Offshore Drilling and Uber Teaching Note. MGT 525 Competitive Strategy Florian Ederer

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1 Offshore Drilling and Uber Teaching Note MGT 525 Competitive Strategy Florian Ederer 1

2 Questions Why does the offshore drilling industry experience such severe cycles in rig dayrates and profitability? What determines how low prices fall in the downturns? What determines how high they rise in upturns? Is the offshore drilling industry attractive? Is it becoming more or less attractive? What segments are the most and least attractive? Why? What does the industry supply curve look like? How would you derive the industry supply curve? If you can, draw it out. (HINT: If you owned a fullyutilized fleet of jack-up rigs in the Gulf of Mexico, how would you decide whether and when to stack some of your rigs as oil prices and rig dayrates fall?) Evaluate the recent fall of the oil price in light of your previous answers and of recent advances in shale fracking. From an economic welfare perspective what are the improvements that Uber offers? Use diagrams if possible. 2

3 Short Run Profit Variability Likely not due to changes in industry Little technological change here Intermittent price wars may be a reason Requires oligopolistic structure, but here close to perfect competition Cyclical industries subject to large demand shifts and profit variability Hotels, airlines, rental cars Electricity markets Oil drilling rigs 3

4 Dayrate Fluctuation Key factors Weather Politics Business cycle OPEC Residual demand is relevant demand curve Large shifts in the demand curve Demand shifters likely much larger than supply shifters Feasible to construct supply curve from market data 4

5 Estimating Demand and Supply 2 Approaches Economic insights on costs and WTP Brute force regression Only works if one curve is held fixed Observed market outcomes are intersections of supply and demand Price and quantity influenced by supply and demand Brute force regression will not work because we do not know where supply or demand curve shifts 5

6 Why brute force does not work Price Quantity 6

7 Supply and Demand Estimation Why do we need to know supply & demand? Optimal pricing requires the demand curve Investment decision depend on long run supply response Naïve price/quantity regressions are meaningless Isolate movements in one of the curves Alternatives to price/quantity regressions WTP (demand) and marginal costs (supply) Surveys: problematic, but potentially useful 7

8 Supply Curve Entry conditions for different types of oil rigs Hot, warm, cold categories might cause kinks in supply curve Heterogeneity within these categories in terms of cost Option value of operating oil rig may matter too Short run supply has capacity constraint Long run supply likely much more elastic especially at high capacities 8

9 Demand and Short Run Industry Profitability Dayrate Bust: low industry profits Boom: high industry profits Operating and Hot Stack Warm Move (Unused) Cold Quantity 9

10 Long Run Entry and Industry Profitability Long run entry Dayrate Operating and Hot Stack Warm Move (Unused) Cold Quantity 10

11 Non-OPEC Breakeven Prices 11

12 US Shale Breakeven 12

13 Aggregate Breakeven Prices 13

14 Capturing Rents High demand Inframarginal firms potentially profit from higher prices All firms benefit if industry is at full capacity Low demand Firms potentially incur operating losses due to positive exit and start-up cost Option value of remaining in industry Elasticity of supply and demand fluctuation Elastic supply: modest profit increases Inelastic supply: large profit increases 14

15 Managing Capacity Constraints Oil rig operators potentially reap large profits if industry is at full capacity but skilled labor might extract higher wages Rig operators respond by hoarding skilled labor and training during downtime Maintenance and refurbishing particularly costly during boom times Build during downturns Consider long run supply response Likely large response if industry consistently operating at full capacity Limit entry as in barges segment (fewer players) 15

16 Strategies in Markets with Capacity Constraints Maintain status quo by constraining supply expansion But, obviously, collusion is illegal Create markets to improve the allocation of resources Intermediaries rather than actual operators may benefit Resale platforms Scalpers Intermediaries can create entirely new markets Uber Missing price adjustment for cabs (variability effect) Too little cab supply (level effect) 16

17 Price Controls Price Supply Price control High Demand Excess Supply Excess Demand Low Demand Quantity 17

18 Allocative Efficiency with Surge Pricing 18

19 Breakdown of Surge Pricing 19

20 Uber Problems Uber currently splits revenue 20/80 Perhaps not sufficient to alleviate problems of labor supply response at or near capacity constraint Sliding scale of revenue split? Lower revenue split for drivers at low utilization rates Higher revenue split for high excess demand Demand response is also crucial Better demand matching, substitution effect Limited geographical pricing response Pricing zones used to be much too large Discrete price jumps led to perverse supply behavior 20

21 Conclusions and Takeaways Understand basic principles of demand and supply estimation SR elasticity of supply and profitability LR response and potential erosion of profits Opportunities in capacity constrained markets Improved market matching Peak load pricing 21

Micro Economics M.A. Economics (Previous) External University of Karachi Micro-Economics

Micro Economics M.A. Economics (Previous) External University of Karachi Micro-Economics Annual Examination 1997 Time allowed: 3 hours Marks: 100 Maximum 1) Attempt any five questions. 2) All questions