Going Really Negative

by: Douglas Tengdin, CFA

We've seen negative interest rates. Are negative prices next?

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Negative 2-year European Government Interest Rates. Source: Bloomberg

In Europe, the central bank charges members to leave deposits on reserve. That, and the central bank's policy of purchasing government debt, has driven short-term interest rates into negative territory. Negative interest rates make a lot of economic and finance theories blow up, but their major effect is to push banks to lend more. In some European countries, consumers can even see their mortgage rates go negative.

As bizarre as negative interest rates seem, negative prices appear even more strange. That's where a merchant pays you to take their goods. I've seen this from time to time - when I used to clip coupons to go grocery shopping. Sometimes, by combining a double-coupon with a store discount, the price for an individual item would be negative.

Well, this sort of discounting has gotten into the oil patch. As you may know, there are many different types of crude oil, and they sell for different prices. They vary by how thick they are, and their sulfur content, and where they're produced. High-sulfur oil is considered "sour," while low-sulfur oil is "sweet." In North Dakota, most of their oil is sweet. But some of their production is sour. Sour oil needs special refining methods to turn it into a useful product. Because North Dakota doesn't have a lot of pipeline capacity, some refiners are paying - and producers are accepting - negative prices to take that crude off the producers' hands. So the producers have to pay the refiners to take their product.

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Varying Crude Oil Grades. Source: EIA

Obviously, that kind of product won't be pumped for very long - there's no incentive for producers to look specifically for and extract more North Dakota sour. But if this type of oil is an unavoidable by-product of an otherwise profitable oil field, it may be considered one more cost of production, and get priced in, like other costs - like labor and equipment.

In microcosm, this is what's ailing the capital markets right now. The oversupply created by the massive restructuring of the Chinese economy has generated massive surpluses in all sorts of industrial commodities - from oil, to copper, to zinc, to scrap steel. They're about 10% of the global economy, but, until recently, they consumed half of the world's commodities. A modern, service-oriented economy doesn't need all that productive capacity.

This oversupply threatens the profitability of other producers around the world. Negative price shocks mean that oil fields and copper mines that used to be viable are no longer so. But, temporarily, there are incentives for existing producers to dump their product on the market, to try to hang on until other producers go under and prices get back to a sustainable level.

In the meantime, consumers enjoy a windfall of lower prices, and sometimes even negative prices. Eventually, consumption will increase, production will decrease, and the situation will get closer to "normal." The laws of supply and demand cannot be repealed. But for the moment, we can enjoy the prospect of banks paying us to take loans, and service stations paying us to fill up our tanks. Fill up!