Graph_-_Predators_pricingPredatory pricing (undercutting) is a pricing strategy whereby producers lower their prices with the ultimate intention of driving out some competitors from the market. Because high cost producers are unable to sustain production at unusually low prices, they must exit the market which shrinks competition. Predatory pricing is illegal in most countries because it intends to choke competition which hurts consumers as they must pay higher prices. One might ask whether predatory pricing is illegal in the global market place. The answer will not surprise you.    

Saudi Arabia and Russia recently have engaged in a brand of “predatory pricing” by refusing to cut back on their production levels despite falling global demand. The net result of the overproduction is unusually low oil prices. The fundamental question is why are Saudi Arabia and Russia, historically the largest producers of oil, adopting such an aggressive production-strategy when they too suffer from lower oil prices? The answer not surprisingly is predatory pricing strategy. By not cutting-back on their production, the major oil producers are playing a long-term strategy of forcing high cost producers out of business. Their ultimate aim is to drive US oil producers out of business, at least the high cost producers. 

 Background

Oil production has been an oligopolistic market with a few large producers controlling the global market share. Saudi Arabia has traditionally controlled the largest market share with Russia being the second major producer. Largely because of the discovery of shale oil, the US has become a major oil producing country. In 2014, the US toppled Saudi Arabia and now has the distinction of being the largest producer of oil with a global market share of 13%.

Consequences

Oil prices have precipitously declined from around $80 per barrel to around $40 per barrel in less than a year because of the oil glut. Not surprisingly, the biggest casualty has been the U.S. energy industry. A great example of this struggle has been Chesapeake Energy Corp., an icon of the U.S. energy boom. In 2012, 54% of Chesapeake’s projects did not generate a single penny of profit. To compound its problems, hundreds of lawsuits and investigations challenged the company’s business practices.

Some activist investors including Carl Icahn forced out its charismatic co-founder/CEO Aubrey McClendon. Under the new CEO, Chesapeake has slashed spending by more than half compared with 2012, and pared its staff by 67%. Its drilling footprint is nearly 5.5 million acres smaller. Antitrust allegations against the company in Michigan have been resolved, as have about two-thirds of the lawsuits filed against Chesapeake over past business practices. Despite all these aggressive cost cutting measures, Chesapeake’s future remains precarious.

The company’s stock price has fallen from a high of around $30 in 2014 to about $5.41 last week, a nearly 85% decline. Chesapeake has written off $15.6 billion in holdings, and its cash flow continues to shrink. In the past several months, the company has suspended its dividend and laid off 740 employees. As the incumbent CEO Mr. Lawler said, “the biggest challenge is external. Chesapeake has been hampered by the low natural gas and oil prices.

Future

Presently, the major players are playing a “game of chicken” or a “hawk-dove game.” The principle of the game is that while each player prefers not to yield to the other, the worst possible outcome occurs when both players do not yield. As State-owned enterprises, Saudi Arabia and Russia are immune to market pressures or cost considerations, which is why they have continued to produce oil at past levels ignoring the negative information in prices. While US oil producers are much more sensitive to market pressures and cost considerations, many have refused to exit the business or cut-back on their production so long as current prices have covered their variable costs. US oil producers are expecting a rebound in oil prices in the near term.

What defines as the near term is hard to predict. While most economists agree that oil prices are unsustainable at $40 a barrel in the long run, we are left with the Keynesian question, what defines a “long-run.”

December 4, 2015; 1.14A

http://www.wsj.com/articles/chesapeakes-boss-faces-tall-order-1448558312?cb=logged0.04550649718616018

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