The Prisoner's Dilemma
Kevin Headland
Director, Capital Markets & Strategy
The prisoner's dilemma is a standard example of a game analyzed in game theory that shows why two completely "rational" individuals might not cooperate, even if it appears that it is in their best interests to do so.
Two members of a criminal gang are arrested and imprisoned. Each prisoner is in solitary confinement with no means of communicating with the other. The prosecutors lack sufficient evidence to convict the pair on the principal charge. They hope to get both sentenced to a year in prison on a lesser charge.
Simultaneously, the prosecutors offer each prisoner a bargain. Each prisoner is given the opportunity either to: betray the other by testifying that the other committed the crime, or to cooperate with the other by remaining silent. The offer is:
- If A and B each betray the other, each of them serves 2 years in prison
- If A betrays B but B remains silent, A will be set free and B will serve 3 years in prison (and vice versa)
- If A and B both remain silent, both of them will only serve 1 year in prison (on the lesser charge)
It is implied that the prisoners will have no opportunity to reward or punish their partner other than the prison sentences they get, and that their decision will not affect their reputation in the future. Because betraying a partner offers a greater reward than cooperating with him, all purely rational self-interested prisoners would betray the other, and so the only possible outcome for two purely rational prisoners is for them to betray each other. The interesting part of this result is that pursuing individual reward logically leads both of the prisoners to betray, when they would get a better reward if they both kept silent. They also cannot trust that the other will not betray so they do not want to remain silent.
The prisoner’s dilemma is one way to help explain the oil production issue both internally in OPEC (the Organization of the Petroleum Exporting Countries) and between OPEC and the other producers, such as shale. If Saudi Arabia cuts production but nobody else does, they would suffer a net loss. Oil prices would go up on a per barrel basis but they would be producing less than they did before, while all other producers would be getting more per barrel and producing the same amount as they had been. However, if all producers cut by some agreed upon level, perhaps based on current market share, all would benefit on an equal basis as prices would increase but market share split would remain the same.
Three decades ago, the spike in prices caused by the 1973 Arab oil embargo and Iran's 1979 revolution sapped global oil demand, while the discovery of oil offshore in the North Sea spurred a new influx of non-OPEC crude.
With world markets awash in oil, Saudi Arabia embarked on a strategy of defending prices, which at the time were largely set by exporters rather than the futures market, like it is today. The kingdom slashed its own output from more than 10 million barrels per day in 1980 to less than 2.5 million bpd in 1985-86.
Other producers failed to follow suit, however, both within the Organization of the Petroleum Exporting Countries and among new petroleum powers such as Britain and Norway. Prices fell into a years-long slump, leading to 16 years of Saudi budget deficits that left the country deeply in debt.
During the 1980s, Riyadh learned the hard way that it could not count on fellow OPEC producers, many of whom continued to pump at higher rates than their agreed-upon quotas, leaving Saudi Arabia to bear the brunt of output cuts.
It was not until late 1985 that the issue came to a head. Finally, in 1985, Riyadh shifted gears, revving up output and cutting prices in a move that triggered a final slump in markets, driving prices down to $10 a barrel but reestablishing themselves in the market. It took 16 years for prices to fully recover.
Source:
http://www.oilsandsmagazine.com/why-its-looking-a-lot-like-1986-in-the-oil-markets/ September 16, 2015
In the 1980s, it was a drop in U.S. and European consumption coupled with the rise of the North Sea; now it is fears of easing demand from Asia and the unexpected growth of U.S. shale oil.
The discussion around production cuts is much more difficult this time around as well, as there are so many more players. The U.S. and Saudi Arabia are the largest producers from a market share perspective, at about 13% each, but there are 22 other countries with at least a 1% share, with Russia being the next largest at 12.2%.
Source: Bloomberg, December 31, 2014
Saudi Arabia is likely the best positioned to withstand lower oil prices the longest as they have nearly $650 billion in foreign reserves. The International Monetary Fund believes that it will take five years to deplete those reserves at current government policy and oil price levels. It is unlikely that any other country or company can withstand the price pressure as long.
The oil price direction comes down mostly to supply/demand fundamentals and there is currently two million barrels per day of excess supply but had been as much as 4 million bbl/day only six months ago. There was a short term surge in demand, as we had record miles driven in the U.S.
Source: Bloomberg, October 31, 2015
At current levels, oil producers would only need to cut production by two percent in order to create supply/demand equilibrium on a daily basis, should demand remain constant. Even after equilibrium is created, there is still the issue of the 500 million barrels of inventory that has built up, an increase of 35% over the last year. To reduce that inventory, you need an additional five percent cut in production across the board, equal to a seven percent total cut in production. This seems like the logical choice (i.e. choice C in the prisoner’s dilemma), where everyone involved would benefit.
Saudi Arabia has recently announced that they would be open to cutting production should there be agreement among other global producers, both OPEC and non-OPEC. Within OPEC, the major issue is the long-standing geo-political issues between various members. For non-OPEC, this would entail getting buy-in from both Russia and the United States. Two major problems exist for this agreement to occur. First Russia has no desire to agree to any cuts in production and secondly the United States oil production comes from independent corporations rather than state-owned enterprises. These companies are often public, have shareholders to please and believe in a free market economy. Furthermore, once an oil company has invested huge sums of money in building an operating platform and the oil is flowing, the supply from that operation is not sensitive to fluctuations in the price: you don’t turn the tap off just because the oil price falls. The U.S. oil market is comprised of many companies with different needs and desires. There is no “Mr. Shale” that can be summoned to the negotiation table. Even if you could get somehow get a unanimous agreement to cut production, you would still be facing the prisoner’s dilemma.
Although, the industry is unlikely to agree to a widespread production cut, it may not be needed. While a cut to production would result in an immediate jump in oil prices, we are likely to see a slowdown in production throughout 2016, leading to a gradual increase in price. In the United States, total rig count has declined 62% over the last year, from 1920 to 737, and oil-only rig count has declined 65%.
Craig Bethune, portfolio manager comments, “Near term I would expect oil prices to remain subdued due to elevated storage levels and continued strong production from OPEC, however the current price near $40 is exerting considerable pressure on industry funding and on the finances of the OPEC producers. This will lead to higher industry production declines due to significant cuts to investment, and we expect non-OPEC production growth to go negative in 2016. Demand remains quite robust with the low oil prices today, with 2015 having the second highest demand growth in a decade despite modest economic growth globally. Further demand growth is expected in 2016, especially with the low crude and gasoline prices globally.”
The prisoner’s dilemma is a simple way to look at the issue of oversupply but in reality, it is much more complicated. Given the unlikely change in supply/demand fundamentals in the near term, we can expect to see oil prices remain range bound. It will be key to keep a focus on data over the next number of months for signs of a change in production, specifically downward, which could lead to an attractive entry point into energy companies.
Key Statistics (week-over-week)
Ending December 4, 2015
Weekly Change
YTD
MSCI World Index (USD)
-0.3%
-0.9%
S&P 500 Index (USD)
0.1%
1.6%
S&P/TSX Composite Index
-0.1%
-8.7%
MSCI Europe Index (EUR)
-3.6%
7.0%
MSCI Emerging Market Index (USD)
-1.7%
-15.1%
Hang Seng (HKD)
0.8%
-5.8%
Topix Index (JPY)
-1.3%
11.8%
Current Week
Last Week
CAD/USD
$0.7484
$0.7479
EUR/USD
$1.0881
$1.0593
USD/JPY
¥123.11
¥122.80
10-Year US Treasury Yield
2.27%
2.22%
10-Year GoC Yield
1.58%
1.57%
Gold USD/oz.
$1,086.84
$1,057.41
Oil USD/bbl.
$39.97
$41.71
Source: Bloomberg
Investing involves risk, and there is always the potential of losing money when you invest in securities. It is important that you consider this information in the context of your personal risk tolerance and investment goals. Before acting on the information provided, you should consider suitability for your circumstances and, if necessary, seek professional advice.
The natural resources industry can be significantly affected by events relating to international political and economic developments, energy conservation, the success of exploration projects, commodity prices, and taxes and other governmental regulations.
Global events have resulted, and may continue to result, in an unusually high degree of volatility in the financial markets, both domestic and foreign.
Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.
This material, intended for the exclusive use by the recipients who are allowable to receive this document under the applicable laws and regulations of the relevant jurisdictions, was produced by and the opinions expressed are those of Manulife Asset Management as of the date of this publication, and are subject to change based on market and other conditions. The information and/or analysis contained in this material have been compiled or arrived at from sources believed to be reliable but Manulife Asset Management does not make any representation as to their accuracy, correctness, usefulness or completeness and does not accept liability for any loss arising from the use hereof or the information and/or analysis contained herein. The information in this document including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Asset Management disclaims any responsibility to update such information. Neither Manulife Asset Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained herein.
All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife Financial, Manulife Asset ManagementTM, nor any of their affiliates or representatives is providing tax, investment or legal advice. Past performance does not guarantee future results. This material was prepared solely for informational purposes, does not constitute an offer or an invitation by or on behalf of Manulife Asset Management to any person to buy or sell any security and is no indication of trading intent in any fund or account managed by Manulife Asset Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Unless otherwise specified, all data is sourced from Manulife Asset Management.
Manulife Asset Management
Manulife Asset Management is the global asset management arm of Manulife Financial Corporation (“Manulife”). Manulife Asset Management and its affiliates provide comprehensive asset management solutions for institutional investors and investment funds in key markets around the world. This investment expertise extends across a broad range of public and private asset classes, as well as asset allocation solutions. Manulife Asset Management has investment offices in the United States, Canada, the United Kingdom, Japan, Hong Kong, and throughout Asia. Where appropriate, Manulife entities are registered with appropriate regulatory authorities in the jurisdictions in which they are required to be registered to carry on their respective business activities. Additional information about Manulife Asset Management may be found at ManulifeAM.com
Manulife, Manulife Asset Management, the Block Design, the Four Cube Design, and Strong Reliable Trustworthy Forward-thinking are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.