[my letter to the Wall Street Journal op-ed department]

Saudi Arabia is trying to emerge from its oil-dependent past: whether it’s selling shares in Aramco, or the many public works projects or its employment initiatives.  It’s curious that for a country that wants to move forward, they are resorting to millennia-old flea market bargaining tactics.  “Walking away from a deal” doesn’t work very well when the country you wanted a concession from (Iran) didn’t even bother to attend the negotiation.  If they truly want to break from the past, they should think more outside-the-box, and consider making use of a modern mechanism – crowdfunding – to achieve their goals.

One of the more memorable examples from business school was the following:

If there are 96 pants that must be sold and 94 customers needing just one, prices are going towards zero.  Prices are going to keep getting pushed down as no one wants to have one of the 2 pants that don’t get sold.  If you burn 4 pants, prices are going to skyrocket, as no one wants to be one of the 2 that go pants-less.  The oil market is similar to this example because the supply and demand curves are very steep in the short term.  Just a small nudge could send prices skyrocketing (in either direction).

Basic game theory says that the old OPEC production cuts won’t work.  Most oil producers are currently running massive fiscal deficits so the urge to cheat is great.  As a result, the members weren’t even looking for cuts in production at the Doha meeting.  All they wanted was a freeze in production, and they couldn’t even agree to that!  It’s questionable that a freeze in production could have made much of an impact on the markets anyway.

Here is my suggestion that should lift oil prices while cementing Saudi Arabia’s role as the dominant player in the oil markets.  You only need ONE country to cut production.  What if Saudi Arabia just came out and said they would reduce their own production by 32%?  Saudi Arabia cutting 32% is the equivalent of all of OPEC cutting 10%.  This would cause a 2 million barrel per day deficit in supply (from the current 2mbd oversupply).

Why would Saudi Arabia (“SA”) do this?  They get paid – using a crowd funding model.  There are many possibilities on how this could be structured.  Consider a sample model where SA gets a pledge from 65% of the world’s oil production to pay them 15% of all oil revenues above $45 per barrel (currently $41).  Saudi Arabia’s break-even would be less than $53 – below this SA loses money (as compared to current production and current $41 oil), and above this is all gravy.  SA is taking a risk, but is it really a “risk” to say if they cut production by 32%, oil would spike by $12?  Oil could double.

If you are a producer, wouldn’t you like the idea of a free bump in oil prices to $45?  The only cost would be fifteen cents for every $1 that oil prices are above $45.  If oil gets back to $85, are you going to complain that you had to pay SA $6 per barrel?  With the old OPEC system, you had to give up something up front (production), to possibly get something (higher prices).  With this system, you have NO risk as a producer.  If you sign up and oil sits here, you lose nothing!  You are incentivized to pledge because just putting in a pledge could drive oil prices higher.  If you don’t pledge, and this deal does not get done, you get NOTHING.  Some participants may like the idea more than others, and those entities could pledge more.  The pledges don’t just have to come from countries – they can come from any company or even individual that can benefit from higher oil.

This system would also cement Saudi Arabia’s role as THE most important oil producer.  A country with only 12.7% of the world market will dominate the oil world.  Never underestimate ego.  Other benefits to Saudi Arabia are that they can save their limited oil resources for later, and they can use the idled resources to reinvent their economy for the future.

There will be many details that need to be worked out as well as political and legal hurdles.  I realize I shouldn’t be helping the producers manipulate prices.  However, I wanted to discuss new approaches to thinking about old problems.  This framework makes more sense from a game theory perspective than the traditional OPEC models.  I’ll consider this my gift to the Arab world in this time of turmoil and my west Texas neighbors.

 

Joseph Choi

President, Curve Advisor

Double Oak, TX