By Vinodkumar Raghothamarao, Director Consulting, Energy Wide Perspectives & Strategy, IHS Markit EMEA
Between the 1940’s and the 1970’s, the average annual price of oil fluctuated within a 6.5% band, but from the 1980’s until the last few years, the variation leapt to almost 11 times that amount. A range of factors have contributed to the most recent volatility, including political crises, financial speculation, and a sharp increase/decrease in demand.
Regardless of the reason behind the initial shocks, the variation from a steady state historical demand induced the “bullwhip effect”, in which small changes in demand cause oscillating and increasing reverberations in production, capacity, and inventory throughout the supply chain in markets for oil and gas field machinery and equipment, such as generator sets, motors, turbines and electrical equipment, a11mong other equipment and supplies.
Small variations in demand at the retail end tend to dramatically amplify as they travel upstream across supply chains with the effect that order amounts are very unbalanced and can be exaggerated in one week and almost zero in following next week. This amplification of demand fluctuations from downstream to upstream in a supply-chain is called the bullwhip effect.
Variability also comes from changes and updates of the demand forecasts. After all we aware that the bullwhip effect is the tendency of small variations in demand to become larger as their implications are transmitted backward through the supply-chain.
This bullwhip effect has caused the following types of economic inefficiency at oil company equipment suppliers:
Equipment manufacturers held excess inventory during the boom and took a long time to draw it down when the recession hit;
Equipment manufacturers made excessive capacity investments near the peak and suffered a low or negative return on investment on it;
Component and parts suppliers lost orders that they were not able to fulfill at the peak due to inadequate capacity and long lead times caused by large backlogs.
In the long term, this volatility costs the equivalent of 9% of the cost of producing a barrel of oil. Smoothing volatility in demand and prices would result in steadier and more profitable capital expansion, which means a higher return on assets. Steadier prices would translate to higher operating profits and lower operating costs as companies would go through fewer waves of layoffs and subsequent re-hiring. Perhaps most importantly, more stable research and development (R&D) investments would result in greater oilfield productivity.
The million-dollar question then becomes: what can oil companies and their equipment suppliers do? Passing all risk to suppliers is a win-lose strategy that only works well for buyers when demand is decreasing because buyers can drive prices lower. In contrast, “going long” minimizes the cost throughout the supply chain, especially if combined with collaborative supply chain management activities such as sharing production, marketing, and engineering information among exploration and production companies, refiners, and manufacturers; sharing of capital investment; and sharing of supply risk through price indexing and the use of options and futures contracts.
If you “go long,” be sure to sign long enough agreements to bridge the up-and-down cycle. Many buyers think a long-term agreement lasts for 3-5 years in duration. Because this is shorter than it takes for an initial demand shock to reverberate through the supply chain, the contract has a significant risk of painful and premature failure. From the past consulting experience working with national oil companies (NOCs), international oil companies (IOCs), independents, and other oil field equipment suppliers, it indicates that if you are going to go long, you may need a much longer agreement in order to fully mitigate the impact of production-inventory- capacity cycles – and the optimal length varies according to the category of purchased equipment or services.