Between the 1940s and the 1970s, the average annual price of oil fluctuated within a 6.5-percent band, but from the 1980s until the past few years, the variation leapt to almost 11 times that amount. A range of factors has 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, among 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 one week and almost zero the next. 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 to demand forecasts. After all, we are 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 them.
• 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.
Over the long term, this volatility costs the equivalent of 9 percent 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 rehiring. Perhaps most importantly, more stable 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 and then only 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 capital investment; and sharing supply risk through price indexing and the use of options and future contracts.
If you “go long,” be sure to sign long enough agreements to bridge the up-anddown cycle. Many buyers think a longterm agreement is 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 past consulting experience working with national and international oil companies, independents and other oilfield equipment suppliers, we know 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.
For more information, visit www.ihsmarkit.com or call (303) 858-6187.