America Should Support U.S. Shale Oil Production against OPEC
A model through which to consider the confrontation
Yuichiro Kakutani, yk462@cornell.edu
Since 2012, OPEC has been increasing oil production despite falling prices created by a global oil surplus. With these moves, OPEC has initiated a de facto trade war against America over control of the global oil market. By initiating this trade war, OPEC plans to bleed temporary losses to choke off the U.S. shale oil industry, the new challenger to its oil monopoly, in order to restore OPEC’s dominant position in the global oil market. This struggle between the U.S. and OPEC can be easily simplified using Fearon’s bargaining model, which defines competition as a “disagreement between actors over the division of a finite quantity (Q = 1) of resource” — in this case, the US and OPEC are competing over the division of the large, but ultimately finite, international oil market1 . As the actors are competing over a finite resource where one side gains market share at the expense of the other, this is a zero sum game. The actors may a) resort to confrontation, or b) negotiate a division of the resource. A confrontation between the two actors, in this case a trade war between America and OPEC, will only result in either a) total victory or b) total defeat. Since stalemates are not modeled, there are only two outcomes for actors: either they win and capture all quantity of the resource (Qvictory = 1), or they lose and surrender all of it (Qdefeat = 0). There are only two possible results in this model since we assume that actors, once committed to confrontation, will fight to the bitter end until victory or defeat.
In a competitive situation, actors will first assess the expected gains from a confrontation, defined in this model as the Expected Value (EV)2 of a confrontation. One key assumption is that if the actors have a high EV, then they will resort to confrontation since they expect large gains from confrontation. The EV is the sum of the probability of victory outcome (Pvictory < 1) multiplied with Qvictory and probability of defeat outcome (Pdefeat= 1−Pvictory : Stalemate is impossible, so defeat is defined as lack of victory) multiplied with Qdefeat.Therefore, EV is:
EV=Pvictory*Qvictory-(1-Pvictory)*Qdefeat=Pvictory*(1)-(1-Pvictory)*(0) EV=Pvictory
Thus, the expected gains from confrontation equals the probability of victory. Therefore, rational actors are more likely to resort to confrontation if they have a good chance of winning the confrontation. OPEC behavior is consistent with this conclusion. Funded primarily by speculators who will abandon the project at the first sight of weakness, the budding U.S. shale oil industry is no match in a direct confrontation with the state-sponsored oil industry of OPEC. In addition, U.S. Shale production has a much higher cost per production of one gallon of oil.3 At the same time and cost Americans extract one gallon of oil, OPEC nations can extract three. These advantages for OPEC nations meant that Pvictory for OPEC is a large number — therefore, EV was large enough for OPEC to confidently begin a confrontational trade war with the U.S.
However, we must remember that a confrontational trade war will impose costs on both actors, regardless of which actor wins or loses. OPEC, blinded by the optimistic outlooks of victory, is not aware that, no matter how likely an actor is to win a confrontation, sometimes, the prohibitive cost of engaging in confrontation may far exceed any benefits of victory. Fearon models the toll of resorting to confrontation by subtracting the Confrontation cost © from EV — the net gain from a confrontation is actually:
EV = Pvictory*Qvictory−C = Pvictory−C
Since different actors incur different costs from the same confrontation, the value of C varies between actors. Compared to the U.S, C is so large for OPEC that despite high Pvictory, OPEC EV is actually very low — therefore, rather than win a costly victory with more harm than good, OPEC will soon prefer to negotiate with the U.S. This assertion is supported by comparing the economic and political cost of a confrontational trade war for U.S. and OPEC, respectively.
Even if US shale oil industries were strained by a confrontational trade war, it’s economic cost will be marginal to limited because the US has a diverse economy — the abundance of other profitable domestic businesses minimizes the cost of an oil trade war to the health of the US economy as a whole. Similarly, a trade war would have marginal effect on U.S. access to capital, given its huge domestic capital pool and practically unlimited access to international capital. On the other hand, most OPEC nations have little diversity of domestic production, and small domestic capital pool and none to limited access to international capital. The oil-dependent OPEC economy would be severely compromised by even minor fluctuations in oil prices caused by a trade war. The economic cost is further exacerbated by OPEC’s low domestic capital reserve. While US domestic capital reserves are pooled in one huge domestic market, the capital of OPEC, spread thinly across its numerous member states, will be quickly cannibalized in a trade war. In addition, the OPEC economies will not be able to find ready lenders like the U.S. to cover public and private lenders either, as their low diversity, flammable economy is highly distrusted by creditors.
The economic upset from loss of oil revenue and depletion of domestic capital will also impose high political costs to confrontation. OPEC states, many of them illiberal dictatorships, suppress popular discontent with placatory social programs funded by the oil production. An exhausted economy will force the government to cut back on these social programs, which may reawaken dormant public discontent. Thus, an oil trade war has the ultimate cost for OPEC nations: the continued survival of the regime. On the other hand, the US regime, an entrenched liberal democracy, may experience some domestic discontent from loss in oil revenue, but can overall withstand even the worst effects of adverse economic conditions. The sum economic and political cost of a trade war, prohibitively high for OPEC nations, should convince even hardline OPEC jingoists to negotiate.
Unfortunately, OPEC, blinded by the prospects of easy victory, was not aware of the immense cost when they first initiated a trade war with the U.S in 2012. However, as the trade war drags on, OPEC nations across the world are realizing that while they will most likely prevail, the economic and political costs are too large to justify a confrontation. The Venezuelans are on the verge of paying the ultimate price of waging a trade war: total social and political collapse. Although not as bad as Venezuela’s, the Nigerian economy walks on tight ropes as oil price fluctuations creates enormous political and economic instability. Even Saudi Arabia, the powerhouse of OPEC, given the immense cost of waging a trade war and numerous proxy wars simultaneously, is estimated to deplete its foreign currency reserves by 2019, which will force them to reduce deficit by cutting down social handouts. The Saudis sweat that decreasing these handouts would be seen as a violation the semi-feudal contract between the people and monarchy of loyalty for prosperity, and hence may legitimate anti-regime Wahabism.
OPEC will soon retract their confrontational policies in favor of a negotiated bargain. Diplomacy is a successive stream of simultaneous decisions — unlike in Fearon’s model where a confrontation continues until one side prevails, in reality, actors can change policy from confrontation to negotiation when they see the writing on the wall, long before they suffer total defeat. And when the bargaining starts, the U.S. will negotiate from a position of strength. Usually, the strict internal discipline of OPEC allows them to negotiate on par with great powers. However, the dire state of member states has largely eroded this internal cohesion. Some members of OPEC experiencing particularly hard political-economic hardships will be satisfied with a smaller share as long as the oil trade war ends. Indeed, there is a growing internal faction within OPEC lead by Venezuela and Nigeria, the two OPEC states most hurt by the trade war, demanding an immediate end to trade war at whatever the cost for OPEC. The U.S. is in a rare position of being able to use the ‘divide and conquer’ strategy on an organization usually renowned for its internal cohesion, and should exploit its unique position to extract maximum concessions from OPEC.
Time is on our side; confrontation costs for OPEC rise every day. All we must do, is to outlast the siege until OPEC realizes the futility of confrontation and surrenders. The range of policy tools available to survive the siege will depend on the post-presidential election political climate, but since the two electable candidates are either mildly protectionist or vehemently mercantilist, both candidates once in office can a) enforce varying degrees of tariffs or b) distribute subsidies to domestic oil industry citing “fair trade” to “protect domestic oil production from an international oil oligarchy.” The potential benefits of protectionism are immense: low energy cost will stimulate the national economy, and resource autarky will reduce our need to intervene in unstable regions of the world that have marginal U.S. interest aside from their resources. An energy independent America is the future we must aim for.
