Essay Competition – Royal Economic Society

Essay Competition – Royal Economic Society.

Those considering applying to read economics at university should think about entering an essay competition. It gives you an opportunity to investigate an area of interest, develop your extended writing skills, and adds weight to a university application. If the aforementioned fail to provide sufficient incentive then there is always the £1,000 prize for the winner.

Shell cuts exploration and output: a strategic error?

Interesting news today from Shell as it has announced that it intends to cut its spending on exploration and new projects by £10bn, or 14%, over three years.

This is a neat illustration of some aspects of microeconomic theory you might be familiar with.  It shows clearly that price elasticity of supply is greater in the long run than in the short run.  As oil prices have plummeted Shell has responded by reducing output very little in the short run, but these cuts to future exploration and output are a signal that they are responding over a three year time horizon.  So far, so good.

However, there are some elements of this story which are not so clear when using economic theory to try to analyse them.  Firstly, as Shell is a significant oil producer this cut will probably have the effect of reducing supply in the longer term, which might well help to push the oil price back up.  Given that oil has an inelastic price elasticity of demand this will benefit Shell as it will sell less oil at a higher price and gain higher revenue.  Fair enough, but it will benefit other oil companies to a greater extent as they will now not need to cut their future levels of production to reduce supply but they will still benefit from the price rise.  It looks like Shell is cutting future output to help others.

In fact, from a game theory point of view it seems to make even less sense.  The oil production business is an oligopoly and therefore decision making is interdependent.  Other oil firms will see that Shell is cutting output, conclude that the oil price will probably rise as a result, and decide that their best move is to keep their levels of output the same, benefiting from selling the same amount of oil at a higher price thanks to Shell.  The way this oil production game seems to work is like a game of “chicken”; the first oil company to lose its nerve and reduce future exploration and production will save the others from doing so and confer large windfall profits on them as the price rises.  It isn’t clear why Shell feels it needs to be the chicken in this game.  Furthermore, if it does, why has it made such an obvious point of it?  If it had made the announcement quietly, or not at all, other oil firms may not have known and might have decided to do the same.  Now, they might not.

Of course, all of this is speculation.  Without much better information about costs of production and exploration and the effect these cuts are likely to have on Shell’s output and market supply it is difficult to know how to model this announcement.  Furthermore, the management of Shell are experienced in the market and probably have much more complex and advanced models showing how their competitors will react.  However, this innocuous story is worth following over the coming months as we wait to see the effect of this on other firms in the market.