Friday, March 10, 2006

The Cepu dispute: a game theoretical perspective

I admit that I did not follow the Pertamina-ExxonMobile dispute over the Cepu block from the very beginning. I also admit that I don't have the perfect information about this controversy. Therefore I won't try to comment on detail about this, nor will I make a judgment on who should be the operator.

I just want to comment on one thing: will 'nationalism' (or similar arguments like 'beware of foreign intervention) make good basis for judgement? For some people, the answer is yes. And I respect that. But would that mean that the people of Banyuurip-Jambaran and Bojonegoro, who prefer ExxonMobile over Pertamina, less nationalistic than they are in the parliament building, or anyone claming to the 'people'?

Talking about nationalism, Kurtubi argued that whoever the operator is, the central government will always have 85% production share, and local government 1.5%.

So if nationalism would not make a good argument, what will? I don't know, frankly. But let me summarize the situation, but please let me know if I'm wrong. We know that oil exploration is a very risky business, and requires a significant amount of investment. And when one started the exploration, it takes some time before your investment start to make return. That's why if you are an oil explorer, you would want a guarantee that you can operate it for a certain period.

The key to the controversy is ExxonMobile wants to extend the exploration contract to another 30 years, from its initial expiration year 2010, after they found that the site have much more potentials. Pertamina argued that the contract can not be extended, and the operation should be transferred to Pertamina when the contract expired.

This can be illustrated by a simple game theory model. From ExxonMobile's perspective, you would 'produce' if you are guaranteed up to period n. If there is no guarantee, or the guarantee is less than n period (in this case beyond 2010), then the Subgame Perfect Nash Equilibrium would be 'not produce' at any period. Means the site would be idle from now until 2010. Even if Pertamina enters the production in 2010, there would be a few years to set up before production starts to be realized. If that's the case, there would be an oil production idle for about a decade. And we are an oil net importer already by now!

Again, I don't really know much about this issue. There is a broader dimension if this controversy, such as the legal aspect. Was Exxon's acquisition of Humpuss legal? And so on. [By the way, was Pertamina not really interested in Blok Cepu before ExxonMobile acquired in from Humpuss, then found out that the site was very prospective?]

What I know is, from the perspective of 'national interests' (whatever that means), clearly no one benefits from the prolonging uncertainty.


  1. It seems like a game theory framework is an overkill here. Exxonmobil simply needs to justify its further investment with guaranteed cashflows.

  2. Hi andersonite,
    you're right. but what makes it a game theory is because Exxon's decision depends on decision of the other agents (govt and Pertamina). and decision of each agent would affect the others' payoffs.

  3. Firstly, i am one of the fans of a.p. The ability to observe the actual issues in economy, combined with the superb theoritical foundation leads him in writing a good article/paper (May be it is part of Harvard Tradition he absorved during the study there at KSG:D)

    I like when people use game theoritical to analyze certain economic issue. Somehow, it has ability to explain certain economic puzzles.

    However, I think, in using the game theoritical analysis, there are several key assumptions that have to be made:

    1. Rules of the game. Is it reapeted or just one shot game? How many period that the game will be played ? Infinitely, finite?

    What about this game?

    2. Assumption on the behaviour of the agents. Do they satisfy the rationality assumption in the standard game theory? I think, in standar game theory, and any equlibria embedded in the standard game theory (NE, MNE, SPNE, PE, etc) all assume that the agents are rational. If this assumption do not hold, I think we should use the evolutionary or behavioural game theory. it certianly need more rigor analysis.

    What about Exxon, Gov't and Pertamina game?

    3. Specific strategy and actions of the agents (obviously strategy is not the same as actions except for very simple game, we could get the same results).

    What is the pay-offs of the gov't and Pertamina if they are doing so (not giving the certainty for Exxon for minimum n period)?.

    thus, a.p would you please add additional infos on the game theoritical analysis u use in exxon case?



    The Loner

  4. to loner:

    1. in this case, we can model both. we can see it as a one-shot game -- extend the contract to 2040 or not; or a (finitely) repeated game if we think that once the contract extension is given, the government can always revise it each year/period. the conclusion does not change much, though.

    2. about rationality -- I don't see any reasons why both Exxon and Pertamina should be irrational. the tricky thing is to model the behavior of the government. but we can always see gov't decision as the result of competing political interests. so, even though it does not maximize financial payoff, does not mean tha the govt is not rational.

    3. you're right, strategy is a collection of action. so for the govt, the strategy would be (extend, not extend). for Exxon is (produce, not produce). I deliberately ignored the analysis for Pertamina, for simplicity reason. but once we understand the simple thing, we can always make it more complicated, can't we?

  5. Interesting and important issues re: oil

    1. What US geological survey results regarding global oil reserve really are?

    2. Global oil-age is estimated to be last just for another 4 decades( 2040s)

    3. But, OPEC will monopoly global Oil in around 14 years (by 2020)

    4. High oil prices affect highly-indebted oil-importing developing countries most because their oil-intensities of production are much higher than industrial economies; they have limited access to International capital to finance or make stable their oil & non-oil imports; resulting in depreciation of their currency, depleted domestic consumption, investment and eventually output. Industrial economies are the otherwise, oil-intensiies of production have been reduced, much access to international capital, etc so no negative impact on their output due to high oil price.

    (sources: OECD ; OPEC
    ; and CIA )

    Long-term prospect: Is the remaining four-decade of oil proved-reserves a big question?

    Should there be no more new oil discoveries, at current consumption rates, existing global oil proved-reserves would be exhausted in less than 40 years. In 2004, global oil proved-reserves were around 1,144 billion barrels, and global oil consumption was around 30.33 billion barrels per annum (Indonesia's oil proved reserve in 2005 is estimated to be only 4.6 billion barrels, US in 2002 is 22.5 bill barrels, Canada 178.9 bill barrels, see CIA website).

    Both figures are still increasing. However, assuming both figures are constant, global oil proved-reserves will be exhausted in 37.72 years.

    Nevertheless, oil proved-reserves-to-production ratio has changed little over the past two decades, particularly in the 1990s.
    In the 1980s where oil prices were high, there had been numerous new oil discoveries. Oil proved-reserves increased by an unprecedented pace far surpassing the increases in global oil demand. Thus oil proved-reserves rose from only 625 billion barrels in 1980 to 1,000 billion barrels in 1990. However in the 1990s, although technology was better than the previous decade, this low and stable oil price period only brought 25 billion barrel increases in total to global oil proved-reserves by 2000 (compared with the 375 billion barrel increases in the 1980s). The latest statistic shows by 2004 proved-reserves had increased to 1,144 billion barrels. It is 144 billion barrel increases in just four years, compared with the 25 billion barrel increases in ten years in the previous episode. This trend is once again in parallel with the global oil price rise of the first half 2000s.

    According to U.S.’s 2000 Geological survey, there still remains considerable scope for substantial additions to reserves. And, the concept of proved reserves itself is linked to commercial viability and therefore reserves have increased in response both to oil price shifts and to technological changes, which have both allowed the extraction of new sources and increased the share of oil within a deposit that can be extracted. This means oil proved-reserves should remain ample for more than four decades to come.

    However, newly-discovered resources have tended to be smaller and more expensive to develop, being increasingly offshore, and the costs of exploration, development and production are higher than in the reserve-rich Middle East. Their distribution is also likely to be increasingly concentrated on the Middle Eastern members of Organization of Petroleum Exporting Countries (OPEC), which already account for around four-fifths of global proved reserves (Figure 15). With unproved-reserves concentrated in a limited number of OPEC countries in which investment is not allocated according to market forces, investment in the energy sector may not be sufficient and new oil discoveries would decelerate. The remaining four-decade only of oil time would once again be the most possible outturn.

    Furthermore, although OPEC’s current share in proved reserves is four-fifths; its share of current production is only two-fifths (Figure 16 and Table 2). At current market structure of production, existing non-OPEC oil reserved would be exhausted in just 13.5 years assuming there are no increases in non-OPEC proved reserves and global demand (worst scenario). OPEC would fully assume its monopoly power by then. Yet currently oil price hike has been in large part attributed to OPEC’s limited spare capacity (although it is somewhat a short-term issue) and OPEC has not gained its full monopoly position yet.

    Global investment, supply and price extrapolations are contingent upon the extent to which OPEC or a subset of OPEC countries (Saudi Arabia, Iran, Iraq, United Arab Emirates, Kuwait, Venezuela, Libya, Nigeria, Qatar, Algeria) will exercise its market power. Exploration, development, and extraction costs in the Middle East are reported to be less than $5 per barrel, while short-run marginal costs are generally estimated to be below $2 per barrel. Other suppliers face much higher, and probably more steeply increasing marginal costs than OPEC and the reserve-rich producers in the Middle East have incentives to exploit this cost advantage by trading off market share for a higher price. The less elastic global oil demand and non-OPEC supply (OECD–Canada and U.S.; CIS–Russia and Kazakhstan; Others–Mexico, Angola, China, and Brazil) are in the long run, the greater are OPEC’s incentives to restrict output and thus raise prices in the face of rising world demand.

    The longer-run supply and demand characteristics of the oil market are thus crucial determinants of future price trends. First, estimates of the long run non-OPEC price elasticity of supply vary from a low of 0.1 to a relatively high 0.6. Second, the elasticity of non-OPEC supply may be nonlinear insofar as at a certain point the oil price would be pushed up sufficiently to encourage investment to promote the production of (ample) non-conventional oil in other countries or alternative backstop technology, such as the liquefaction of other plentiful fossil fuels. For example, the cost of extraction of oil from tar sands in Canada has fallen considerably over past decades, and expectations of a sustained high oil price may trigger investment in expanding such activity. Third, higher prices induce investment in (non-reversible) energy-saving technology or substitution between fuels (natural gas, wind, solar, nuclear, etc.), tending to make the price elasticity of demand for oil asymmetric (the longer-run price elasticity of demand is higher than the short-run elasticity). The negative impact of an oil price rise on domestic demand and income will diminish over time as consumers and producers modify their behavior. However, research seems to indicate that there is an asymmetric effect, insofar as oil demand does not revert to its initial level as oil prices fall. In that case, the income losses experienced by energy importers may eventually be partly reversed. Where fluctuations in oil prices create uncertainty, there may be a reduction in trend investment activity, but it is less clear that the effects on profitability or capacity utilization are asymmetric.

    Finally, although global oil proved reserves are sufficient for four more decades to come, OPEC’s attainment of full oil monopoly power in just 3.5 years to come (worst scenario) has posed a considerable risk on the global economic sustainability. Will global dependence on oil have been reduced to a safe level by then? That is the real big question for global long-term energy plan.


    The significance of oil and effects of its price hikes on both oil-importing developing & industrial economies:

    In total volume terms, industrial economies still consume more than the developing economies—49.8 mbpd compared to 33.6 mbpd in 2005 (Table 2). Globally, demand for oil keeps rising every year from around 60 million barrels per day (mbpd) in the 1980s or around 22 billion barrels a year (bbpy) to around 70 mbpd in the 1990s or around 25.7 bbpy to around 80 mbpd in 2000-2005 or 29 bbpy with economies like the U.S., EU, China, Japan, Russia, India consuming the most (Table 3).

    U.S. and other oil-importing industrial economies as the most oil-consuming economy should suffer the most from increases in oil prices. However, over the past thirty years, oil intensity of production--total oil consumption per unit of output--has been declining in industrial economies. Figure 5 shows the oil intensity of production--total primary oil used per unit of output--in both developing and OECD economies. This is an outcome of more efficient use of oil, as ongoing fuel-saving technical change has contributed to continuing reductions of energy intensities, an increasing utilization of alternative energy sources, such as natural gas in power generation, and a shift in the composition of output towards less oil intensive sectors. Due to its lower oil-intensity of production, the more elastic demand of oil to prices, and the ample access to international capital to finance their imports, the terms-of-trade (imports that can be financed by exports) losses from oil price increases in industrial economies are getting smaller over time (Figure 6) and compared to developing economies. As a result, their currencies are relatively stable and there are no substantial reductions in consumption, investment and imports spending. These are shown by the still high current account balance deficit in industrial economies and smaller reduction in domestic demand compared to developing economies (Figure 7).

    Oil-importing developing economies, by contrast have generally undergone increases in oil intensity of production up to the mid 1990s -- partly reflecting a change in production structure towards manufacturing and increasing vehicle ownership -- before falling marginally. Moreover, developing economies have limited ability to attract capital flows in developing economies and the prices of non-oil commodities exported by developing economies sometimes do not increase as much as the price of oil, therefore the terms-of-trade losses suffered by developing economies from oil price increases are higher then the industrial economies. These then induce depreciation in their currencies and substantial reductions in consumption and investment spending and ultimately reduce spending on imports. (Figure 7).


  6. continue Re: the above articles from OECD publication

    Dunno whether they're factual and reflecting high-level importance in terms of oil issues.

    Would highly appreciate comments and inputs from a well-known economist like u ^o^

    m.t. (just love to learn interesting current issues)