OPEC and the tragedy of the commons - why its members will cheat

This is OPEC's basic problem and it has no solution

US opening-market oil prices are presently up from Friday's close, although prices dropped about one percent over the weekend in Asian markets after the US rig count showed a net gain. Brent oil futures have topped $55 per barrel, its highest level in 18 months.

The bull market for oil is still resounding from OPEC's Nov. 30 deal to cut production by 1.2 million barrels per day. OPEC is also seeking another 600,000-bpd cut by non-OPEC countries, with half coming from Russia. Russia has already said it would and by the end of Dec. 10 we should know whether other non-OPEC producers will meet the goal.

But here's the thing: oil production both in and out of OPEC is already at near all-time highs and has been rising since summer. OPEC and other producers have been running production up preparing for a deal to run it part-way down.

Example:

Russia on Friday reported average daily oil production of 11.21 million bpd for November - its highest in almost 30 years.

And while Moscow has agreed to cut its output by 300,000 bpd in early 2017, it said it would do so against November levels. That means that even after a reduction, its output would remain higher than it was at the peak of the oil glut in the first half of 2016.

Jeffrey Halley of brokerage OANDA in Singapore said oil traders were "nervous (as) Russia's output has hit record levels, meaning their part of the production cut takes them back to what they were producing only quite recently". 

In the Middle East, where the deepest OPEC production cuts are expected, there are also signs that production will rise before it gets cut.

Saudi Arabia and Kuwait are expected to agree this month to resume oil production, with a potential of 300,000 barrels in daily output, from jointly operated oilfields which were shut down between 2014 and 2015 for environmental and technical difficulties.

This is cheating on the agreement in advance of when it kicks in next month. And producers' track record on keeping such agreements is really, really lousy. Brown University professor Jeff Colgan wrote in Foreign Affairs in October, after the Nov. 30 summit had been announced, that historically OPEC's deals have been meaningless:

In a detailed analysis of OPEC’s behavior since 1982, I found that OPEC cheated on its own aggregate production target a whopping 96 percent of the time—and every member is guilty of taking part. Worse still, changes in production targets had almost no impact on production itself. Maybe 2016 will be different, but this pattern cannot be ignored.

OPEC’s main problem is that it has no real way of enforcing its agreements. Members such as Algeria, Iraq, and Venezuela typically want the organization to do what cartels do: constrain oil supplies and raise world prices. But even though they understand that restraint would benefit the organization as a whole, they are not usually willing to sacrifice their own output. 

Any economist understands this almost intuitively. Its the classic "tragedy of the commons."

The tragedy of the commons is an economic problem in which every individual tries to reap the greatest benefit from a given resource. As the demand for the resource overwhelms the supply, every individual who consumes an additional unit directly harms others who can no longer enjoy the benefits. Generally, the resource of interest is easily available to all individuals; the tragedy of the commons occurs when individuals neglect the well-being of society in the pursuit of personal gain.

Understand that in the worldwide oil commons, the "given resource" is not oil, but dollars. To restate the definition:

As the demand for dollars overwhelms the supply (because of falling oil prices), every oil-producing nation that keeps producing high levels gains revenue at the expense of nations that cut production. Generally, dollars are easily available to all producers; the tragedy of the commons occurs when individual nations neglect the revenue of other producers to maximize their own revenue.

This kind of behavior is universal no matter the "given resource."

The concept and name originate in an essay written in 1833 by the Victorian economist William Forster Lloyd, who used a hypothetical example of the effects of unregulated grazing on common land (then colloquially called "the commons") in the British Isles. The concept became widely known over a century later due to an article written by the ecologist Garrett Hardin in 1968. In this context, commons is taken to mean any shared and unregulated resource such as atmosphere, oceans, rivers, fish stocks, or even an office refrigerator.

As Brown demonstrated, 96 percent of the time OPEC's members follow the commons principle quickly and readily. There is no reason to expect anything different this time except, perhaps, that cheating will occur sooner this time than before because most member states are more cash crunched than they were in prior agreements.

End note: One more thing to remember about the OPEC deal. It is an agreement to reduce oil production but is silent on oil exports.

It is also worth noting that the OPEC agreement refers only to production, not exports. The Saudis have been shipping crude from a stockpile of near 280 million barrels and will continue to meet its market commitments from those stockpiles. Cutting production by half a million barrels a day has no short-term impact on how much oil the Saudis export.

In September, for example, Saudi Arabia’s crude stocks dropped by about 2.3 million barrels, according to JODI data, and the country ended the month with 278.7 million barrels in its stockpile. 

In 2015, the latest year for which I could find figures, Saudi Arabia exported 7,163,300 bpd and produced 10,192, 600, for a net stockpile gain of three million (rounded) bpd. Some of that excess the country uses for itself, of course, but even so it has been stockpiling oil a long time. Even if Saudi Arabia cuts production by its agreed-upon rate of 500,000 bpd, it can keep exports unchanged for at least 18 months.

Update: Here are the bpd production charts of every OPEC nation, by quarter, since January 2005. Here is the overall OPEC chart:

Even at almost 34 million bpd, OPEC's share of global oil supply is less than 35 percent and shrinking. And that's before the cuts kick in next month.