Streetwise Professor

December 7, 2011

Gazprom’s Newest Bogeyman

Filed under: Commodities,Energy,Politics,Russia — The Professor @ 3:33 pm

Whenever I need a good laugh I look around to see what Gazprom says about the perils of spot pricing mechanisms for gas.  (OK.  I confess.  My sense of humor is, uhm, idiosyncratic.)  And they seldom disappoint!

Like this gem:

Spot prices, which European customers have asked the Russian gas export monopoly to factor into long-term contract prices, should play a “subordinate, balancing role,” said Sergei Komlev, head of pricing and contract formation at Gazprom’s export division.

Gazprom supports “the existing dual hybrid pricing model,” Komlev said today at a conference in Moscow. Switching to 100 percent spot indexation or de-linking oil and gas prices “is unacceptable to gas producers because it will create opportunities for predatory pricing.”

Uhm, just how would that “predatory pricing” work, exactly?  Predatory pricing involves the sale of a product at below marginal cost with the intent to drive competitors out of the market.  Once exit occurs, the predator then raises price to supercompetitive (and perhaps monopoly) levels.

The problem with this strategy, as appealing as it is to the economically illiterate (well, I am talking about Gazprom management, so . . . ), is that (a) it can only work under very special conditions, (b) these conditions unlikely to hold in practice, and (c) the documented examples of successful–or even attempted–predation are virtually non-existent.  And I would say that the use of the modifier “virtually” is unduly cautious.

Predation is unlikely to work in an industry as unconcentrated as gas–and if anyone is in a position to be a predator, it is Gazprom, as the world’s largest producer with the world’s largest reserves.

But the more basic problem is that predation can’t destroy the competitor’s productive assets.  For instance, if a big gas producer tried to charge a below-cost price in an attempt to drive Gazprom out of business, Gazprom’s wells and pipelines would still exist, and could come back on line as soon as the predator attempted to raise price.  Meaning that the predator would lose money driving down prices, but would never be able to profit by raising them to supercompetitive levels.

In other words, predation is usually a great way for the predator to lose money.  Which is why it is more a figment of heated imaginations than an economic reality.

As for empirical examples, Rockefeller’s Standard Oil was the poster child.  Ida Tarbell–the daughter of a refiner that lost out in competition to Rockefeller–alleged in various muckraking articles and books that predation is how Standard Oil was built.  But the painstaking, non-muckraking, historical research of John McGee (then at Chicago, and published in the JLE) showed that Tarbell’s characterization was all wrong.  Standard Oil did not engage in predatory pricing.

So, predatory pricing is just another Gazprom bogeyman.  A risible scare tactic employed to defend an increasingly indefensible position.

Gazprom reminds me of the little Dutch boy, holding back the waters by putting his finger in the hole in the dike.  But Gazprom’s problem is that there are more holes than it has fingers.  Just follow the news and you’ll see story after story about gas exploration and development and export just about everywhere in the world.

One interesting development occurred the other day in Qatar.  Russia has downgraded its diplomatic relationship with the Gulf country because of an incident in which a Russian diplomat was roughed up, allegedly when Qatari officials tried to seize the diplomatic pouch he was carrying.

Recently, Qatar and Russia had been singing of the same hymnal with respect to gas contracting practices.  Moreover, Qatar has been Russia’s main interlocutor in discussions to create a gas cartel analogous to OPEC.  Given the proliferation of supply sources, actual and potential, the prospects for such a cartel are dim on economic grounds.  But political friction between Qatar and Russia makes the prospects even more remote.

Given the gravity of the accusation, one wonders what would have been so serious as to lead Qatar to take such an action.  Most likely guess: something related to Iran.  There are many indications that there is a covert war going on against Iran.  The Gulf states are in a cold war with Iran–and maybe it is a little warmer than that.  Russia’s role with Iran has been equivocal, at best.  Under these circumstances, one can readily imagine why Qatar would go after a Russian diplomat.

Regardless of the actual story, political tension between Qatar and Russia is just another hole for Gazprom to plug.

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  1. the documented examples of successful–or even attempted–predation are virtually non-existent.

    The British left love to insist this has happened with the UK supermarkets, but never, ever come up with any evidence of it. I’m sure the powerful Indian middle-men, who do so well at the expense of Indian consumers, will be using this as a weapon to thwart the proposed reforms of India’s retail laws whhich threaten to allow foreign supermarkets access to the country.

    Comment by Tim Newman — December 7, 2011 @ 11:25 pm

  2. Russia-Qatar relations have always been somewhat strained since the assasination of this chap in Doha by Russians.

    Comment by Tim Newman — December 7, 2011 @ 11:29 pm

  3. I never knew that Ida Tarbell was the daughter of an oilman who lost out in competition to Rockefeller. Somehow that always got left out in many history books, where her “investigative journalism” has always been hailed as a milestone.

    And it’s good news that Qatar and Russia are on the skids. Russia invested quite a lot on the notion of that cartel. For them to downgrade now surely means that there was something there in that diplomatic bag they didn’t want Qatar to find out.

    Comment by Finnpundit — December 8, 2011 @ 12:35 pm

  4. @Finnpundit–I was wrong in the details, right in the essence. Tarbell’s father was an oil producer, not a refiner:

    Born in a log home in Hatch Hollow, northwestern Pennsylvania, on November 5, 1857, Ida Minerva Tarbell grew up amid the derricks of the Oil Region. Her father, Frank Tarbell, built wooden oil storage tanks and later became an oil producer and refiner. “Things were going well in father’s business,” she would write years later. “There was ease such as we had never known; luxuries we had never heard of… Then suddenly [our] gay, prosperous town received a blow between the eyes.” The 1872 South Improvement scheme, a hidden agreement between the railroads and refiners led by John D. Rockefeller, hit the Pennsylvania Oil Region like a tidal wave. It hit the Tarbells too, leaving behind painful memories that would be rekindled thirty years later. “Out of the alarm and bitterness and confusion, I gathered from my father’s talk a conviction to which I still hold — that what had been undertaken was wrong.”

    The ProfessorComment by The Professor — December 8, 2011 @ 12:46 pm

  5. The “new” discovery of gas in China, and what some of the geologists I know say concerning theoretical supply of gas should have most raw material supplying countries worried for three reasons:

    1.The history of oil pricing has shown a tendency for severe price inelasticity over a two to three year horizon during periods of reduced demand: stunningly quick collapses in 82-86, 90 94, etc. This tendency can only increase if there is significant replacement of Oil with natural gas.

    2. The number of countries entering the Oil market, either through exporting or through new discoveries has risen significantly in the last 10 years, with more project scheduled to come on line. This will make oligopoly price discipline much more difficult to manage or enforce.

    3.Energy is energy. Once produced, the issue between types of energy is the ease of storage, transport and use. As pipelines expand and end processes convert from [politically volatile to low volatility sources of fuel (domestic gas vs Salafist oil) and In other words oil will tend to move to equilibrium with crude, one way or another. Also the new Chinese discoveries will limit GAZPROM’s market even further.

    Finally, the change in energy mix and production may have macro implications that would hurt Russia even more. Seymour Melman, a former teacher of mine who was brilliant though a mistaken socialist, did a study over 65 years ago showing that Labor productivity was inversely correlated to the real cost of energy. As it dropped, Labor Productivity rose. This was also the case in Total Factor Productivity, beyond the contribution of the drop in Labor Productivity.

    Basically it pointed out that as real energy costs drop, all commodities prices drop either because the cost ff growing them declines, or the cost of processing or reprocessing them goes down. In other words comparative advantage will accrue to industrial and post industrial economies. Russia is poorly placed to take advantage.

    This is not to say the US won’t screw up – I put nothing past Obama and the Sierra club, the NIMBY and the “I don’t want those poor people to get money and crowd my beaches” crowd, not to mention business interests that may be threatened.

    Comment by Sotos — December 8, 2011 @ 1:21 pm

  6. @Tim–the correct definition of predatory pricing is when a firm sells below its marginal cost. Business person X usually calls competitor C a predator if C sells below X’s cost. Big difference.

    The ProfessorComment by The Professor — December 8, 2011 @ 1:54 pm

  7. SWP,

    For sure. But you can bet the millionnaire middle-men in India will be citing the plight of the common man in order to maintain their cushy positions. Not that Indian millionnaires are unique in that respect.

    Comment by Tim Newman — December 8, 2011 @ 11:34 pm

  8. -SWP and Tim

    Couldn’t agree more. Let’s remember Adam Smith’s comment that the first thing businessmen try to do is to combine to protect (fix) their markets. Unfortunately we in the 21st century have lost the distaste for state mandated monopolies that the Anglo-sphere had in the 18th and 19th century.

    Comment by Sotos — December 9, 2011 @ 9:10 am

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