Price wars: definition, tactics and outcomes

With talk of a price war brewing in the oil markets that have sent the energy commodity’s price plunging to fresh lows, we take a look at what it means, how it has fared historically, and its implications within the current context.

What is a price war?

A price war is defined as a repeated cutting of prices below that of competitors as companies compete to offer the lowest price in the market.

It starts off by one company lowering its price below that of the general market price offered by its competitors, which in turn forces others to respond by lowering their prices so as not to lose market share to the company (or companies) initiating the price cut.

Why initiate a price war?

A price war usually starts amongst producers or suppliers who are offering a similar product in the marketplace, and given they can’t compete on other factors with a lack of difference between their product and that of their competitors, a natural result is to try to reduce prices to entice more buyers into purchasing their product over that of the competition.

This is the case with commodities that show little difference between producers, and stands in contrast with say carmakers who can differentiate between themselves and others by design, segment, options, quality, branding, and advertising.

Price wars usually occur:

1. When companies are trying to enter a market and establish themselves as a dominant player
2. Where they’d rather reduce prices and produce more at a competitive cost then cut output
3. Where a company is threatened with bankruptcy and is in need of short-term liquidity preferring to liquidate their products below market price than leave them idled and risk company closure
4. And/or when the market is shrinking and it forces companies into cutting prices to maintain their share of the market

Outcomes of a price war: who survives and who thrives?

The outcome of a price war is a significantly lower price (usually double-digit percentage drops) that benefits the consumers of those products.

However, this also severely tests producers who now have a much lower revenue stream. It also tests suppliers - who not only are holding inventory from when prices were higher, and must now offset it at a lower price and take on short-term losses, but must also contend with lower profit margins on new production.

This is because even if percentage profit margins are the same (such as 10%), the same percentage of a product with a significantly lower price results in a smaller profit overall.

Another common outcome is that companies with higher costs fail to survive in a cut throat marketplace, meaning only those who are able to produce at lower costs combined with a healthy enough balance sheet to weather the storm can make it, with short-term losses a common theme and downsizing a natural outcome.

However, given this usually occurs when the market is shrinking, those that do manage to survive by default emerge with a higher market share (a company with 20% market share that witnesses a drop in the market by 30% but maintains their production will see their market share of this smaller market rise to 28% without a change in output).

Oil, a price war example

With oil, the most recent price war was in 2014, and forced prices of the energy commodity to below $30 (WTI) by the start of 2016.

It forced oil-based economies into austerity, and governments to issue bonds and run larger government deficits to avoid a steep drop in spending and a failure on domestic obligations that were rising at the time, and will continue to do so this time around with the coronavirus testing government budgets.

It also forced many shale producers to shut down rigs and initiate cost-cutting strategies in an attempt to survive the price plummet.

The catalyst for the drop in oil prices this time around has been a steep drop in demand due to the coronavirus forcing oil producers into battling each other for dwindling market share.

Saudi Arabia slashed prices over the weekend in what is the start to a price war between oil producers in an attempt to hold onto its Chinese market share, a market that prior to the coronavirus was considered to be the last main expanding market for oil.

However, should oil prices rise back up, and rigs made idle can easily come back online, so while it might test companies and governments in the short term, it’s unlikely to test output in the mid to long term.