Cooperation Games
How Oil Markets behaved during the Iran-Israel Conflict this Week ?
We should talk about Nash Equilibrium
Originally published as a paper titled ‘Equilibrium points in n-person games’, in Proceedings of National Academy of Sciences (PNAS) in 1950, John Nash won a Nobel for this groundbreaking work in economics
He taught at the Department of Mathematics in Princeton. Most economists are failed mathematicians (yours truly - included), and at some point, we all fell hopelessly in love with the pure elegance of Nash equilibrium
‘tis mathematically beautiful, and it blends game theory with economics
Think about a group of oil producers in the middle east (such as The Organization of Petroleum Exporting Countries, OPEC). OPEC is an oil cartel, or as we call it in economics - an oligopoly
When we think about a number of oil producers,
While each individual producer might want to flood the market with oil to maximize his or her own revenues, but as a group, it makes no sense to do that. Why is that ?because, if each producer floods the market with oil, there is too much supply and the market cannot absorb all that supply, and when this happens, the price decreases. Classic economics, right ? supply is greater than demand and hence price decreases. You might sell product, but you are selling it at such a cheap price that you are indeed losing out on revenues you could have potentially made
Now, let us think of the opposite too
Producers might think constraining supply might lead to a price spike, and they can sell each barrel of oil at a higher price. But, if every producer thinks like that and they all constrain supply, then there simply isn’t enough supply to meet the global oil demand. Hence in this case, you lose revenue by not selling enough product when the market has more appetite for it
Or, even worse, because you have made this ingenious decision to constrain supply and reduce your own market share, you are opening the door for other producers not in the cartel (such as the United States and Guyana) to produce oil and meet the remaining demand
So, what is Nash Equilibrium ?
It is how a country chooses its own production level (Q) that would maximize its profit, by considering the output levels of all other countries in the oligopoly (OPEC)
In essence, no country can deviate from its chosen output level and expect to improve its profits
Why is that ? because if country A increases production, then too much supply leads to decrease in price and the country loses revenue by selling the product at such a cheap price. If country A increases production, then other countries might react by increasing their own (pre-agreed upon) production levels, which only decreases the price even more. When this happens, country A loses revenue even more by selling the product at a rapidly decreasing price. Saudi Arabia did this in 2020 to undercut its competitors (WSJ)
Au Contraire, if country A decreases production, it loses revenue by not selling enough product and thus losing market share in the process
So, Nash equilibrium is that definitive sweet spot … it is a country’s optimal (or, equilibrium) output level for oil, where if the said country, deviates from that output level (higher or lower) - it is likely to make less profits
That makes intuitive sense, right ? If the total demand is 100, and if everyone in the cartel is producing a combined total of 70, you don’t really want to produce more than 30, because if you do, supply exceeds demand, and the price per unit starts to decrease. The price decreases not only for you, but for everyone else too (as you all sell oil at one price on any given day) - and the group collectively makes less profit
If the demand is 100, and if everyone else produces a combined total of 70, you also don’t want to produce 20 (when you have the ability to produce 30), because you are losing out on profits you could have made by selling ten units more
So, your sweet spot is 30 - and that in a nutshell is your equilibrium output
You have to play ball with your competitors for the greater “good”. So, when you decide your output level, you need to choose it such that you maximize your profit, but you also need to consider how much all your competitors are producing when compared to the global demand for the product every day
That’s why Nash equilibrium is brilliant - it’s the stale-mate on a chessboard for co-operation games with n players
As his Nobel winning paper is fittingly titled, equilibrium points for n-person games, or … profit maximizing output levels for an oil cartel that has n producers in our case
John Nash also rendered Adam Smith incomplete. Smith’s theory of - if we all individually maximize our welfare (utility or happiness), then the society maximizes its own welfare is indeed incomplete when it comes to cooperation games
In cooperation games, you have to choose your output based on what maximizes your profit, by considering the output levels of your competitors. Oligopolistic pricing works based on Nash equilibrium, and the first time you understand the intuition behind it, you feel like you are floatin’ on air. I still remember that very day when I understood Nash equilibrium, I was in my 20s, I was hopelessly idealistic, and I was in Central Campus in Ann Arbor
I left academia a long time ago, and you’d be amazed how many people in the real world think theoretical economics is futility wrapped in futility, it’s mostly because they have neither read nor understood Nash, they either didn’t care or simply did not have the patience to do it
In one of my previous jobs, I had a data science manager who once told me that the supply demand curves taught in economics grad school are over-rated. Of course, please educate me dude, say more things … what other things you think are over-rated ?
Beyonce ? Taylor Swift ? Pecan pie ? A slice of pepperoni with warm melted cheese dripping from it ?
I nodded along as he spoke, with a look that had the subtext of,
‘Why in the world would You know about the elegance of a Nash curve ? You wouldn't know the elegance of a Nash curve if it’s Sofia Vergara and she is standing in your living room !’
Economics is poetry and Nash equilibrium is the undeniable testament for it
This is one of my favorite series : things happen in our world and the market reacts to it - immediately so
Lets see if it all make sense
After Israel killed the leader of Iran-backed Hezbollah, and sent in troops into Lebanon to minimize Hezbollah’s control in the region, things only escalated from there
and Iran retaliated by attacking Israel on 10/1 (last Tuesday)
The Strait of Hormuz is a narrow water-way that separates Iran from the Arabian peninsula (which includes countries such as Saudi Arabia, Yemen, Oman, UAE, Qatar, Kuwait and Bahrain). Hormuz also connects the Persian Gulf to the Arabian Sea and is a major artery for global oil shipment and trade
Iran and other gulf nations primarily use Hormuz to ship oil eastward, to countries in Asia such as China, Japan, South Korea and India
and westward, to Europe and the US
Source (University of Texas, Austin, Strauss Center)
One fifth of the world’s oil supply passes through the strait every day, and if Israel attacks Hormuz, it essentially means significant volatility in oil prices in the future. ClearView Energy Partners estimate that a seven day interruption can lead to a spike of $ 28 per barrel in oil price (WSJ)
The United States wants to support Israel in its retaliation, but Washington also does not want gasoline prices skyrocketing, with merely 29 days to go before the election
Brent Crude Futures essentially fix the price of oil for it to be delivered at a future date, regardless of the market price of oil at that said future date. Say, you buy futures at $ 75 per barrel for 12/1, then a barrel of oil will be delivered to you at $ 75, regardless of the market price of oil on 12/1. If the market price is $ 80 per barrel on 12/1, then you saved yourself five dollars per barrel
So, as businesses get nervous about price spikes due to conflict in the Middle East, they essentially want to lock in prices for the future. So, they buy futures, and as we buy more of anything, the price of it increases
As mentioned above, Iran attacked Israel on 10/1, and the Crude Oil futures market reacted to it
In addition to businesses, investors speculate on prices too, and they in all likelihood bought oil futures to take advantage of such spikes - and this buying increases the price of futures too
This is exactly how I would expect the market to behave - and it is exactly how it did behave
My faith in profit maximizing agents in our society continues to stand the test of time - both during times of war and peace
Reference : WSJ, Proceedings of National Academy of Sciences, Nobel Prize, University of Texas, Austin