The Prisoner’s Dilemma in Oil

oilCommodities and commodity-related investments are an important feature in the 2016 Capital Markets Forecast. This piece focuses primarily on the Prisoner’s Dilemma currently unfolding in the area of oil. For the full article as written in our Capital Markets Forecast, please click here.

Across the investment landscape in Market Risk, the opportunity top of mind for many investors is the potential for a rebound in commodity prices, most notably oil. Commodities, oil, and oil-related equities could rally, as assets tend to have sharp rallies when sentiment and technicals get overly bearish. However, the key word for us is “tradeable.” Assets do not decline directly to their ultimate bottoms but rather arrive there with brief stretches of bullish price action. A good example of this was March of 2015. Despite the media frenzy, we resisted calling a bottom in the oil price, citing our thesis that market did not yet understand the underlying oversupply story.

This scenario is playing out exactly as we expected. Last week’s sharp increase in oil was on short covering from the “plan” for the Saudis and Russians to freeze production. This was destined not to work. Today, crude-oil stockpiles are at record highs, and as of February 23, 2016, oil ministers from both Saudi Arabia and Iran vowed to continue production for the time being. Markets reacted with another drop in the oil price, as the WTI Index fell to ~$32 on February 24. In effect, what we have is a classic Prisoner’s Dilemma. And until this supply issue is resolved, oil and other oil-dependent asset classes will not hit their ultimate bottoms.

What is a Prisoner’s Dilemma?

The prisoner’s dilemma is classic game theory which explains why two (or more) rational persons/companies may not cooperate, even when it seems in their best interest to do so. Say we have two oil producers, both of whom are suffering revenue and profit erosion as the price of oil declines. In a world where price-fixing is either not allowed (per US government regulation) or not possible (as OPEC is far less effective than in the past), Producer A and Producer B can choose to either cut oil production or maintain it. Regardless of what the competition does, it is in each producer’s best interest to maintain production. However, by acting in their individual best interests, the producers actually do what is in their joint worst interests. We cannot underscore how crucial it is to understand this point. Each producer will keep pumping to gain market share, prolonging the price declines, which will perpetuate the need to pump further and keep supply at excess levels.

prisonersdilemma

Source: Balentine

 When will we finally see a bottom in oil prices?

We likely will not see this play out anytime soon, and in many ways we are just beginning. Politicizing, public decrees, and agreements may cause oil prices to surge up; however, broken promises and secret production will drive prices back down. In other words, investors should anticipate a lot of volatility in this space.

Only when producers truly lose their motivation to produce (typically via merger/acquisition or bankruptcy) will this dynamic cease, at which point the bear markets in oil-related and commodity-related investments may run their course. Until we see consolidation in the space amongst the producers with better balance sheets (i.e., without solvency concerns to allay), the supply of commodities will likely keep flowing, thus capping the potential return on commodity-related asset classes.

Once a bottom does occur, however, based on historical precedent, there will be plenty of opportunity to capture the upside vs. rushing in to try and catch a bottom. These bottoms tend to endure, as second-order and third-order ramifications from the price declines take time to manifest.

As this continues to play out, the themes of selectivity and being mindful of risk/reward tradeoffs in our Market Risk building block will prevail.

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