Tuesday, 7 May 2019

Petrol profits

The Commerce Commission's paper on measuring profitability in the petrol business didn't formally call for submissions but if people had any views they could send them in by close of play today. Here are a few of mine.

The first thing is that, somewhat surprisingly, firms - perhaps many of them - can be earning persistent 'excess' profits even in workably competitive markets. The graph below, which is the absolutely standard 'demand curve crosses the supply curve' picture, shows how it happens.

We know that producer A would be earning its weighted average cost of capital at price Pbecause it is willing to offer to supply at that price, and it wouldn't if it wasn't. At the higher market price of Pe it is making above-normal-WACC returns.

Or as a very good text book* says, when you have upward sloping supply curves, as in my view you often will, "the market price in equilibrium will normally be determined by the level of cost of the higher-cost producers - the 'marginal producers' - who will make only a 'normal' profit (the market price only just covers their costs) ... At the market price, the lower-cost suppliers will make a healthy margin above cost".

So the ComCom paper is bang on when it says that "Even where competition is effective, the profitability of some suppliers may be above normal or competitive levels" (para 37) and that "Analysis of profitability by itself may not distinguish whether higher than competitive levels of profits are due to cost advantages [as with producer A in the graph], the exercise of market power, or a mix of both".

It follows that the focus of the profitability analysis should be firmly on the returns being earned by the marginal producer at Pe and not on intra-marginal producers like A. This was the approach correctly adopted in last year's first report from our Electricity Price Review (write-up here, with links to the review). It looked at whether prices were in line with the costs of the next (the 'marginal') generator commissioned.

The logic was
Contract prices that were above costs on a sustained basis would suggest weak competition among generators, and that the entry, or threatened entry, of new generators was not restraining prices. On the other hand, prices that were well below costs on a sustained basis would suggest looming problems with reliability of supply because new investment would not be able to keep pace with demand. The comparison suggests competition has been effective in restraining prices. Figure 14 shows how wholesale prices have moved broadly in line with the cost of adding more capacity. Importantly, there is no evidence contract prices have been above costs on a sustained basis in recent years (p32)
The other main point I'd like to make is that the ComCom paper currently places some reliance on where analysis of 'gross margins' might take you in any assessment of profitability. I'd say that the answer is, almost nowhere. They may have accounting or commercial relevance, but for all the reasons mentioned in para 68 of the paper they are indeed "an incomplete measure of performance". From an economic perspective gross margins tell you very little, although they might (in a very homogeneous industry) give some limited insight into productive efficiency. In particular there is no way of telling whether any particular level of gross margins is "too high"

I appreciate that in a world of limited and non-standardised industry data, ComCom is going to have to scrabble for whatever indicators, however indirect, are available to hand. But I'd downplay the gross margins route, and put more reliance on estimates of return on capital employed or return on equity (ROE), which in a market economy are the numbers that matter from an allocative efficiency point of view.

Two final small points.

In para 93 ComCom says that it will consider as an indicator of profitability "The returns being achieved on recent and proposed investment both by new entrants, and by existing participants expanding their operations, in the retail fuel markets ... we would expect returns on more recent investment to approximate the cost of capital if competition is workable and effective", which is very much along the lines of the point I made above about the profit conditions of the marginal producer. The only gloss I'd add is that, as ComCom looks at recent or proposed investments, it should be wary of the 'hurdle' rates companies tend to use to assess the profitability of investments (the projects have to have an internal rate of return that beats some minimum 'hurdle' level).

While generally it's very useful to examine internal company thinking at the time, the evidence is that hurdle rates are not good sightings of what the investing company thinks is its true WACC or ROE. The hurdle rate is typically well north of that, as companies tend to use hurdle rates to filter out overoptimistic managerial gaming of the investment budget.

And if the focus is going to be on ROE (as it ought), Stats already has some estimates of petrol company ROE in its Business Performance Benchmarker tool. Here for example are ROEs by size of petrol station. No idea of the basis of the calculations, but on the adage that if all else fails, read the instructions ...

* Gunnar Niels, Helen Jenkins, James Kavanagh, Economics for Competition Lawyers, 2nd edition, Oxford University Press 2016, p10

Friday, 3 May 2019

In a regulatory moo-d

The latest Auckland seminar from LEANZ - the Law and Economics Association of New Zealand - brought together a panel of experts on the theme, 'What's Right and What's Wrong with New Zealand Dairy Sector Institutions?'

An important issue at any time, but especially on the money right now with the current review of the regulatory Dairy Industry Restructuring Act (DIRA). So far (according to the Review website) it's reached the stage where it's analysing the submissions on the discussion document it put out last November, and the Review team is now working on policy recommendations for regulatory change. Unless I've missed it, there doesn't seem to be a master list on the site of all the submissions received, but google a bit and you'll find some of the main players' views. Fonterra's are here.

The LEANZ panel was a battle-hardened bunch of dairy experts: in alphabetical order Tony Baldwin, business consultant, A E Baldwin New Zealand; Phil Barry, Director, TDB Advisory (his LEANZ slides are here, well worth a look); Alex Duncan, Consulting Economist at Finology; and Alex Sundakov, Executive Director at Castalia.

It would be nice to say I came away with all the moving parts neatly analysed and clarified and put into a tidy box, but - in the nicest possible way - I didn't, and that's fine. As Mencken's Law says, "For every complex problem there is an answer that is clear, simple, and wrong".

That said, I can't say I was totally disabused of the notions in my head before I went into the seminar, either. 'National champion' strategies are to my mind poor plans (see here and here) and I think the Commerce Commission got the right end of the stick when it proposed in 1999 to disallow the merger that ultimately (via DIRA) became Fonterra (I dug out the details here).

They may not have settled down into a coherent whole, but some of the ideas I took away from the seminar were:

  • I liked Tony Baldwin's exploration of deep-seated, long-standing cultural norms in the dairy industry (including worship at the altar of 'white gold', dislike of competition, a wariness of markets in general and outside capital in particular, a strong desire for government involvement/support) and which, he argued, are still in play today and will continue to shape wherever we go next. Tony tells me he's polishing up his slides with extra commentary, and I'll post a link (and maybe some discussion) once they're ready. Alex Sundakov wasn't greatly minded to traverse 'old history' and suggested we should focus more on what's in front of us today, and there is that, but Tony's story still seemed highly relevant to me. Tony also concluded that the current regulatory structure can't deliver the strategy it's committed to, which I'm leaning towards as well. On similar lines Alex Sundakov also argued that existing institutional mechanisms aren't able to accommodate necessary market adjustments
  • Alex Duncan, who I last encountered when he took the Commerce Commission for its first walk through the intricacies of the milk price manual, made an intriguing point. The mantra in dairy has been 'value add': he questioned that. He felt that the ingredients business - your powders, your casein - could be the real money-spinner, because it has the production flexibility to turn out whatever pays best on the day, especially if a deeper futures market develops and enables it to lock in transient opportunities or sell-off existing positions if better ideas turn up
  • The seminar was largely free of entrenched  'pro Fonterra' and 'anti Fonterra' attitudes but still accommodated some discussion of Fonterra's calculation of the farmgate milk price. In  principle Fonterra could raise the input costs of competing processors via a high price. In practice, that's hard to square with evidence of profitable new entry (see for example Phil Barry's Slide #7) or with the potential discipline from investors in the Fonterra Shareholders' Fund who have an interest in making sure the dividend is not disadvantaged by an overly high farmgate price. Though, as someone said at the seminar, what effective recourse do they have other than to sell out of the FSF? 
  • Alex Sundakov was somewhat bemused by the Kiwi predilection for froofrooing over whether regulation is necessary and what form it should take, and said that the Aussies tended to go "Bang! You're Regulated!" (my summary). Fair point - policy analysis in New Zealand has typically been, let's charitably say, exhaustive (don't get me started on reform of s36 of the Commerce Act). But I'm not sure he's right in this case about the Aussies' pace. The ACCC proposed a mandatory code of conduct for the processors who buy the Aussie farmers' milk back in April 2018, itself the outcome of an 18 month inquiry started in 2016. The draft code surfaced in March this year: who knows when (or if) the regulation will go live. And in any event, ditherers or not, Aussie code or not, dairy farmers in New Zealand are much better protected from oligopsonistic market power than their counterparts across the ditch.
A fascinating evening. If you're not on the LEANZ mailing list, subscribe. If you're yet not a member, join up. And thanks too to Richard Meade who organises the Auckland events, and to Bell Gully for the generous hosting that makes these seminars viable.