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Sun 26 Apr 2020 08:31 AM

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Negative oil prices - not a new phenomenon

In several sectors of the economy, negative prices have existed for years, meaning that it is not the seller but the buyer of a product who is paid, writes Lovrenc Kessler

Negative oil prices - not a new phenomenon

Negative prices for oil have caused a sensation in the last few days. The price of a barrel of WTI fell to minus 40 dollars. But the phenomenon of negative prices is by no means new. In several sectors of the economy, negative prices have existed for years, meaning that it is not the seller but the buyer of a product who is paid.

Examples can be found in power generation and banking. Triggers are imbalances between supply and demand and marginal costs of zero. Both new production conditions and the Internet are the drivers behind these triggers. In addition, cross-period and cross-product effects can induce the optimality of negative prices.

In normal transactions, the customer pays the seller a positive price and receives the product or service in return. The customer is willing to pay the positive price if the good purchased is of benefit to him. From the seller's point of view, the short-term lower price limit is the marginal cost, which means that he or she only sells a product at a positive contribution margin. In the traditional world, marginal costs were generally greater than zero, so that prices of zero were rare and those below zero practically never occurred. In the case of oil, this has now happened for the first time.

The Internet, but also other new technologies, are changing this situation fundamentally. The marginal cost of an additional product unit is often zero or close to zero. But these effects go even further. With solar power the marginal cost of electricity generation is not only zero, but the electricity produced must be consumed, i.e. purchased. In some circumstances, this can only be achieved if the supplier incentivizes the buyer with a payment in addition to the delivered product. The situation is similar with the oversupply of oil.

Negative power prices

At the European Power Exchange the number of hours with negative electricity prices has increased from 15 hours in 2008 to 211 hours in 2019. Last year, the power producer paid the buyer a (negative) price per megawatt hour for almost ten days. The buyer received the electricity plus money. How can this be explained? Obviously, one condition is that even with a price of zero, the supply of electricity is greater than the demand. What remains is a supply overhang.

Normally, electricity producers would stop production under these circumstances. However, this is not possible with certain power generation methods, such as photovoltaics. Even traditional power plants have limited flexibility. The electricity produced must be purchased. This purchase only occurred on the relevant days if the electricity producer paid the customer a negative price.

One can speak of "temporal coupled production". In order to be able to produce on days with positive prices and make a profit, the producers must subsidise the electricity on days with negative prices. With the negative oil prices we are currently observing, we encounter the same conditions. It is more advantageous for the oil producer to pay the buyer something in addition than to interrupt production or rent expensive storage capacities.

Negative interest

Interest is nothing other than the price of money. Negative interest rates were first observed in Denmark in 2012. Today they have become a widespread and much discussed topic. The discussion has taken on philosophical proportions. Swiss Federal Reserve Chairman Thomas Jordan holds that, "A negative interest rate is not contrary to human nature." Quite a few states can now obtain money at negative interest rates. There are also negative interest rates for private customers. For a loan of 1000 Euros with Check24 one only had to pay back 972.49 Euros after twelve months. This corresponds to an interest of -2.7 percent.

The portal Smava lent 1000 Euros for three years and only demanded 923 Euros back. Economist Carl-Christian von Weizsäcker speaks of a "negative natural interest rate" as a phenomenon that is by no means temporary, but rather permanent. He sees the cause in a "structural surplus of the private will to save over the private will to invest. For European banks it can be more profitable to lend the surplus money at an interest rate of -0.2 percent instead of depositing it at the central bank and having to pay negative interest of -0.5 percent. And if depositors are willing to provide the bank with money at a negative interest rate, the bank can lend this money at a negative interest rate and still achieve a positive contribution margin.

Negative prices due to transfer effects

There are special situations in which negative prices may occur due to inter-period, cross-product or person-related factors. Free samples (e.g. for pharmaceuticals or consumer products), i.e. prices of zero, are widespread for new product launches. Here the rule that the price should be above marginal costs is neglected during the product launch phase. This tactic makes sense if the price of zero stimulates sales in subsequent periods, i.e. the customers won with the free sample buy the product more often in the future. However, the question arises why zero should be the lower price limit in this situation.

If you think one step further, zero appears as an arbitrary lower price limit. Perhaps the acceptance of a new, previously unknown product could be accelerated by paying a negative price to the first acquirers instead of "only" offering the product at a price of zero. With marginal costs of zero this option becomes much more attractive than with the high positive marginal costs in the traditional economy. In fact, such negative prices can be observed. In its initial phase, PayPal used negative prices. Each new customer received 20 US dollars. In China, providers of bicycle sharing services such as Mobike paid their customers to use the bikes.

An analogous argument can be used for cross-product effects. If a product A promotes the sales of a profitable product B, it can make sense to offer product A at a negative price. This chain of effects can be relevant for freemium constellations. In the usual freemium model, the basic version has a price of zero. Here again the question arises why the lower price limit should be zero?

If, as a result of the experience with the basic version, many users convert to the paid premium version, it may well make sense to pay first-time users of the basic version for a limited period of time, i.e. to set a negative price. Many telecommunications companies offer customers who sign a service a smartphone for free or for a symbolic price of 1 Euro or Dollar. Again, the question is whether new customers should get paid for accepting the smartphone. A medium-sized marketer of telecommunications services reported a success with a negative price for the smartphone. The negative price was paid in cash, which probably increased the effect.

The cash backs that are widespread in the Middle East fit into this context. Almost all major banks in the UAE (and in the meantime also in KSA) are offering credit cards with a cashback benefit of up to 10% to attract new customers in an attempt to cross-sell them other products, e.g. car or housing loans later.

In the US, cashbacks for car sales are also common. With this method, you buy a car for $30,000 and then get $2,000 back in cash. This 2,000 dollars can be interpreted as a negative price. What sense does that make? Why not just pay $28,000? Daniel Kahnemann's prospect theory has an answer. The payment of the 30,000 dollars creates a perceived loss, because this sum must be sacrificed. This loss benefit is offset by the benefit of getting the car.

There is also a third benefit component, namely the benefit of receiving 2,000 dollars in cash. Obviously, many car buyers feel a higher net benefit from this price structure than if they simply pay $28,000 for the car and do not receive a negative price in the form of the cash back. Not so long ago in the UAE, a real estate developer even offered new homeowners a luxury car on the purchase of its villas and apartments.

Ultimately, the question is how marketing and promotional measures work compared to negative prices. Product launches are regularly supported with substantial budgets. The funds flow into instruments such as advertising, displays, promotions and discounts. So far, negative prices are rather rare with new product launches. But a negative price can be more effective than advertising or similar measures without having to provide larger budgets. With marginal costs approaching zero, such conditions become more likely. Some suppliers will go below the lower price limit of zero and offer their products at negative prices. Even today, prices below marginal costs are being used in promotions. It is likely that we see more negative prices in the future.

Conclusion

In theory, the short-term lower price limit is the marginal cost. If this is zero, then zero becomes the lower price limit. However, we are increasingly seeing negative prices. Behind these prices are production and cost conditions that override the price floor of zero. This can be caused by oversupply, which has to be sold even though demand is insufficient when the price is zero.

This is currently the case with the oil price and has been, for years, with electricity prices. Cross-period and cross-product effects combined with low marginal costs can also lead to negative prices. To arrive at optimal solutions, the effects of promotional measures and negative prices must be quantified. In the Internet age, it can be expected that investments in negative prices will increasingly pay off in the future.

Lovrenc Kessler is managing partner, Simon-Kucher & Partners

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