Use the s-word

March 6, 2000
For future market cycles, the oil industry should learn to use the s-word.

For future market cycles, the oil industry should learn to use the s-word.

That's "s" for "shortage."

In a perfectly communicative world, increases in prices for oil products would provoke little controversy. Consumers would ask, "Why are we paying 50¢/gal more than we were a few months ago?" Suppliers would respond, "Because the market has swung into shortage." And that would be the end of it.

Alas, it is not a perfectly communicative world.

Understandable reluctance

No one in industry or government wants to use the word "shortage." The reluctance is understandable. Reliability is an important factor of competition among suppliers. Shortage implies failure. So suppliers have "distribution problems" or some such thing, never shortage.

And many countries have policies calling upon governments to do unpleasant things in the event of oil shortage. Members of the International Energy Agency, for example, are supposed to share oil if any one of them experiences "shortage" of specified dimension. The sharing has never occurred. The market upheavals occasioned by the Iranian revolution and Persian Gulf war weren't shortages, it seems. They must have been distribution problems.

Furthermore, suppliers to the oil market are companies toward which popular suspicion runs high. Were an oil company to explain a price spurt on the basis of shortage, consumers would respond, "Show us."

There's the problem. Consumers, regulators, and some industry leaders seem to imagine shortage as empty tanks and pipelines, as though shortage cannot exist as long as the delivery system contains any oil at all.

In reality, shortage occurs long before tanks and pipelines run dry. Shortage exists when the system's primary constraint is the amount of oil available for delivery. The opposite condition, surplus, exists when the primary constraint is the level of need. The relationship between oil available for delivery and the level of need is not always easy to measure.

Inventories provide a clue. They rise during surplus and fall during shortage. But changes are easier to measure than volumes. No one knows how much space exists in the world in which to store oil, let alone how much oil exists in that space at any given time.

It is in any case not necessary to know how much oil is in storage in order to distinguish between shortage and surplus. The market tells the story through price patterns. When prices of immediately deliverable oil are sharply higher than those of oil for future delivery, the market is short. Such a pattern implies intensifying competition for physical supply to fill immediate need. When such a condition prevails, as at present, areas at the margin of consumption, such as high-demand areas served by transportation vulnerable to weather, can encounter problems. That's what happened in the recent cold snap in the pipeline-phobic US Northeast.

Price patterns reveal the behavior of buyers and sellers at every point in the distribution system. For months, they have been screaming "Shortage!" That the condition results from reluctance by important exporters of crude oil to raise production makes it no less real.

An acceptance of the condition might help oil companies deal with the politicians now complaining about failure to store oil prior to the heating season. The explanation should be simple: No one can store what isn't available (except at a self-sacrificial price sufficient to bid the oil away from someone with immediate need).

Concrete explanations

In the latest crisis, government and industry officials bore up admirably to the political pressures that came their way. Their concrete explanations about the effects of freezing rivers on barge traffic surely played better on television than abstractions about price patterns would have done.

Still, they'll do better next time to give price the interpretive role it deserves and unflinchingly diagnose shortage when the problem is obvious.