Commentary – Two-for-one Pizzas, One-Dollar Airline Tickets and $40 Oil
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I’m watching the screen. Every dollar knocked off a barrel of oil shakes the market like a mortar shell. This is war. World war. It’s a price war between the corporate foot soldiers of major oil producing nations.
Oil prices have halved in three short months and the early casualties are starting to come in. Severe budget cuts. Wounded bank accounts. Bankruptcies. Shell shocked bankers. At a national level, some producing nations like Venezuela are already limping. The fog of this price war has just set in and it’s hard for stakeholders in this business to see much beyond a lot of pain.
So, what comes next in this global oil conflict? What will constitute a victory? Which participants will win and lose? When will it be over? What are the consequences? Is market stability possible going forward? How should we think about answering these questions?
Let’s start by turning away from flickering price quotes and spreadsheets that go stale in a week. It’s time to dust off some literature on the subject of price wars. Safe to say, fighting on price to sell competitive products is quite common in the business world. So, oil executives can learn a thing or two from the front lines of two-for-one pizzas and one-dollar airline tickets.
But first, what constitutes a price war? Academic studies propose many definitions. Excessive competition that leads to rapidly falling price is one. But the war becomes real when combatants get wounded with costs that are above what is needed to replace production. Poor investment returns that don’t justify sinking further capital into the business is another signal that players are duking it out beyond reason. A more severe characterization necessitates that some competitors succumb to “market death.” Already, the corporate oil morgue has welcomed a few early bankruptcies and be assured, more are on the way. But the broad criterion that captures the essence of it all is quite simple: You know it’s a price war when the long-term viability of the players in the fray is not sustainable.
So, the global oil business is in a price war by nearly every definition. At $50/B the industry can neither grow nor even sustain output to meet future demand.
What started this mess? Academic studies on price wars conclude that many factors can lead to the firing of the first shot. A sudden softening of demand (think China) is often an early warning signal to defend market share. On the supply side, protecting turf is a common reason for one or more participants to arm the red button. For example, a strong incumbent is often inclined to attack the market with all guns blazing in order to destroy a brazen new entrant that is bringing on new capacity. In this regard, market analysts are pointing to Saudi Arabia as the heavyweight that’s intent on destroying US and Canadian tight oil producers. For sure, it’s in the Kingdom’s interest to get rid of the sudden, unwelcome 3.5 MMB/d that’s been lobbed into the market over the past five years.
Many people ask, “Why don’t other OPEC members, or the Russians reign in production by a little bit each to help boost prices?” The answer is, “That’s not how competitors react in the early days of a price war.” In fact, producers have a tendency to produce even more when price first falls, because they try to offset revenue loss by boosting output. Data from October and November of last year shows this pattern of behaviour in Russia, Iraq, Libya, the US and even Canada to name a few competitors. All of which means we should expect more production and potentially lower prices for a few months yet – at least until market death begins to cull the fray.
But oil is not manufactured like laser printers and razor blades. Oil fields, unlike assembly lines, decline in output without ongoing capital investment. And the energy commodity that everyone loves to hate is geopolitically charged. What makes this price war even more complicated – and more damaging – is that it’s not just about a group of companies fighting for market share, say for dish soap. The 155-year history of oil reminds us that pricing is fought on multiple fronts: the commodity markets; the capital markets; the back rooms of cartels; the environment; and the underground bunkers where national security and the use of real guns, bombs and missiles are strategized. Geopolitical jockeying between the large producing regions means there is a whole other war going on behind the price war. That could mean even lower prices; or it could spike them up too.
Nevertheless, we can use the commercial lessons from non-oil price wars to get a sense of what’s coming in the near and distant future. Unfortunately, the teachings tell us that industry conditions are going to get worse over the next few months before they get better, and that the damage to all competitors will be significant. Paraphrasing Sun Tzu, author of the quintessential The Art of War, “There are no examples of nations benefitting from prolonged warfare.”
Next week: Upcoming battles and the terms of victory.
Suggested Readings
- Oliver P. Heil and Kristiaan Helsen, “Toward an Understanding of Price Wars: Their Nature and How They Erupt,” International Journal of Research in Marketing 18, no. 1 (2001): 83-98.
- Akshay R. Rao, Mark E. Bergen and Scott Davis, “How to Fight a Price War,” Harvard Business Review 78, no. 2 (2000): 107-116, https://hbr.org/2000/03/how-to-fight-a-price-war
