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The CC Decision on North Sea Helicopter Services

The economic concept ofcontestability is often regardedas a purely theoretical ideal. But the UK CompetitionCommission (CC) decision in CHC Helicopter Corporationand Helicopter Services Group ASA demonstrated that infact this concept can be applied directly in certain real

world settings.1 The acquisition creates a duopoly.Nevertheless the CC found that the merger would not actagainst the public interest because the threat of potentialentry would constrain the two suppliers and prevent themraising prices. In other words the market is contestable.

The CC reversed the MMCs earlier analysis

HSG and CHC, through their subsidiaries Bond andBrintel, supply helicopter services to offshore oil and gasfacilities in the northern zone of the UK sector of the NorthSea. There is only one other supplier, so the acquisitioncreates a duopoly.

In its 1992 decision on Bond Helicopters Ltd and BritishInternational Helicopters Ltd (Helicopters I) the MMCblocked the reverse acquisition of Brintel by Bond becauseof concerns that the remaining two suppliers wouldrecognise their mutual interdependence and not competevigorously against each other (i.e. J oint Dominance). Inthe present case (Helicopters II) the CC accepted theparties arguments that the merger would not result inhigher prices. What factors lie behind this change ofassessment?

Buyer power

Increased buyer power was one reason for believing themerger would not lead to higher prices. Smaller oilcompanies increasingly exercise buyer power throughconsortia that jointly buy services. The revenue per flighthour has fallen significantly since 1992 and the contractsnow require helicopter operators to bear more risk.

One reason why oil companies can secure good terms isthat each contract represents a significant portion of a

helicopter service suppliers revenue. Contracts areawarded in a bidding process and suppliers have anincentive to compete vigorously for each contract.

In bidding markets the usual inverse relationship betweenthe number of competitors and the level of prices does notnecessarily apply in some circumstances prices can be

competitive even when there are just two bidders.2Moreover in this case there is another reason why thecontracting process imposed by oil companies meanssuppliers will be forced to set competitive prices, even witha duopoly. A combination of the size of contracts and theability of oil companies to manage the timescale of thetendering process and contract length reduces entrybarriers. The CC found that this, together with otherfactors, makes the market contestable.

1 Lexecon advised HSG during the CC investigation.2 See the Lexecon Competition Memos When Two is Enough, J une1995, and Boeing/McDonnell Douglas, J uly 1997.

Contestability and hit-and-run entry

In contestable markets existing suppliers charge low priceseven if they have very high market shares. In principleprices can be competitive even if the incumbent is amonopolist. Incumbents in contestable markets set lowprices because they fear that, otherwise, they will beundercut by hit-and-run entrants. A hit-and-run entrantcomes into a market when prices are high and exits whenthe incumbent reacts and forces prices back to thecompetitive level. For hit-and-run entry to be a credible

threat, four conditions must hold.

Hit-and-run entry can be profitable provided:(1) there is a pool of potential entrants;(2) entrants do not have a cost disadvantage;(3) sunk costs are low; and(4) eithercontracts are large and/or long,

orincumbents are slow to react.

Each of these conditions was met in Helicopters II.

(1) Pool of potential entrantsIn order to supply offshore helicopter services apotential entrant would need to be able to satisfy theoil companies that it could meet the necessary safety

standards. However helicopter suppliers operating inoffshore environments outside the UK sector alreadyhave the necessary skills and reputation. Since the oilcompanies operate globally they are familiar withthese other suppliers, and hence there is a pool ofcredible potential entrants outside the market.

(2) Relative costsHit-and-run entry is less likely to constrain post mergerprices if entrants have higher operating costs thanincumbents. Entrants will come into a market onlywhen prices are sufficiently high that their profits willcover sunk entry costs. If their operating costs werehigher than those of the incumbents, entrants mightnot find entry profitable until prices had risen wellbeyond pre-merger levels.

In fact the main operating costs for any companysupplying offshore helicopter services, whether entrantor incumbent, are the same: crew cost, maintenancecost, and capital cost of the aircraft.

(3) Sunk costsSunk costs are investments that cannot be recoveredon exit. Hit-and-run entry will be profitable only if theentrant can earn profits that cover any sunk entrycosts before it is forced to exit. High sunk costs meanthat entrants need either that high prices last longer,or that they be further above the competitive level,before hit-and-run entry becomes profitable.

In fact helicopter operators established outside the UKsector have already incurred the sunk costs needed toenter the industry. They have head offices andfacilities that can be used for major maintenance.

They could use a satellite operation to enter without

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incurring significant additional sunk costs, which wouldbe limited to the legal costs of obtaining anynecessary licences.

(4) Reaction times and contract lengthFinally a hit-and-run entrant is unlikely to earn profitsthat cover its sunk entry costs if the incumbents canreact quickly by reducing prices and hence theentrants profits when entry occurs. In marketswhere prices can change between transactions and

where incumbents can react very quickly, hit-and-runentry may not be attractive even when sunk costs arevery small.

By contrast in a market where price is largely set aspart of a long term contract the entrants revenue isdetermined by the terms of the contract it signs ratherthan by subsequent competition. An entrant canrecover its sunk costs so long as its first contract islong enough or large enough. No matter how quicklythe incumbent is able to react, the profitability of theentrants existing contract will not be affected once it isagreed.

In Helicopters II, contracts were for a minimum of 3 to5 years, and gave annual revenues of millions ofpounds, compared to sunk costs of a few hundredthousand pounds.

Together these factors mean that a rival not currentlyoperating in the UK sector could enter profitably, inprinciple even for a single contract, if the incumbents didnot offer competitive prices. Was there empirical evidencethat this was possible in practice?

No entry does not mean no constraint

There have been some examples in helicopter servicesmarkets where a supplier has entered a new region for aone-off contract that was not subsequently renewed. It isfair to say, however, that these examples of what could be

described as hit-and-run entry have been rare, which leadsto the classic problem of how to interpret an absence ofentry.

One possible reason is that there are barriers to entry.The other possibility is that the market is so competitivethat entry is not attractive. In Helicopters II, the CCconcluded that the lack of entry was evidence ofcompetitive pricing rather than barriers to entry and therewas further evidence to support this conclusion.

A natural experiment

The North Sea provided a convenient natural experimentto test the hypothesis that a combination of the threat ofentry and a competitive bidding process would be sufficientto prevent prices rising in the UK sector should the numberof players fall from 3 to 2.

The Norwegian sector of the North Sea was similar to theUK Northern Zone in all respects except one: there werethree operators in the UK Northern Zone, but only two inthe Norwegian sector. However there was no evidencethat operators in Norway have been able to benefit fromany reduction in competition as a result of the smallernumber of active suppliers.

A comparison of gross margins shows that contracts inNorway have not contributed any more to overheads thanhave those in the UK Northern Zone. The graph below

compares the gross margin3 per hour for all the contracts

3 Revenue per hour for type S61N, minus salaries and fuel costs. Figuresare relative to Norway 1995.

in the UK Northern Zone operated by the merging partiesin the UK and of the contracts operated in the Norwegiansector by the two operators there. The results support thehypothesis that the intensity of competition in each regionis not determined by the number of suppliers active there.

0.00

0.50

1.00

1.50

1995 1996 1997 1998

Years

UK NORWAY

Link to market definition

In Helicopters II the CC defined a narrow market. It foundhigh market shares but concluded that there was nocompetition concern because of the constraint offered bypotential entrants. An alternative way to account forpotential entry in cases like these is to widen the market orto adjust market shares in some other way.

The US authorities in their merger guidelines refer to thosecompanies which, although not in the market, have thepotential to enter swiftly and easily, as uncommittedentrants. When calculating market shares the FTC andDoJ , in principle, treat these uncommitted entrants asthough they were already in the market and make anadjustment to market shares to account for them. Thisadjustment is usually not numerical but is in the nature of amental footnote that high share means less than usual.

In Europe, competition authorities also recognise thatuncommitted entrants can affect competition, and in

some situations this is taken into account by widening thedefinition of the market. The most familiar instance iswhen the market is widened to include supply sidesubstitutes. Exactly the same approach could have led theCC to widen the geographic market to include areas wherepotential entrants already operated.

The aim of all these adjustments is to define the market insuch a way that market shares encapsulate as muchrelevant information as possible about competitiveconstraints. Nevertheless, widening the market to includethe locations and products of potential entrants is generallya blunt instrument for dealing with the observation thatthese suppliers constrain prices. In some cases, as here,the better approach is to acknowledge that high market

shares do not always confer market power.

Conclusions

Contestability is often viewed as a theoretical ideal, acuriosity rather than something that is observed in realmarkets. The usual analysis of contestability focuses onmarkets where incumbents can react to entry very quickly.Helicopters II suggests that, if certain market conditionsare present, markets where prices are set under long termcontracts may come close to approximating the ideal ofcontestability.

April 2000

Charles River Associates (published originally by Lexecon Ltd, prior

to the acquisition of Lexecon by Charles River Associates)