Camelot Portfolios Talking Points

Game Theory in Action for Crude Oil

In every beginner’s economics class, students are likely taught the law of supply, and the law of demand. When these laws interact with each other, they form an equilibrium. This fundamental economic idea is the basis for explaining markets around the world, and intellectuals have expanded economic thoughts to explain why markets work the way they work. One economist changed this belief about equilibrium into why markets gravitate towards sub-optimal equilibrium. Economist and mathematician John Nash explained the behavior around sub-optimal markets around this idea of game theory. This situation can be applied to crude oil, one of the most followed markets around the globe.

Since the rise of shale and other “ground-breaking” technologies in the crude industry, game theory rationally explains the concepts of the dilemma faced by OPEC and shale producers. The best example to simplify the sub optimal markets in oil is the prisoner’s dilemma. Assume there are two criminals arrested for a crime. There is an interrogation by the police, and each criminal is independently interrogated. If both of the criminals stay silent, they get 1 year in jail. If they confess to who committed, they walk free, and the other person has 5 years in jail. However, it they both confess they get two years in jail.

In this example, both of the criminals are likely to betray their fellow criminal. Their interest lies with a better outcome if one does not confess, and the other betrays. So it is expected both of the criminals to betray each other for their self-interests, and both will have to serve jail time.

Getting back to the oil industry, current events are operating in a similar way as the two criminals operate. Depicting the oil industry as criminals is not what this article is implying, rather the intentions of the major participants in the oil industry.

In a simplified version of current events in the oil market, OPEC tried to cut oil production in an effort to increase prices in the oil market about six months ago. Unsurprisingly, shale production did not seem to share the same thoughts as OPEC. Shale producers continued to ramp up production and have started to see a boost in revenues. Today, OPEC countries have lower revenues and continue to see a decreasing piece of the pie.

Looking back in history, the game was completely different since OPEC was the only game in town. They could make the decision to keep production or cut without harming market share. Rather than admitting to changing circumstances, economic losses for countries heavily dependent on oil production could continue.

Growth continues around the World

While the United States has seen market increases over the past six months, the tides in foreign market have turned towards the upside. Both the developed and the developing markets are positive after the first four month of the year. In Europe, Poland’s market index, WIG, is leading with 29.3 percent growth year-over -year, and Greece’s market index, Athens General, has grown 25.59 percent (Economics). In Asia, the developed Japanese market, Nikkei, has grown 19.05 percent, while Korea equity index, KOSPI, has grown 17.19 percent (Economics).

The tides have lifted the majority of markets around the world, yet some countries continue to struggle. In Africa, Kenyan’s market index, Nairobi 20, decreased 19.3 percent year-over-year (Economics). The Botswana stock market decreased 8.13 percent (Economics). In the Americas, Ecuador’s equity index, ECU, decreased 3.51 percent (Economics).

Overall, the majority of market indexes around the globe have seen increases in the past year. There are exceptions for some lagging countries because of political and economic instability.

Compiled by the Camelot Portfolios Investment Committee

Darren Munn, CFA, Chief Investment Officer

Eric Kartman, Research

Drew Steinman, CPA, Trader/Research

Frank Echelmeyer, MBA, CKA®, Advisor Consultant

-for Broker/Dealer and RIA use only-

References

Economics, Trading. Trading Economics. May 2017. 2017.

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