Cooperate or Compete? Insights from Simulating a Global Oil Market with No Residual Supplier.

• Author: Rioux, Bertrand

1. INTRODUCTION

   The oil market is undergoing profound structural changes due to the tight oil revolution and the prospect of plateauing or peaking oil demand. These developments could induce either more cooperation or more competition between oil-producing countries. In this paper, we simulate a global oil market with no residual supplier that would organize production levels to manage the price of oil, i.e., a global market where all producers behave as competitive price takers.

   We develop an equilibrium model of the global oil market through 2030 with a detailed representation of oil-producing assets throughout the world. Rather than applying a dominant firm model with a competitive fringe, as is standard in oil modeling (Plaut 1981; Rauscher 1988; Jones 1990; Behar and Ritz 2017; Golombek et al. 2018; Volkmar 2019; Pierru et al. 2018; Pierru et al. 2020), we test cases under a competitive market with no residual supplier scenario in which every oil-producing country behaves as a price taker. In this case, investment and production decisions depend only on how marginal production cost compares to price. We analyze how market prices would potentially materialize in such a scenario.

   We then compare the outcomes of the hypothesized competitive market to an alternative reference residual supplier scenario. We examine two cases within this scenario: in the first, OPEC members collectively operate as a residual supplier; in the second, Saudi Arabia acts as the only residual supplier, and other OPEC members join the competitive fringe. In both instances, the residual supplier follows a price targeting strategy: it adds or subtracts oil from the market to achieve the desired global market price, based upon how much is being supplied by the fringe. (1) We calculate Saudi Arabia's oil revenues in the different scenarios and examine which market configuration is the most profitable for Saudi Arabia. This analysis has implications for Saudi Arabia's potential willingness to fill the role of residual supplier.

   The two residual supplier cases reflect different perspectives within the research community. While some studies treat OPEC as the world's dominant oil firm (Rauscher 1988; Jones 1990), others (Plaut 1981; Adelman 1995) argue that Saudi Arabia performs the role of the dominant firm within OPEC when its members fail to coordinate the organization's output. In a review of the evolution of OPEC models, Fattouh and Mahadeva (2013) concluded that OPEC's market power has varied over time and thus that no single model fits OPEC's behavior. Behar and Ritz (2017) suggest that OPEC can shift to a market share strategy in certain circumstances.

   Following the oil crisis of the 1970s, the literature on the strategies of oil-producers (especially OPEC) regarding pricing and production decisions has grown substantially (e.g. Powell 1990; Gately 1995). The geopolitical environment and oil market structure are much different today than in the 1980s-90s. First, the market has been transformed by a combination of increasing production and declining costs of unconventional tight oil, weakening OPEC's market dominance and its ability to influence prices. Second, non-OPEC oil supply has grown at a different pace than global oil demand. Third, legislative attempts, such as the No Oil Producing and Exporting Cartels (NOPEC) Act, which was proposed by the United States (U.S.) Congress to allow the national oil companies that make up OPEC to be sued under U.S. antitrust law, may potentially make it difficult for OPEC to engage in coordinated cuts in world oil supply (Rystad Energy 2018b; Reuters 2019).

   To our knowledge, the only other study that investigates the implications of a competitive market is by Bornstein et al. (2019) who developed an equilibrium model of the oil industry. The parameters of the model are estimated using micro-level (oil company) data covering the 1970-2015 period. The paper considers two alternative market structures. In the first structure, both OPEC and non-OPEC companies behave competitively, whereas in the second, OPEC companies cooperate, and non-OPEC companies are a competitive fringe. Then using variance decomposition and impulse-response functions, the paper measures the impacts of exogenous demand shocks and supply disruptions on prices, production, and investment. The results show that although demand and supply shocks affect similarly the variance of prices in both market structures, the market structure has a significant impact on steady-state oil prices. Within the same framework, the authors also study the implications of introducing competitive fracking and show that the volatility of oil prices declines with the increase in the share of fracking production in total oil production.

   Our paper differs from Bornstein et al. (2019) in several aspects. First, to simulate a world oil market with and without a residual supplier, we take an equilibrium approach based on piecewise linear supply curves, deterministic price patterns, and a demand function calibrated to a reference outlook, whereas Bornstein et al. (2019) focus on demand and supply shocks in alternative market structures. Second, unlike Bornstein et al. (2019) who use historical data for modeling and evaluation, we design scenarios based on institutional projections. Third, Bornstein et al. (2019) do not consider the availability of capital for investment in the oil industry. We simulate various scenarios taking into account financial constraints and compare the outcomes of alternative market structures. Thus, our simulations enable us to analyze what would happen if investors and financial institutions shift away from the upstream oil sector. Finally, Bornstein et al. (2019) do not look at the implications of market structure for Saudi Arabia while we simulate Saudi Arabia's free cash flows under alternative market assumptions.

   The framework we propose and the simulations we perform provide useful insights regarding the implications of a competitive oil market. Hence, we believe that our study contributes to the debates over the future of the global oil market and the significance of the residual supplier role traditionally filled by Saudi Arabia and OPEC.

   The next section describes the representation of demand, the decision rules for producers, and other features of the model. Section 3 details scenarios that explore the consequences of structural changes in the world oil market, including the role of the residual supplier, and different scenarios regarding investment in new oil production capacity. Section 4 discusses the results and their interpretation. Finally, Section 5 offers concluding remarks.

2. MODEL DESCRIPTION

   We build an aggregate model of the global oil market within an equilibrium framework in which price clears the market. The discussion below describes the supply and demand representations and provides a comparison to techniques used in other world oil market models. Online Appendix A provides the complete mathematical formulation with equations.

   The model simulates the medium-term consequences of a market with and without a residual supplier. First, to calibrate our demand outlook, we establish a reference residual supplier scenario in which the residual supplier targets a given oil price by increasing or decreasing production in response to the total output of all other suppliers, treated as fringe competitors. Then we solve for the market equilibrium under the competitive scenarios where all producers behave as price takers (no residual supplier). The model also estimates the financial consequences for different suppliers in terms of oil revenues.

   In the model, the world oil market clears, for all periods simultaneously, with demand balancing supply on an annual basis, for all hydrocarbon liquids including crude oil, condensates, natural gas liquids (NGL), refinery gains and other liquids (biofuels and alcohols destined for the same market as petroleum products). We represent global demand and supply as a single node and do not account for regional crude flows. (2)

   2.1 Representation of global oil demand

   The following equation (1) specifies total world oil demand in each year t ([D.sub.t])

   [PLEASE DOWNLOAD THE PDF TO VIEW THE MATHEMATICAL EXPRESSION] (1)

   where [A.sub.t] is a scaling parameter capturing the effects of all exogenous factors, and [p.sub.t] is the three-year moving average market price. We consider a single global oil price based on the Brent Crude oil marker. [Y.sub.t] is the current global gross domestic product (GDP), [epsilon] is the long-run price elasticity of oil demand, and [gamma] is the long-run income elasticity of oil demand, or the impact of global GDP. The price elasticity of demand is applied to the three-year moving average price to reflect the lag on the impact of oil prices on demand (Hamilton 2003; Kilian 2008).

   Global GDP in year t is given by

   [Please download the PDF to view the mathematical expression] (2)

   where [g.sub.t] is a reference GDP growth rate. The ratio [p.sub.t] / [p.sub.t] in equation (2) represents the impact of prices on GDP growth, where [p.sub.t] is the three-year average reference price linked to the reference GDP growth. The parameter [theta] can be interpreted as the elasticity of real economic growth with respect to variations in the price of oil. For instance, if the moving average oil price ([p.sub.t]) is higher than that of the reference level ([p.sub.t]), then for [theta]

   A straightforward way to specify equations (1) and (2) is to use elasticity estimates available in the literature. Then, [A.sub.t] can be calibrated based on consistent projections from a desired reference case (i.e., using the expected oil demand [D.sub.t] moving average oil price [p.sub.t] and global GDP [Y.sub.t] in the reference scenario). We show in the online Appendix A.4 that an approximate value of [theta] can be obtained by formulating a time series equation that relates...