How to Think About Negative Prices
6/16/20
Back in April, much of the world was stunned when oil prices turned negative. This seemingly unprecedented development has been understood to mean that those seeking to secure oil got paid to take the oil off the supplier’s hands. This turn of events represented a remarkable opportunity for those who were positioned for imminent use or those that had the capacity to store the oil for later use or sale.
I take issue with appropriateness of characterizing this episode as one in which oil prices went negative. It’s not that the price of oil went negative. Instead, what actually happened was that that two distinct transactions were occurring at the same time. The resulting “negative price” was the result of bundling these two transactions and netting the component prices.
Excess supply drives prices down; excess demand drives the price up. Clearly, it would be time of excess supply when negative prices are reported — in fact, a glut. Many holding oil in excess of their needs were forced to look to storing it, as demand appears to have been fully sated. Storage servicers, however, effectively confronted existing holders of oil with two choices: the holders could retain ownership of the oil and pay a seemingly exorbitant storage fee, or they could transfer ownership to the new storage facility and have that storage facility cart the oil away. The reported negative prices weren’t a true reflection of the price of oil, per se. Rather they were the effect of bundling the price of oil with the price of disposal and storage.
People give things of value away all the time, but in doing so, they don’t revalue the donated items and assert that they have a price of zero. My wife and I put books we’ve read and don’t care to keep out on our stoop, expecting passersby to pick them up. We do this not because we see the price of the books as worthless but because we see our cost of disposal being greater than the true economic price we would get with resale. Whoever picks up our books certainly wouldn’t see those books as having a zero price, either. The true price of the books would still be positive. The same issue is at work in the oil market.
Identifying commodity prices as being negative reflects a measurement problem. Reported negative prices misrepresent the true economics at work. Unfortunately, quite a number of people have suffered as a consequence of this measurement error. At the top of the list would be market participants who made financial decisions that rested on the expectation that prices would never pierce the zero boundary. More pernicious than that and of broader concern is the fact that we use reported price data in research studies. Measurement errors in the prices used in said research could lead to faulty conclusions and costly decision making.
The same issues are at work in financial markets in the form of negative interest rates, which are found in a variety of counties, including Denmark, Japan, Sweden, and Switzerland. The interest rate is the cost of money. With positive interest rates, borrowers pay lenders; with negative interest rates lenders pay borrowers. Examples of negative interest rates are currently limited to situations where governments lend to financial intermediaries. In these cases, the states involved have sought to grease financial wheels and provide liquidity to those institutions to encourage those firms to lend more broadly. The reported negative interest rates reflect a bundling of the value of a government subsidy payment to intermediaries with the true cost of money; and the price associated with the subsidy is the larger of the two. Netting these two components muddies the understanding of the underlying economics.
