73-“Illogical” Pricing

 

Over the years, we have had more than a few clients claim that pricing in their industry is “illogical.” But these prices are set and agreed to by people, using logic. Prices aren’t usually “illogical,” but they can often be painful. Here are some examples of both good and bad prices and how they came about.

Posted 1/19/09

How can pricing hit zero? This has just happened with container freight rates on shipments from South Asia to Europe. Other rates are not much better. Container shipment fees from North Asia to Europe have fallen to $200, taking them below the shippers’ operating costs. $200 per container is bad, but how do you get to zero?

Our previous blog (“Why Overcapacity Often Gets Worse”) discusses pricing in overcapacity.

The price in a commodity industry is equivalent to the cash cost of the next person to enter the industry or the last person to exit. So, what do these prices tell us about costs? Are they “illogical”?

First of all, the prices are not what they seem. In addition to the “price” there are other charges for fuel, called bunker costs, and other fees. So, even at a zero price for the container shipment, the shipping company still makes some cash contribution. Second, the cash costs of operating ships are largely fixed. One observer noted that idle ships are now stretched in rows outside Singapore’s harbor. These are ships whose cash cost of operation are higher than those ships that are now sailing, even though shipping rates are “zero”.

Third, the industry is in severe overcapacity. This overcapacity is the result of a significant fall-off in export demand. Exported container movements have fallen between 25 and 40% in Japan, Korea and Taiwan. Even China is now seeing a contraction in shipments. Activity in the U.S. ports is also falling. Shipments from Long Beach and Los Angeles, which are America’s two top ports, have fallen nearly 20% from a year ago.

Container fees from North Asia, at $200, represent a demand level relative to capacity somewhat better than that from South Asia. Still, few, if any, shipping companies are making an operating profit at $200 a container.

This situation is likely to continue until demand begins to grow again. (See the Symptom and Implication, “Prices are rising as the industry runs out of capacity” on StrategyStreet.com.) Overcapacity ends in one of two situations. In the first situation, price competition stops despite there being more capacity than the industry needs. This occurs when a maximum of four competitors gain control of 85% or more of industry capacity. Furthermore, these four competitors must refuse to discount against one another in search of additional sales volume. In the second situation, industry demand grows by enough to sop up excess capacity and prices begin to rise in order to attract new capacity into the market. By far, the most common way that industries exit overcapacity is through demand growth. (See the Perspective, “What Ends Hostility” on StrategyStreet.com.)

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Update 2022:

In mid-2022 a 20 foot container shipped from Shanghai China to Long Beach had a beginning price of $1500.  A 40 foot container began at $2000.  These rates have fallen by half in the first 3 months of 2022.  The cost can be much higher than that.  During a period in 2021 the cost of a 40 foot container shipped from China to the US West Coast was as high as $20,800, 5 times the rate of one year earlier.  By late October 2021, rates were running between 10 and $12,000 The transit takes between 16 to 18 days.  New orders for shipping capacity, equivalent to 20% of existing capacity, will not come online until 2023.

A short-term increase of capacity by 20%, as forecast for this industry in 2023, can cause a substantial fall off in pricing. The ultimate purpose of price in any market is the discouragement of some capacity addition. That is, the price must be low enough to discourage competitors from adding capacity that will be used against you. Once your capacity is fully sold out, you no longer have the capability of influencing prices. Then, the price will rise high enough to cover the cash costs of the next increments of capacity needed in the market. In a high capital intensity industry like shipping, a company would find it worthwhile to do a careful projection of supply and demand in order to forecast future prices. See HERE for how to do this.

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Update 2/26

Let’s take a look at what has happened to pricing over the last few years to tell us what has happened in the industry and what is likely to happen in the next few years. Note that the prices we cite are averages across many routes and vessel sizes. We use them to provide directional guidance. We begin by going back to the halcyon days for the industry, from 2021 until mid 2022. The market was extremely tight with utilization rates at 95% or above on the average route. The Covid disruptions caused utilization rates to skyrocket. Rates ran up to $10,000 per 40 foot equivalent unit (FEU).  From mid 2022 through 2024 rates began to return to normal with utilization rates in the mid-to high 80s and prices falling toward $3000 per FEU. Finally, during 2025, rates continued to drop into the range of $2000-$2800 per FEU. These rates might have fallen further were it not for the disruptions caused by the virtual closure of the Red Sea and droughts in Panama. These disruptions caused the equivalent of a 10% increase in effective utilization of capacity. These disruptions quietly masked the slow emergence of overcapacity.

New capacity seems to be growing somewhat faster than the market growth. Fundamental growth in the market is around 3% per year. During the 2021 to 2022 timeframe, the industry ordered a good deal of new capacity. This new capacity is coming on stream at a rate of 3 ½ to 4% per year, somewhat faster than average market growth.  This excess capacity growth along with relatively low rates of scrappage of older vessels project price pressures for the industry over the next 3 to 4 years.

We examine industry costs to determine what past pricing tells us and what future pricing might be. Average cash costs for the industry include fuel, port charges, crew costs and maintenance. These costs total in the range of 1000-$1500 per FEU, with larger vessels falling in the range of $900-$1200 and smaller vessels in the range of $1300-$1700. The full costs of the average vessel, including depreciation and all other operating costs, along with a reasonable return on investment, fall in the range of $1800-$2500 per FEU.

Comparing these required price levels with the price levels of the last few years tells us that the industry has been short of effective capacity at least until the end of 2025. At current rates of $2000-$3000 per FEU, the industry makes a reasonable return on investment for most players, and it can afford to purchase new capacity to accommodate market growth. As long as industry capacity is constrained by the Red Sea and Panama, the future prices will still likely fall as net capacity grows faster than the market grows. If the two major constraints were to go away, prices would likely fall relatively quickly to the cash costs of some of the industry’s marginal participants. Most likely, the industry will see price pressure in the next couple of years. Prices could fall into the range of $1700-$2000 per FEU to discourage the use of marginal industry capacity in order to match effective industry capacity to current market demand.

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