Unit 3: Cartels and game theory - The Oil Industry

The Organization of Petroleum Exporting Countries (OPEC) is an example of an oligopoly colluding overtly to fix the price of a barrel of oil - currently there are 12 members and according to OPEC they control 81% of crude oil reserves. One of OPEC's main aims is to “ensure stable oil prices, secure fair returns to producing countries and investors in the oil industry“. 

Prices have hardly been stable of late, in fact according to the Economist "the price of Brent crude fell over 25% from $115 a barrel in mid-June to under $85 in mid-October, before recovering a little". This great article is well worth a read as it goes into the global consequences of this fascinating turn of events in such a key market. But what caught my eye, in particular as we're not far off looking at oligopolies and game theory in A2 Microeconomics, was this Bloomberg article pointing out a potential breakdown of the OPEC price fixing agreement as predicted by the prisoner's dilemma and game theory:

"China is finding oil supplies 14,000 miles away, aided by the global rout in prices that’s left producers vying for new markets. PetroChina Co. said it bought Colombian crude for a northern refinery for the first time because it was good value. The transaction underscores how the world’s second-biggest oil consumer is benefiting as producers from the Middle East to Latin America vie for customers in Asia."

Part of the reason for this price fall is the rapid increase in US production (not a member of OPEC) - see graphic left - and the Saudi response was to INCREASE production by half a percent (causing other OPEC members to follow the Saudi lead) determined to protect their market share against non-cartel rivals. 

“OPEC appears to be gearing up for a price war,” Eugen Weinberg, head of commodities research at Commersbank , wrote on Oct. 2 - another feature of Oligopoly behaviour explained by the kinked demand curve. 

The prisoner's dilemma highlights the difficulty in cartels lasting any length of time as the temptation to break the agreement and reap the rewards is simply irresistible - now the US, Latin American and others not tied to OPEC are willing to sell for cheap, are we witnessing the beginning of the end of this cartel?

Possible question:

With reference to the Extract, assess reasons for Oil producing countries’ changing behaviour. Refer
to game theory in your answer. (16 Marks)