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:

By early 2023, a 20 foot container shipped from Shanghai China to Long Beach had fallen to a price near $1,500, and a 40 foot container to near $2,000 — roughly half of what the trade was still paying in mid-2022, when transpacific spot rates remained in the thousands of dollars per container. The cost had been far higher than that not long before. In August 2021, the spot cost of a 40 foot container shipped from China to the U.S. East Coast spiked as high as $20,800, five times the level of one year earlier; West Coast lanes ran high as well, though not quite that high. By late October 2021, rates on the main China-to-West-Coast lane were running between $10,000 and $12,000. The transit takes between 16 and 18 days. New orders for shipping capacity (Pattern: the total unit volume a facility or group of facilities can produce annually, at its highest practical operating mode), 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 and 8/26

Let’s take a look at what has actually happened to pricing since our last update, because the path was rockier than the smooth glide toward $3,000 we described. We go back to the halcyon days for the industry, from 2021 until mid-2022, when Covid-era demand pushed utilization rates to 95% or higher on the average route and rates as high as $10,000 per FEU (40 foot equivalent unit). Rates then fell much further than “toward $3,000” — the World Container Index bottomed at $1,997 per FEU in February 2023, an 81% collapse from its September 2021 peak. The Red Sea’s closure and the Panama Canal’s drought then pushed rates back up through 2024, and in 2025 a temporary U.S.-China tariff truce triggered a rush to ship ahead of the next tariff deadline, spiking the World Container Index to $3,527 and the Shanghai-to-Los Angeles lane specifically to $5,876 in May and June alone, before both fell back later in the year. Our estimated 2025 range of $2,000-$2,800 per FEU undersold how volatile the year actually was; by 2025 the Red Sea and Panama disruptions weren’t just masking the slow emergence of overcapacity, they had become the dominant driver of price swings in both directions.

New capacity is also growing faster than we guessed. Fundamental demand growth in the market remains around 3% to 4% a year. But fleet capacity is expanding at 5% to 6% a year in 2025 and 2026 — the current orderbook equals roughly a quarter of the existing fleet, among the largest in the industry’s history. Combined with relatively low scrappage of older vessels, that wider gap between supply growth and demand growth means the industry’s overcapacity (Pattern: a condition in which competitors in an industry can supply more than the market demands at the current market price) problem is bigger than we estimated, not smaller, and the price pressure ahead is correspondingly greater.

Our cash cost estimate needs revisiting. We put cash costs — fuel, port charges, crew, and maintenance — at $1,000 to $1,500 per FEU. Bunker fuel is a major share of that number, and bunker prices are up roughly 67% since February, before adding the war-risk and Cape of Good Hope routing premiums the industry is now paying to avoid the Red Sea. Treat our February cost figures as a floor, not a current estimate, until a fresh study is done.

Here’s what we got wrong in February: we expected price pressure over “the next couple of years” as the Red Sea and Panama constraints eased and the industry’s overcapacity reasserted itself. Instead, the constraints got worse. Renewed conflict risk around the Strait of Hormuz and continued Houthi attacks have kept most container traffic on the long route around the Cape of Good Hope rather than through Suez. That detour, port congestion, and slower steaming to manage fuel costs have taken an estimated 10% of the industry’s nominal capacity effectively off the market. Add a fresh round of tariff-driven frontloading, and the World Container Index hit an all-time high of $4,639 per FEU in July 2026 — up 73% from a year earlier, above even the 2021 pandemic peak.

This doesn’t change the underlying logic, only the timing. Every dollar of today’s $4,600 rate sits on top of a capacity surplus that is now larger than we thought, not smaller. A Red Sea reopening or a Hormuz de-escalation could happen quickly, and when the ships now detouring around Africa return to the shorter route, the capacity that’s effectively missing today comes back to the market all at once. When that happens, we would expect rates to fall further and faster than the $1,700-$2,000 floor we projected in February — the larger the disruption premium built into today’s price, the harder the eventual landing.

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