Oil is not the first negative price, and it won’t be the last

Negative prices for oil — when the price of a barrel fell to -US$40 (-S$57) last week — have created a stir globally. 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, with an increased influx of usage in digital services, and 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, that is purchased.

In some circumstances, this can only be achieved if the supplier incentivises the buyer with a payment in addition to the delivered product.

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, power producers paid buyers a (negative) price per megawatt hour for almost 10 days. Buyers 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. 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.

UNDERSTANDING TRANSFER EFFECTS

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.

Quite a few states can now obtain money at negative interest rates. There are also negative interest rates for private customers.

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”.

There are special situations in which negative prices may occur due to inter-period, cross-product or person-related factors.

Free samples are common for new product launches. Here, the rule that the price should be above marginal costs is neglected.

This tactic makes sense if the price of zero stimulates sales in subsequent periods, that is, the customers who got the free sample would 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.

In fact, such negative prices can be observed. 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 also be relevant for what is known as freemium services. In the usual freemium model, the basic version has a price of zero but a premium version will cost you. An example is Spotify.

Here again the question arises: Why should the lower price limit 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 set a negative price and pay first-time users of the basic version for a limited period of time.

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.

Today, prices below marginal costs are being used in promotions. This is because of economies of scale — with the concept that it becomes cheaper with every additional customer. With the marginal cost approaching zero, it is likely that we see more negative prices in the future.

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 where usage of digital services is progressively becoming predominant, it thus can be expected that investments in negative prices will increasingly pay off in the future.

ABOUT THE AUTHOR:

Professor Hermann Simon is honorary chairman of Simon-Kucher & Partners, a global consulting firm with 39 offices worldwide that he founded in 1985. He has published 35+ books in 26 languages, and is a member of several editorial boards of numerous business journals.