The price of petrol is of interest to most families, occupying a key component of weekly expenditure. Over the past decade, it has fluctuated significantly, from around 85p per litre to over £1.40. More recently, prices have been around £1.03 to £1.10, depending on the brand and the location. But, will we see prices falling below that magical £1 per litre mark?
We have recently seen a 2p drop in wholesale fuel prices and it is this which has led to speculation about a further fall in prices at petrol stations to below £1. This, according to the RAC, has a ‘very good chance’ of happening.
A key determinant of petrol prices is the market price for crude oil and it is this which has been contributing towards the low petrol prices. As these prices filter through to the pumps, the RAC suggests that prices may once again come down. Furthermore, with some of the key petrol stations being operated by the big supermarkets, competition for sales and hence on prices may be fierce.
But, now let’s consider another well-informed organisation. According to the AA, the chances of petrol prices falling below £1 are ‘remote’. So, who should we believe? In fact, we can probably believe both. The market price may not fall below £1, but in the run-up to Christmas and in the start of the New Year, we may well see petrol on sale for under £1 as a means to entice shoppers or, as the AA has said, as a ‘marketing gimmick’. As you can see from the picture, Asda has dropped the price below £1 per litre in some of its petrol stations.
You might think this is a little strange, given the inelastic nature of the demand for petrol: after all, as prices of petrol rise and fall, I for one, don’t change my demand. This is also confirmed by HMRC, which reports that total petrol consumption is falling despite the low prices. But, it’s probably less about changing your total demand for petrol and more about from where you buy that total demand. For any one petrol station, the demand may be relatively elastic. It is this which may fuel a price war on petrol. The following articles consider this.
£1 per litre petrol? It’s unlikely The Telegraph, Rozina Sabur (20/11/15)
‘Good chance’ of £1 per litre petrol, says RAC BBC News (20/11/15)
Petrol prices ‘could fall below £1 per litre’ ITV News (20/11/15)
Fuel Prices: ‘Good chance’ of £1 a litre Sky News (20/11/15)
Questions
- What are they demand-side and supply-side factors which have helped to cut the price of petrol? Use a diagram to illustrate your answer.
- How much of a role has OPEC played in keeping petrol prices down in the UK?
- Why is the demand for petrol price inelastic?
- HMRC suggests that despite low prices, the demand for petrol has been falling. Does this suggest that the demand curve for petrol is upward sloping? Explain your answer.
- If the demand for petrol is falling, can this tell car companies anything about the future demand for vehicles? Which concepts are important here?
- If petrol prices do not fall to reflect falling oil prices, what does this suggest about the profit margins on petrol? Should government intervene?
There have been a number of recent developments in communications markets that may significantly alter the competitive landscape. First, the UK Competition and Markets Authority (CMA) has provisionally cleared BT to takeover the EE mobile phone network. The deal will allow BT to re-establish itself as a mobile network provider, having previously owned O2 until it was sold in 2005. The CMA said that:
They operate largely in separate areas with BT strong in supplying fixed communications services (voice, broadband and pay TV), EE strong in supplying mobile communications services, and limited overlap between them in both categories of service.
BT will therefore be in a better position to compete with rivals such as Virgin Media who were early movers in offering. 
Second, O2 itself (currently owned by Telefónica) is the subject of a takeover bid from Hutchinson Whampoa who already owns the mobile network Three. Because the companies meet their turnover criteria, this deal is being investigated by the European Commission (EC) and the signs don’t look good. If it goes ahead, it would create the largest mobile operator in the UK and leave just three main players in the market. The EC is concerned that the merger would lead to higher prices, reduced innovation and lower investment in networks. Previously, considerable consolidation in telecommunications markets across Europe has been allowed. However, recent evidence, including the prevention of a similar deal in Denmark, suggests the EC is starting to take a tougher stance.
If we compare the two proposed takeovers, it is clear that the O2–Three merger raises more concerns for the mobile communications market because they are both already established network providers. 
However, it is increasingly questionable whether looking at this market in isolation is appropriate. As communication services become increasingly intertwined and quad-play competition becomes more prevalent, a wider perspective becomes more appropriate. Once this is taken, the BT–EE deal may raise different, but still important, concerns.
Finally, the UK’s communications regulator, OFCOM, is currently undertaking a review of the whole telecommunications market. It is evident that their review will recognise the increased connections between communications markets as they have made clear that they will:
examine converging media services – offered over different platforms, or as a ‘bundle’ by the same operator. For example, telecoms services are increasingly sold to consumers in the form of bundles, sometimes with broadcasting content; this can offer consumer benefits, but may also present risks to competition.
One particular concern appears to be BT’s internet broadband network, Openreach. This follows complaints from competitors such as BSkyB who pay to use BT’s network. Their concerns include long installation times for their customers and BT’s lack of investment in the network. One possibility being considered is breaking up BT with the forced sale of its broadband network.
It will be fascinating to see how these communications markets develop over time.
BT takeover of EE given provisional clearance by competition watchdog The Guardian, Jasper Jackson (28/10/15)
Ofcom casts doubt on O2/Three merger BBC News, Chris Johnston (08/10/15)
BT and Openreach broadband service could be split in Ofcom review The Guardian, John Plunkett (16/07/15)
Questions
- What are the key features of communications markets? Explain how these markets have developed over the last few decades.
- What are the pros and cons for consumers of being able to buy a quad-play bundle of services?
- How do you think firms that are currently focused on providing mobile phone services will need to change their strategies in the future?
- Why is BT in a powerful position as one of the only owners of a broadband network?
- Instead of forcing BT to sell its broadband network, what other solutions might there be?
Global merger and acquisition deals with a combined value of £2.7 trillion ($4.06 trillion) have taken place so far this year (1 Jan to 3 Nov). This is a 38% increase on the same period in 2014 ($2.94 trillion) and even surpasses the previous record high for the same period in 2007 ($3.93 trillion) (see the chart from the Dealogic article linked below).
Measured by dollar value, October was the fifth biggest month in Mergers and Acquisitions (M&As) history with the announcement of $514bn of actual or proposed deals. These included:
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the proposed £71 billion deal to acquire SABMiller (the world’s second largest brewer) by AB InBev (the world’s largest brewer); |
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the $67bn takeover of network storage provider EMC by Dell (the world’s third largest computer supplier); |
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the proposed deal to acquire Allergan (producer of Botox) by Pfizer (the producer of Viagra). |
Although the dollar value of M&As was extremely large in October the actual number of deals, 2177, was significantly lower than the average of 3521 over the previous 9 months.
Are these large M&As in the interests of the consumer? One advantage is that the newly combined firms may have lower average costs. Reports in the press, following the announcement of most M&As, often discuss the potential for reductions in duplicate resources and rationalisation. After the successful completion of a takeover two previously separate departments, such as finance, law or HRM, may be combined into one office. If the newly integrated department is (i) smaller than the previous two departments added together and (ii) can operate just as effectively, then average costs will fall. This is simply an example of an economy of scale.
Average costs will also decrease if x-inefficiency within the acquired business can be reduced or eliminated. X-inefficiency exists when an organisation incurs higher costs than are necessary to produce any given output. In other words it is not producing in the cheapest possible way. In a number of takeovers in the brewing industry, AB InBev has gained a fearsome reputation for minimising costs and removing any waste or slack in acquired organisations. In an interview with the Financial Times, its chief executive, Carlos Brito, stated that:
“In any company, there’s 20 per cent that lead, 70 per cent that follow and 10 per cent that do nothing. So the 10 per cent, of course, you need to get rid of.”
If any reduction in costs results in lower prices without any lessening in the quality of the good or service, then of course the customer will benefit. However, when two relatively large organisations combine, it may result in a newly merged business with considerable market power. With a fall in the price elasticity of demand for its goods and services, this bigger company may be able to increase its prices and make greater revenues.
An important responsibility of a taxpayer-funded competition authority is to make judgements about whether or not large M&As are in the public interest. For example, the Competition and Markets Authority in the UK investigates deals if the target company has a UK turnover that exceeds £70 million, or if the newly combined business has a market share that is equal to or exceeds 25 per cent. If the CMA concludes that an M&A would lead to a substantial lessening of competition in the market, then it could prohibit the deal from taking place. This has only happened on 9 occasions in the last 12 years. If competition concerns are identified, it is far more likely that CMA will allow the deal to go ahead but with certain conditions attached. This has happened 29 times in the last 12 years and the conditions are referred to as remedies.
The CMA has recently published a report (Understanding past merger remedies) that attempts to evaluate the relative success of the various remedies it has used in 13 M&A cases.
Articles
Are big mergers bad for consumers? BBC News, Daniel Thomas (30/10/15)
Mergers and acquisitions madness may be about to stop The Guardian (11/10/15)
M&A deal activity on pace for record year The Wall Street Journal, Dana Mattioli and Dan Strumpf (10/08/15) [Note: if you can’t see the full article, try clearing cookies (Ctrl+Shift+Delete)]
Global M&A Volume Surpasses $4tr in 2015 YTD Dealogic, Anthony Read (04/11/15)
M&A Volumes Weaken in October despite Megadeals Financial Times, James Fontanella-Khan and Arash Massoudi (01/11/15)
The merger of Dell and EMC is further proof that the IT industry is remaking itself The Economist (12/10/15)
Questions
- Using a cost curve diagram, explain the difference between economies of scale and x-efficiency.
- Explain why a takeover or merger might reduce the price elasticity of demand for the goods or services produced by the newly combined firm.
- Explain how the CMA determines the size of the appropriate market when calculating a firm’s market share.
- Draw a diagram to illustrate the simultaneous impact of greater market power and lower average costs that might result from a horizontal merger. Consider the impact on consumer, producer and total surplus.
- What is the difference between a structural and a behavioural remedy?
The demand for oil is growing and yet the price of oil, at around $46 per barrel over the past few weeks, remains at less than half that of the period from 2011 to mid 2014. The reason is that supply has been much larger than demand. The result has been a large production surplus and a growth in oil stocks. Supply did fall somewhat in October, which reduced the surplus in 2015 Q3 below than of the record level in Q2 – but the surplus was still the second highest on record.
What is more, the modest growth in demand is forecast to slow in 2016. Supply, however, is expected to decrease through the first three quarters of 2016, before rising again at the end of 2016. The result will be a modest rise in price into 2016, to around $56 per barrel, compared with an average of just over $54 per barrel so far for 2015 (click here for a PowerPoint of the chart below).
But why does supply remain so high, given such low prices? As we saw in the post The oil industry and low oil prices, it is partly the result of increases in supply from large-scale investment in new sources of oil over the past few years, such as the fracking of shale deposits, and partly the increased output by OPEC designed to keep prices low and make new investment in shale oil unprofitable.
So why then doesn’t supply drop off rapidly? As we saw in the post, A crude indicator of the economy (Part 2), even though shale oil producers in the USA need a price of around $70 or more to make investment in new sources profitable, the marginal cost of extracting oil from existing sources is only around $10 to £20 per barrel. 
This means that shale oil production will continue until the end of the life of the wells. Given that wells typically have a life of at least three years, it could take some time for the low prices to have a significant effect on supply. According to the US Energy Information Administration’s forecasts, US crude oil production will drop next year by only just over 5%, from an average of 9.3 million barrels per day in 2015 to 8.8 million barrels per day in 2016.
In the meantime, we can expect low oil prices to continue for some time. Whilst this is bad news for oil exporters, it is good news for oil importing countries, as the lower costs will help aid recovery.
Webcasts
IEA says oil glut could worsen through 2016 Euronews (13/11/15)
IEA Says Record 3 Billion-Barrel Oil Stocks May Deepen Rout BloombergBusiness, Grant Smith (13/11/15)
Articles
IEA Offers No Hope For An Oil-Price Recovery Forbes, Art Berman (13/11/15)
Oil glut to swamp demand until 2020 Financial Times, Anjli Raval (10/11/15)
Record oil glut stands at 3bn barrels BBC News (13/11/15)
Global oil glut highest in a decade as inventories soar The Telegraph, Mehreen Khan (12/11/15)
The Oil Glut Was Created In Q1 2015; Q3 OECD Inventory Movements Are Actually Quite Normal Seeking Alpha (13/11/15)
Record oil glut stands at 3 billion barrels Arab News (14/11/15)
OPEC Update 2015: No End To Oil Glut, Low Prices, As Members Prepare For Tense Meeting International Business Times, Jess McHugh (12/11/15)
Surviving The Oil Glut Investing.com, Phil Flynn (11/11/15)
Reports and data
Oil Market Report International Energy Agency (IEA) (13/11/15)
Short-term Energy Outlook US Energy Information Administration (EIA) (10/11/15)
Brent Crude Prices US Energy Information Administration (EIA)
Questions
- Using demand and supply diagrams, demonstrate (a) what has been happening to oil prices in 2015 and (b) what is likely to happen to them in 2016.
- How are the price elasticities of demand and supply relevant in explaining the magnitude of oil price movements?
- What are oil prices likely to be in five years’ time?
- Using aggregate demand and supply analysis, demonstrate the effect of lower oil prices on a national economy.
- Why might the downward effect on inflation from lower oil prices act as a stimulus to the economy? Is this consistent with deflation being seen as requiring a stimulus from central banks, such as lower interest rates or quantitative easing?
- Do you agree with the statement that “Saudi Arabia is acting directly against the interests of half the cartel and is running OPEC over a cliff”?
- If the oil price is around $70 per barrel in a couple of years’ time, would it be worth oil companies investing in shale oil wells at that point? Explain why or why not.
- Distinguish between short-run and long-run shut down points. Why is the short-run shut down price likely to be lower than the long-run one?
It is now some seven years since the financial crisis and nearly seven years since interest rates in the USA, the eurozone, the UK and elsewhere have been close to zero. But have these record low interest rates and the bouts of quantitative easing that have accompanied them resulted in higher or lower investment than would otherwise have been the case? There has been a big argument about that recently.
According to conventional economic theory, investment is inversely related to the rate of interest: the lower the rate of interest, the higher the level of investment. In other words, the demand-for-investment curve is downward sloping with respect to the rate of interest. It is true that in recent years investment has been low, but that, according to traditional theory, is the result of a leftward shift in demand thanks to low confidence, not to quantitative easing and low interest rates.
In a recent article, however, Michael Spence (of New York University and a 2001 Nobel Laureate) and Kevin Warsh (of Stanford University and a former Fed governor) challenge this conventional wisdom. 
According to them, QE and the accompanying low interest rates led to a rise in asset prices, including shares and property, rather than to investment in the real economy. The reasons, they argue, are that investors have seen good short-term returns on financial assets but much greater uncertainty over investment in physical capital. Returns to investment in physical capital tend to be much longer term; and in the post-financial crisis era, the long term is much less certain, especially if the Fed and other central banks start to raise interest rates again.
“We believe that QE has redirected capital from the real domestic economy to financial assets at home and abroad. In this environment, it is hard to criticize companies that choose ‘shareholder friendly’ share buybacks over investment in a new factory. But public policy shouldn’t bias investments to paper assets over investments in the real economy.”
This analysis has been challenged by several eminent economists, including Larry Summers, Harvard Economics professor and former Treasury Secretary. He criticises them for confusing correlation (low investment coinciding with low interest rates) with causation. As Summers states:
“This is a little like discovering a positive correlation between oncologists and cancer and asserting that this proves oncologists cause cancer. One would expect in a weak recovery that investment would be weak and monetary policy easy. Correlation does not prove causation. …If, as Spence and Warsh assert, QE has raised stock prices, this should tilt the balance toward real investment.”
Not surprisingly Spence and Warsh have an answer to this criticism. They maintain that their critique is less of low interest rates but rather of the form that QE has taken, which has directed new money into the purchase of financial assets. This then has driven further asset purchases, much of it by companies, despite high price/earnings ratios (i.e. high share prices relative to dividends). As they say:
“Economic theory might have something to learn from recent empirical data, and from promising new thinking in behavioral economics.”
Study the arguments of both sides and try to assess their validity, both theoretically and in the light of evidence.
Articles
The Fed Has Hurt Business Investment The Wall Street Journal, Michael Spence and Kevin Warsh (26/10/15) [Note: if you can’t see the full article, try clearing cookies (Ctrl+Shift+Delete)]
I just read the ‘most confused’ critique of the Fed this yea Washington Past, Lawrence H. Summers (28/10/15)
A Little Humility, Please, Mr. Summers The Wall Street Journal, Michael Spence and Kevin Warsh (4/11/15) [Note: if you can’t see the full article, try clearing cookies (Ctrl+Shift+Delete)]
Do ultra-low interest rates really damage growth? The Economist (12/11/15)
It’s the Zero Bound Yield Curve, Stupid! Janus Capital, William H Gross (3/11/15)
Is QE Bad for Business Investment? No Way! RealTime Economic Issues Watch, Joseph E. Gagnon (28/10/15)
Department of “Huh!?!?”: QE Has Retarded Business Investment!? Washington Center for Equitable Growth, Brad DeLong (27/10/15)
LARRY SUMMERS: The Wall Street Journal published the ‘single most confused analysis’ of the Fed I’ve read this year Business Insider, Myles Udland (29/10/15)
The Fed’s Loose Money, Financial Markets and Business Investment SBE Council, Raymond J. Keating (29/10/15)
How the QE trillions missed their mark AFR Weekend, Maximilian Walsh (4/11/15)
Financial Markets In The Era Of Bubble Finance – Irreversibly Broken And Dysfunctional David Stockman’s Contra Corner, Doug Noland (8/11/15)
Questions
- Go through the arguments of Spence and Warsh and explain them.
- Explain what are meant by the ‘yield curve’ and ‘zero bound yield curve’.
- What criticisms of their arguments are made by Summers and others?
- Apart from the effects of QE, why else have long-term interest rates been low?
- In the light of the arguments on both sides, how effective do you feel that QE has been?
- How could QE have been made more effective?
- What is likely to happen to financial markets over the coming months? What effect is this likely to have on the real economy?
The price of petrol is of interest to most families, occupying a key component of weekly expenditure. Over the past decade, it has fluctuated significantly, from around 85p per litre to over £1.40. More recently, prices have been around £1.03 to £1.10, depending on the brand and the location. But, will we see prices falling below that magical £1 per litre mark?
But, now let’s consider another well-informed organisation. According to the AA, the chances of petrol prices falling below £1 are ‘remote’. So, who should we believe? In fact, we can probably believe both. The market price may not fall below £1, but in the run-up to Christmas and in the start of the New Year, we may well see petrol on sale for under £1 as a means to entice shoppers or, as the AA has said, as a ‘marketing gimmick’. As you can see from the picture, Asda has dropped the price below £1 per litre in some of its petrol stations.
