71-“Illogical” Pricing

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.)

Posted 1/19/09

Update:

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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THE SOURCES FOR STRATEGYSTREET.COM: For over 30 years we observed the evolution of more than 100 industries, many hostile.  We put their facts into frameworks applicable to all industries and found patterns.  Strategystreet.com describes the inductive results of these thousands of observations and their patterns.