a scenario, which is $43 or $44 (per barrel) oil, and sustain their national budgets.”

As a result, Saudi Arabia would likely move to boost oil prices to protect its own finances, according to Dove (“U.S. shale CEO sees Saudi Arabia moving to lift oil prices”, Reuters, June 27).

Despite the glut, Pioneer has no plans to curb its own drilling. “We’re not going to not drill because this very well may be the time where the well costs are as low as they’re ever going to be,” Dove said.

"We can pare away and still be profitable even in a $45 (per barrel) environment," he said. "We may just dial back at the margin in that scenario and not be a significant over-spender."

The gist of his argument was that someone would have to cut production to lift prices, but it would not be Pioneer, one of the most prominent shale drillers in the Permian Basin.

Similar logic holds for all producers, but if they all carry on drilling, the result will be continued oversupply and a decline in prices.

Dove seemed to think Saudi Arabia would act as a swing producer again, and in the process deliver a windfall for shale firms in the form of higher prices.

But acting as a swing producer simply to protect rival shale firms from a renewed price drop would not be a rational strategy for Riyadh.

The only rational strategy is to eschew the swing producer role and allow prices to decline to the point where the shale drilling boom is curbed.

In this game, acting as a swing producer is futile, and the only winning move is not to play - as Saudi Arabia discovered the hard way during the 1980s and is rediscovering now.

Since the start of the year, Saudi Arabia has given up market share, only to watch other producers increase their own output, and end up with prices no higher than before.

Further production cuts by Saudi Arabia and the rest of OPEC would likely result in the same self-defeating outcome.

Saudi Arabia and its OPEC and non-OPEC allies have committed themselves to restraining output to the end of March 2018.

The production cuts have arguably backfired but the kingdom has good reason to stick with the plan to maintain its credibility.

For the future, however, the rational course is to make clear that the cuts will not be renewed when they expire next year.

Saudi Arabia and the others should commit to gradually normalising their production levels in the course of 2018 and abandoning output restraint.

The result would likely be somewhat lower oil prices in the near term, but that would curb the shale boom and protect Saudi Arabia’s market share and revenues in the medium term.