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A Clue on How Markets Work


A Minyan sent me an article written by someone at another financial website last week about a possible oil price war. The premise was that Sweden was not cooperating on production restriction guidelines as announced by OPEC.

I chuckled and quickly deleted the article from my mailbox. I had a very busy week last week, so it wasn't until this weekend that I had a second to consider that article and how it fits into our responsibility at Minyanville.

I feel responsible to comment on the article because it exhibits so well what we consistently see out of financial commentary: a complete misunderstanding of how markets work.

Price wars occur primarily in markets that experience commoditization: because there are low barriers to entry or little differentiation in production, price is often the only level on which companies can affect their market share, and thereby their revenues. When one company begins cutting prices in such a market, the process often becomes a self perpetuating phenomenon.

Any economic entity has one long term objective: to maximize profits, not necessarily revenues. It may be that increasing revenues will lead to increased gross profits if the effect from a decrease in margins (from lower prices) is less than the contribution from higher revenues.

And here is where the writer exhibits his misunderstanding of how markets work. There certainly could be a price war in oil (anything is possible), but it is much more likely to occur when prices are going down, not up. When prices are going up it indicates a lack of supply (even if it is artificial). Lowering prices in such an environment would not maximize gross profits while increasing revenues. When there is an oversupply and prices are generally going down, an entity producing a commodity would likely feel much more pressure to lower prices in an attempt to keep gross profits from eroding by attempting to raise revenues by increasing market share at the expense of their competitors.

My main point is that there is a lot of garbage put out there by the financial media and you must be careful. Just read the Financial Times and then the Wall Street Journal. It is like they are each reporting on two different planets.

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No positions in stocks mentioned.

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