oil: how the price dynamic has changed

Value Line vs. O”Neil

My first Wall Street job was with Value Line, a firm which has seen better days but which dominated the retail market for investment information in the 1970s – 1980s.  It still publishes the Value Line Investment Survey, a newsprint weekly that over a 13-week cycle provides historical data, analyst commentary (generally not good nowadays) and a computer-generated comparison of relative investment attractiveness (based on PE and earnings growth) for a universe of around 1800 stocks.  As I recall, the Survey cost about $250 a year back then and had about 80,000 subscribers.

Analysts and portfolio managers who worked for the company couldn’t understand why the price was so low.  We all thought the publication should sell for at least double the going price.  Since the main costs of publication were for printing and postage (sadly, not for salaries), the company could triple or quadruple its profits by charging $500.  The publication was surely worth it.  Yet the firm’s owner adamantly refused to budge.  A real head scratcher.

Then we found out why.

A rival emerged in the form of William O’Neil and Company, a suppliers of very detailed price charts and other technical information to individuals and institutions. O’Neil launched a chart-based weekly service covering the same universe of stocks, cpriced at $125 a year.  No analysis, but similar historical data, loads of technical information and highly detailed charts that put Value Line’s to shame.

The publication lasted about a year and then folded (I Googled O’Neil just before writing this.  The firm appears to have revived the idea and to now be selling a similar service.  I didn’t investigate, though.)

Why?

I remember figuring at the time that O’Neil needed at least 5,000 subscribers to be cash flow positive (this was a long time ago, so my numbers may be way off.  Their accuracy isn’t necessary for my point, though.).  If it got there, it could gradually add features and increase marketing   …and start to grow itself into a serious competitor to Value Line.  O’Neil couldn’t get north of 2,000 with its service, however, and quickly got tired of bleeding red ink.

Suppose the VLIS had been priced at $500 instead of $250?  O’Neil could have priced his service at, say, $250   …or even $350 and still offered a generous discount.  At 2,000 subscribers he would have been in the black–and growing into an increasingly sharp thorn in Value Line’s side.

The clear economic response to this development would have been for VL to cut its price to $250 to make O’Neil unviable.  But that would have been psychologically very hard to do.  It would have created internal morale problems as belt-tightening took hold.   And it might also draw the attention of the Justice Department.  Waiting two or three years, hoping (in vain) for the competitive dynamic to change, would only compound the problem.

pricing umbrella

That was my introduction to the concept of a pricing umbrella, the idea that high margins creates a fertile, sheltered environment in which competition can grow.

why it’s bad

Two negative consequences:

–competition can gain critical mass, and

–even if it can’t, if newcomers have made significant capital investment they will continue to operate–at a loss–to extract whatever cash they can from their failing businesses.

OPEC’s umbrella

More or less, this is the messy situation that OPEC has created in the oil market.

Under the protection of a $100 a barrel price, unconventional, technology-based competitors have emerged, mostly in the US so far.  This happened about half a decade ago.  The newcomers were initially able to extract oil profitably at $80 a barrel (as opposed to less than $10 for Saudi Arabia).  But they’ve improved their techniques to the point that many can make money at $40.

results of the oil price halving

In the near term, highly financially leveraged high-cost oil producers will be forced by their creditors to stop spending on new projects.  They will continue to produce from existing wells until they run dry, however.  It’s just that all their cash flow will be devoted to repaying debt.

The long-term problem for OPEC is that the new technology–whose development high prices stimulated–won’t go away.  As/when prices rebound to, say, $60 a barrel, hydraulic fracturing will begin to expand aggressively again.  I think shale oil output will rise relatively quickly, as solvent oil development firms take over in-the-ground infrastructure left idle by their bankrupt brethren.

At some point, the oil price will bottom.  I don’t know whether that point is now or not, but I’ve been thinking that something like $40 a barrel will be the floor.  On the other hand, I don’t see the market returning to the status quo ante within any reasonable amount of time.

How this affects oil stocks tomorrow.

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