Predatory Pricing: OPEC 2014 | 1

Group 8: Nicholas Heide, Savannah Zheng, Jonathan Manzer, Zihao Li

ECON 3461: Organization of Industry

Professor Talia Bar

April 23rd, 2018

Predatory Pricing: OPEC 2014

Economic Growth is the increase in aggregate productivity in an economy. This is

referring to an increase in the capacity by which an economy can produce goods and services. (i)
The equivalent gauge of productivity can be quantified, thanks to Simon Kuznets in 1934, into
what we today call a country’s Gross Domestic Product (GDP). GDP is a measure of
productivity and more specifically is the effectiveness with which factors of production are
converted into output. This paper will define predatory pricing in a global arena, showcase and
analyze a specific instance to support this productivity condition, and explain how the countries’
GDPs are affected by such competitive predation.
To first explain how predation causes instability to economic growth and international
markets one must first understand the two defining theories, as per defined by a study at Cornell
University. The first of which is called the Classical Predation Theory. The Classical Predation
Theory is generally associated with business practices that would otherwise enhance profits but
which are utilized to enlarge market share with the expectation that it will congruently lead to
higher long-term profits. In simpler terms, it is the interpretation that predatory pricing is where a
dominant firm sells below its current cost to eliminate its competitors and earn a monopoly profit
through owning majority market share. This understanding has then since been abandoned by
current day economists and seen as flawed. The second theory is the Modernist Predation
Theory; this theory brings into consideration the Classical Theory’s flaws. The flaw is that it did
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not take into consideration the amount of cost undertaken by the dominant firm when using such
a monopoly-angled technique. The Modernist Theory brings to light the idea that the dominant
firm, being that it is already dominant, meaning it has a higher volume of sales relative to the
peripheral firms’ sales, would undergo massive losses due to cost of production. The dominant
firm's cost of production would then be equal to the loss per sale multiplied by the quantity sold.
This cost would in turn be so enormous that the technique of predation would not be cost
effective. If this is not deterrence enough, the modernist theory also argues that even if the larger
firm were to outbid and eliminate its rival firms, predation wouldn’t lead to a monopoly
equilibrium profit due to the lack of barriers from firms re-entering the market. Firms re-entering
would view the dominant firm competing at a lesser marginal cost; hence competition would
almost never be negated (ii).
However deterring these parameters may seem, under specific conditions predation
would not only be plausible but also ideal. There are two conditions that would warrant this
behavior: the first being that it may be profitable if entry barriers prohibit new firms from
entering the industry and the productive assets of the existing firms are highly specialized and
diversified. In this case the dominant firm maintains the incentive to use predatory pricing for
higher long-term profit maximization. The second condition is that if a dominant firm were to
eliminate a smaller firm, by relative comparison, it may serve as an example for other competing
firms and stand as a “lesson” that the dominant firm would pursue such predation when entry or
undesired behavior occurs. This is basically a deterrent against entry or price competition by
rival firms. In this instance, predation would mark for monopolized price equilibrium and may
maximize long-term profits (ii).
In 2014, Saudi Arabia and the rest of OPEC filled the first of those conditions and
underwent large-scale/global predatory pricing. OPEC (Organization of Petroleum Exporting
Countries) is a conglomerate of oil producing countries that have formed a cartel to coordinate
and orchestrate policies to best produce and distribute crude oil to consumers around the world.
The oil manufacturing industry has momentous fixed costs related the setup and operating costs
of rigs. Equipment and the infrastructure such as access for roads, electricity, and water
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represents the costs that correspond with rigging setup. U.S. shale rigs on land cost
approximately $18 million to $25 million USD. This price may also vary depending on the type
of rig purchased, which can be nearly twice as much as previously listed. Globally, shale mining
rigs list on average from $25 million to $40 million USD. Offshore drilling rigs range from 15 to
20 times that of the average onshore rig. The average price for one offshore rig is approximately
$650 million USD with an average cost of $200,000 USD per day. Nonetheless, oil rigs are not
cheap to produce even to some of the richest countries in the world, such as the United States
(iii). With such huge fixed costs associated with entry into the oil producing market, OPEC saw
an opportunity to exploit.
From 2010 to 2014, oil production exploded. U.S. Shale producers have grown
drastically, from producing 5,482,000 bpd to 8,663,000 bpd of oil. This is an overall increase of
approximately 58%. Such a large growth quickly gained the attention of the OPEC. The problem
with such a large increase in production was that the global demand for oil was at a standstill.
Global oil demand remained flat. The global average was only growing at a mere 1.1%. The U.S.
had a production growth rate of 16% whereas its demand grew at just 0.6% for 2014. Another
producer that witnessed a large increase in oil production growth was Iraq, at a 32% increase for
2014 (iii). Europe and Asia had also reported very small demand growth. With the United States
and OPEC expanding and producing even higher amounts of oil a global surplus began to form.
OPEC realized this surplus in global oil and decided to act on it in a predatory manner. In
the November of 2014 meeting Saudi Arabia convinced OPEC to maintain current oil production
levels. By doing this OPEC began flooding the market with a surplus of oil. Saudi Arabia’s idea
behind this move was to take advantage of its low-cost of production and send the market prices
to fall far beyond the levels that such high-cost producers, such as the United States, could
withstand and are driven out of the market in order to result in a higher monopoly-like
(competition will never be completely driven out) equilibrium price after a price correction
through a corrective reduction in production. By definition this act of predation is extremely
costly and knowing so OPEC was prepared to rely on its combined $2.5 trillion USD in
exchange reserves to counteract the loss in profit. In simpler terms, OPEC was starving
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themselves of profit in order to drive out its competition. OPEC was even prepared to produce
oil until the market surplus drove the price down to an astonishing $20 dollars a barrel (iii).
This profit starvation took its toll on not only the United States but also, ironically, on
countries within OPEC. At the start of this predation strategy, the price of oil stood tall at
approximately $105 dollars a barrel, as of mid June 2014. By December 2015, the price of oil
had plummeted to approximately $35 dollars a barrel, a drastic 65% drop. This fall can be further
shown in the accompanying graph below.
(iii)

Late 2014, the U.S. had the highest number of oil producing rigs than ever before at 1609
rigs. By May 27th, 2016, the United States had a total of 316 total operating oil rigs. That’s a
decrease of ~80.37% (iii). As depicted in the chart below it was a huge loss in production
capability for the United States.
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(iv)

(v)

Each oil rig, depending on its size, is maintained and run by a range of a few dozen
workers to up to 200 workers. To put this in better perspective, 1,293 rigs were taken out of
working condition, at a rate of approximately 100 people working each rig, resulting in
approximately 129,300 newly unemployed skilled workers (iv). This deficit in a specialized
labor force coupled with loss in profitable oil production adversely affected the U.S. GDP. As
depicted in the graph below, the United States’s GDP from mining suffered a sharp decline in the
late 2014.
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There are four ways countries can produce economic growth. The first is that a country
discovers or acquires new or better natural/economic resources. The second way to generate
economic growth is growing the labor force. The third way is to create or acquire superior
advances in technology or other capital goods. The fourth and final way is increasing
specialization of workers. This means to have more specialized workers, more highly skilled, to
output more efficient production. Due to the newly created highly skilled, specialized, and
unemployed 130 thousand workers, the United States saw a deficit in its GDP under its
production from mining. Luckily, oil production only makes up about 7.3% of the United States’
GDP. This figure may seem large but in comparison to other country’s oil dependent economy,
7.3% is relatively small (vi). This large-scale depletion of skilled and specialized personnel,
infrastructure, and the fixed costs of the equipment needed to operate these rigs, creates a cost
barrier to reentry. It does not bar the U.S. from reentering sometime later in the future but for the
meantime, Saudi Arabia and the rest of OPEC have created that such barrier to allow the
technique of predatory pricing to ensure long-term price manipulation and in-turn long term
monopolized market equilibrium profits.
As OPEC further produced to aid the surplus of oil in the market and drive the price
down, some not-so-well-reserved oil dependent countries within OPEC began to also feel the
costs of plummeting the price. In the December 2015 OPEC meeting, countries like Venezuela,
Algeria, and Nigeria, whom are all economically dependent on oil revenues tried to plea with
Saudi Arabia and its GCC partners to cut production to allow the price to fluctuate back to
standardized levels in order to make their countries profitable again and non-dependent upon
cumulative reserves. Saudi Arabia and the rest of its GCC partners denied their request and
instead allowed for such countries to allow price improvements in exchange for a bit of their
market share. Basically, Saudi Arabia and the rest of the afloat countries received greater market
share from countries that could not survive under the current low profit-high production market.
Saudi Arabia at this point in time has successfully knocked out the western shale rigging
market share and has taken dominant control of the market. As comfortable as this position may
seem, Iran called for a 30 billion dollar investment in their oil and gas industry for means of
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continuous production. This was believed to double its national production once sanctions were
lifted in 2016. Weary, Saudi Arabia saw there own OPEC partner, Iran as a competitor to its
market share and feared it would lose market share once the investment in such production
infrastructure was in place. A deadlock became apparent as both Saudi Arabia and Iran were
solely competing for market share, which in turn sent oil prices plunging even further.
Despite such competition Saudi Arabia, taking more than a 50% decline in its oil
revenues, the IMF (International Monetary Fund) observed Saudi Arabia’s economic growth to
be at 3.5% for 2015. The country relied on $650 billion dollars in reserves and did so
marvelously (iii). This feat can be showcased by the respective graph below (vii).
(vii)

After coming to terms with the partners of OPEC, Saudi Arabia and its allies cut slowly
cuts its production and allowed the price to rise back up to standard. Now having the market
cornered OPEC has taken a very dominant position in the global market share they are able to
corner the market and control the price once again. As displayed by the figure below, Saudi
Arabia’s annual crude oil production and annual GDP growth are directly correlated.
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In stark contrast to Saudi Arabia’s economic growth due to its predation tactics, Algeria,
also a committed member of OPEC fell short of its intended long term profits, once convinced
attainable by Saudi Arabia in the December meeting of 2014, and was forced to feed off it
foreign exchange reserves. This greatly impacted its GDP annual growth rate and a correlation
becomes present upon comparison. In addition to the comparison between Algeria’s GDP annual
growth rate and its foreign exchange reserves is also the comparison between the market price of
oil and its foreign exchange reserves, as present below (viii).
(viii)
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As clearly depicted, once the predation and excess production of oil began dumping in
the market, post 2014, Algeria had to rely on its foreign exchange reserves to keep their economy
upright. Giving up market share to Saudi Arabia and other stronger OPEC players drove Algeria
from the market post 2016, Algeria’s GDP annual growth rate has yet to recover.
In conclusion, predatory pricing is a competitive and cut throat-pricing technique that
requires practically perfect execution in order to achieve the goal of long term economic
monopolized market equilibrium profit. The dominant firm must have a large enough foreign
reserve to back its economy during the period of firm starvation. Had OPEC realized this, they
may not have agreed to commit to such a risky strategy given that now a large some of countries
have depleted their reserves, been forced into a smaller market share position, and/or have
promoted lesser economic growth across the board. Predatory Pricing is a goldilocks strategy
that may only benefit few and will only do so under the most accurate of conditions to allow long
term monopolized equilibrium market profits and in turn increased economic growth.
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References:
(i) Staff, I. (2014, October 02). Economic Growth. Retrieved from
https://www.investopedia.com/terms/e/economicgrowth.asp
(ii) Brodley, J. F., & Hay, G. A. (1981, April 4). Predatory Pricing: Competing Economic
Theories and the Evolution of Legal Standards. Retrieved from
https://scholarship.law.cornell.edu/cgi/viewcontent.cgi?article=4242&context=clr
(iii) A. (2016, January 04). The Biggest Conspiracy of the Century by Saudi Arabia and
OPEC to Eliminate It's Competition. Retrieved from
http://www.thegoldandoilguy.com/the-biggest-conspiracy-of-the-century-by-saudi-
arabia-and-opec-to-eliminate-its-competition-2/
(iv) US Oil Rig Count:. (n.d.). Retrieved from
https://ycharts.com/indicators/us_oil_rotary_rigs
(v) United States GDP From Mining - Forecast. (n.d.). Retrieved from
https://tradingeconomics.com/united-states/gdp-from-mining/forecast
(vi) Oil & gas industry accounts for 7.6% of U.S. GDP. (2017, August 01). Retrieved
from https://talkbusiness.net/2017/08/oil-gas-industry-accounts-for-7-6-of-u-s-gdp/
(vii) Saudi Arabia Crude Oil Production 1973-2018 | Data | Chart | Calendar. (n.d.).
Retrieved from https://tradingeconomics.com/saudi-arabia/crude-oil-production
(viii) Algeria Foreign Exchange Reserves 2013-2018 | Data | Chart | Calendar. (n.d.).
Retrieved from https://tradingeconomics.com/algeria/foreign-exchange-reserves