The predators from Riyadh

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VIEWYesterday, French economist Jean Tirole won the Nobel Prize in Economics for his work in understanding imperfect markets such as monopolies or oligopolies. Personally, Tirole has been a huge influence in how I view the world. His graduate-level textbook on Industrial Organization remains, to me, the standard in the field, even though it is getting a bit long in the tooth.

Here is what Tirole’s textbook says about a little something we like to call predatory pricing (quoting Joskow and Klevorick):

“Predatory pricing behavior involves a reduction of price in the short run so as to drive competing firms out of the market or to discourage entry of new firms in an effort to gain larger profits via higher prices in the long run than would have been earned if the price reduction had not occurred.”

As it happens, this is incredibly relevant to Venezuela right now. Yesterday, several news organizations talked about how Saudi Arabia is leading a push toward lower oil prices in the near future.

The Saudis, the largest oil exporters in the world, are giants in the world’s oil markets by virtue not just of their size and the level of their reserves but because of their enormous spare capacity. Basically, the Saudis can turn their oil pumps on and off in a way that makes a large difference in the oil markets, and only they have the capacity to do this.

What do the stories say about what’s going on? In a nugget, the Saudis are worried about the long-term prospects in the market if oil remains expensive. The growth in shale oil production worries them, particularly in the US, which has now become the world’s top oil producer. There is also some concern that higher oil prices can spur investment in off-shore fields such as the one off the coast of Rio de Janeiro. All of this threatens the kingdom’s dominance of world oil markets.

The message they are sending? “People should get used to low oil prices for a while.” By flooding the market, the Saudis are pushing prices down and making new entrants think twice before deciding whether to stay or not.

Is their behavior an example of predatory pricing? Who knows? As Tirole puts it, “although predatory behavior can be demonstrated within an abstract model, deriving empirical tests for antitrust analysis is difficult indeed.” What seems like predatory pricing to one person may seem like the obvious reaction to a new entrant in the market – lower prices driven by greater competition.

However, the smell test indicates that this is indeed predatory behavior on the part of our OPEC partners. That is why Kuwait and Saudi Arabia are so far ignoring Venezuela’s desperate pleas for an emergency meeting of OPEC to stem a drop in prices that threatens the very existence of the Bolivarian regime. One Kuwaiti minister was quoted as saying “I haven’t heard of any call for an emergency meeting,” the equivalent in oil circles of turning off your cell phone to avoid uncomfortable calls.

Can predatory pricing work? There is no consensus on this among economists. As Tirole puts it, “the predator tries to convey bad news to its rivals about their profitability in its market. The predation does not affect the rivals’ real prospects, only the perception of these prospects. Under rational expectations, predation may or may not succeed in driving (or keeping) rivals out of the market.”

In other words, shale oil may well ride out the Saudi storm, in which case we would probably see low oil prices for a good long time.

If they are indeed doing this, the Saudis are sacrificing short-term profits for long-term gains. If these actions precipitate the fall of the Maduro regime and the substitution for a more inclusive, democratic government, then we could also say these moves are inadvertently causing short-term pain for the sake of a better future.

I know it’s cold comfort, but keep that in mind next time you realize that your salary is not enough to buy all that you need. The Saudis are waking us up from the populist daze Venezuelans have been living in. Waking up usually sucks, but it’s something you simply need to do.

1 COMMENT

  1. Ja jajajaja JC maybe because right now I’m writing from steamy Barbados. But… I meant also going thru the swallowing first the galling cod oil cucharada to gain democracy and freedom in the end.

    • Well, sure, for people in Venezuela it’s going to be one jagged little pill, but if you’re overseas and paying $1,50 per liter of gas like I am, then it’s all good.

  2. Nice. This goes hand-in-hand with what Monaldi was saying about the diminished role of sunk costs in Shale Oil production in that Baker Institute Talk. He emphasized that shale oil investment is much less lumpy than conventional investment, which means investors aren’t as locked in by previous decisions as they are in conventional oil. With shale you need to keep investing throughout to keep getting oil out.

    Maybe the Saudis just want to put a bunch of North Dakotans out of business.

    But then, given that the investment isn’t lumpy, won’t the North Dakotans just start fracking again the second the Saudis let up?

      • Gimme the lochas !

        Well, actually, don’t bother unless it’s the real thing in silver. Otherwise, it won’t cover the cost of shipping.

        But anyway : the answer to that question is very simple : YES !

        It’s all the more YES ! that the technology and the operation practices are now well established and the question is no longer “how do I get the oil of that rock and ship it to markets?”. That, we known how to do.

        Now, the question is “is it worth it?”. It’s a pure business decision, with fast and fairly predictable returns, the closet to a platonic free market oil has even been.

        It means that the price of oil is now fairly well anchored on mid term timelines (2 years or so), floating about around the marginal producer costs. It may go as low as $40, bounce back above $100, but all in all, it will average around $70 to $80. Higher, shale oil turns on. Lower, shale oil turns off.

        This time, the Saudis are playing a somewhat losing hand (not completely, but it’s complicated. Shale oil is no the only threat to them). But if they can sink Maduro on the way, great !

    • Why would the Saudis would let up? As long as there is a strong substitute for their oil they have to keep prices low. They don’t have any other option as we will obviously find even better/greener/cheaper alternatives to fossil fuels. Better to sell as much as you can for as long as you can at a discount.

      • If experience is any guide, it will, slowly, but it will.

        Down-hole (not mining) heavy oil in Alberta is a fairly similar story of a marginal producer dealing with wild swings in oil prices.

        Those guys managed to survive the crazy ride from the late 70s through the 90s to today and keep innovating, going from cold flow production to CSS to CHOPS and now SAGD. And that was with a product much less fungible than shale oil and in environments far worse than North Dakota or Texas.

        Once you get the exploration risk out of the way, oil is all about costs, costs and costs.

        • The Saudis are just reacting. The cost to produce Shale Oil will continue to decrease. Unless the price stays at $80 or lower for more than 6 months, we are unlikely to see much production taken off.

          Remember that at 92-3 million bopd, global consumption remains strong. It’s just the growth RATE that has decreased slightly.

  3. I get Saudi’s logic: decrease the price of oil in order to keep demand high and deincentivize the development of alternative forms of energy.

    But I remember a few years ago, before the Great Recession when oil was selling for $120-130, that Saudi was pressured by the West to increase supply to drive the price down. The problem was that Saudi did increase supply, they just didn’t have any buyers; which led to the belief that the price of oil at the time was not based on supply-and-demand fundamentals.

    This leads to my ultimate question: does Saudi have buyers for the extra oil they’re going to produce? Or are they just going to take one for the team in the short-term?

    Also, this spells DOOM for Iran, Venezuela and Ecuador; whose breakeven prices are well $115.

    I would also have a deep concern for Iraq, whose breakeven price is estimated at $106. How much would a low-price fuel the conflict that’s happening across the Levant?

    • Not to keep demand high but costs too high to compete with conventional extracted oil. Let me if i understud correctly. The high prices oil has enjoyed until now have had the secondary effect of make other forms of oil extraction (e.g. fracking) profitable.

      I’m not an expert but the Saudi’s idea behind this is to make fracking costs too high in comparation with conventional oil and taken out of business or at list unviable.

      That’s the predatory nature of this measure but it will kill Venezuela, not they worry too much about it.

  4. We have been waiting for the US of A to come to the rescue and here come the Saudis!

    Since yesterday I paid USD75 for a tank of diesel and my last electricity bill was at USD350 I gotta say, lets wake up buddies and lets enjoy the hangover

  5. The collapse of the world oil markets, a decision instigated by the ‘predators from Riyadh,’ may turn out to be the defining moment for the Chavistas. Its’ implications are profound. This is the perfect storm. The fools occupying Miraflores are still selling gasoline for pennies on the dollar, while curiously paying 6 billion dollars in essential foreign currency for bond payments to the hated capitalists in October. Why? Are they expecting new credit lines from Wall Street? Plus, there are consumer shortages everywhere, the armed colectivos are being short-changed on bribe money, industrial production is collapsing on a daily basis, there is anywhere from 10 to 15 billion dollars of unpaid bills (airlines included), and the central bank is printing Bolivars as fast as the printing presses can handle the paper. How long can this last? Three months? Four?

        • Because most paquetazos get announced after the Christmas hangover. Venezuelan govts have this nasty habit of pretending everything is peachy on December, spending a lot of money they don’t have, and after that comes the time to either kick the can a notch (keeping growth-disrupting distortions intact) or announce a hastily made clusterfuck of shock therapy. Either way we’re gonna have a dark, dark 2015.

  6. it is off topic but, somebody remembers the five revolutions and the sacudón? I haven’t read about them in weeks. Today I woke up and I miss them…

  7. The drop in the price of oil in 1986, triggered IIRC by a Saudi increase in production, by putting a cash squeeze on the Soviet Union, played a part in the demise of the Soviet Union. [Yes, the drop commenced in late 1981..]

    • People are speculating the Kerry’s recent visit to Saudi relates to the “oil as a weapon” theory in anticipation of and leading to the demise of Russia, Venezuela and Iran. Personally I think they are giving us yanks too much credit.

  8. I was just wondering before this post, why things are getting progressively more unstable in the middle east, and are just pretty bad most other places, and oil and gold are going down. I think you have a good answer for the oil part.

  9. “…the very existence of the Bolivarian regime.”
    This is the only thing I disagree with.
    This regime is not bolivarian at all, it’s just chavista or castrista, Bolívar rolls in his grave everytime he’s put in the same sack than these sonufabitches that tyrannize us.

    “…sacrificing short-term profits for long-term gains.”
    That’s called capitalism, folks (Invest and have low profits now, to prepare and receive higher gains later at a steady pace), and it’s another uppercut to communism, it’s funny to see how chavistas are biting their own elbows in blind rage at the prospect of “losing the war against capitalism”

  10. The predatory cycle goes on and on , we have seen it time and again…. not the first time they play with the spigot, nor the last …. if you are a country with mega reserves and a small population (i.e. the likes of Qatar, Kuwait or SA) your interest horizon is not the same as those with the inverse relation. The wonder of Venezuela is that it has managed to join, and have its interests converge with the group they do (organically) not belong to …. namely those with smaller reserves, who need the highest price possible today and care little about tomorrow (when their wells have all but run dry) … Another wonderful feat of the red regime …..

  11. I think this is a win-win-win for Saudi Arabia. Dropping the price of oil puts pressure on the international bad boys club made up of Iran (and by proxy, Syria) and Russia along with their ally Venezuela. T
    he relations between Iran and Saudi Arabia have gone steadily downhill in recent years and between ISIL, Syria and Iran, a drop in oil products helps out Sunnis and hurt Shias. The Kerry angle may also have been something to do with global oil prices impact on Russia and another push on them to stop the incessant pressure on Ukraine. Venezuela, a buddy to the others, just happens to be badly managed enough to be caught in the crossfire.

    I remember the collapse in oil in the 80s, and it cracked shale oil exploration at the time. http://www.nytimes.com/2006/12/21/business/21shale.html?pagewanted=all&_r=0
    Given the current cost of production for a many of the fields, it will impact their profitability, but I don’t see it having the devastating effect it did 30 years ago. Predatory pricing? Probably, but I don’t think the fracking industry is the primary target.

    Regardless, I’m pleased that gas is closer to $3/gallon than $4.

  12. Perfect timing by the Saudis, not only do they get to damage the alternative energy sources (all that investment in shale gas, solar energy and batteries is toast now, to be recovered in minimum 15-20 years), they also got their biggest potential competitor, Venezuela at just the time when it isn’t capable of ramping up production any more. $80 oil should set back Venezuela’s oil industry more than a little, all that expensive to process heavy crude and tar is going to stay in the ground a while longer.

    And reducing the price of oil should do the world economy no harm either. Win, win, win for them. Quite a poke in the eye for Maduro & Co.

  13. Juan,

    This is why the rest of the world doesn’t care about what happens in Venezuela, because Venezuela doesn’t care about the rest of the world! For you to write to this piece and not even mention the political dynamic at work in the Middle East right now is quite ignorant.

    • Possibly, are you referring to the Saudi’s wantingt to squeeze Iran’s economy even more and put more pressure on them to stop their nuclear program? or…

  14. I think the Saudis are just trying to prop up the World economy, giving some certainty against a backdrop of uncertainty and bad news from Europe, Russia, Latin America and maybe China.

  15. It’s an interesting coincidence that Saudi Arabia and Venezuela have the largest petroleum reserves and the lowest “below ground” costs to increase production. The Saudis can choose production volumes using strategic models that maximize profits over the long term, while the Venezuela regime is likes to re-demonstrate the principle that “beggars” can’t be choosers.” It must be very frustrating having all this oil trapped underground because of ideological strategies that expropriated the companies that could get the oil out of the ground at very low cost!

    • It must be very frustrating having all this oil trapped underground because of ideological strategies that expropriated the companies that could get the oil out of the ground at very low cost!

      Except that most of the Chavista expropriations were in the Orinoco tar belt, where the need to thin the tar out to a usable viscosity ramps up the cost of extracting the oil. And where the high cost of extraction prompted PDVSA to look for foreign partners in the 1990s.

      • The youtube video in a post last week, of a LatinAmerican economics conference, a representative from (I think) Chevron disclosed that the heavy oil was not an issue at all! Apparently, the heavy oil technology is not a significant factor. The significant factor was the above ground costs which was lack of domestic skilled labor. He basically said you can’t get things done in Venezuela because the people who could get things done have emigrated to USA and The Middle East.

      • He also said that Venezuela’s politics were also not a problem. That surprised me. He said that he can work with Charismo by factoring the political risks in the negotiation. It’s worth the hour of time to listen to it.

  16. Understanding Saudi motivations is both easy and complicated. There are different players at the top with very different views and objectives. What they all seem to fear is the US becoming disentangled from their oil. In 1997-98 the certainty that PDVSA could deliver on its expansion plan scared them and at the end of 97 they increased production instead of lowering to adapt to lower levels of consumption brought about by the Asian Crisis. By mid-98 they had forced Venezuela to pull back on the expansion and agree on 400,000 b/d reduction The Chavez got elected (how much did the dire economic situation in the latter half of the year have to do with this election?) and Bernard Mommer convinced him that the Saudis and allies were dead serious and that the best game to play was one of price and not volume. The rest is history.

    During the period preceding the Arab Spring and during the turmoil itself the Saudi’s became passive and allowed the hawks Iran and Venezuela to take the lead. Suddenly the risk of political chaos justified accepting prices much higher than their optimal long term target. Prices stayed high for too long and you have encouraged US shale, Canadian tar sands, Brazil Presal, efficient use and wind and solar. Plus the real winner of this was Russia that increased its production by 4MM b/d without any cost on the price side. Double whammy for Vlad. Other than Nico, he will pay a very high price if in addition to a tec embargo on oil equipment he has to face lower prices for a long period of time.

    The long-term stupidity of Hugo Chavez has yet to mask his short and medium term ‘success’ (if we define his total power grab as that), but I have a feeling the crash will be SPECTACULAR and I am not sure who they will blame. On the oil side they wasted the most amazing boom in history and all they have now are unfulfilled dreams and unpayable debts. .

  17. The big question for me is whether lower oil prices will topple the chavista regime? Or will they ride the storm out and ramp up the repression.

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