High prices: another explanation

Sept. 18, 2000
Winter weather lies just over the northern horizon in North America.
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Winter weather lies just over the northern horizon in North America.

And as colder systems move further south in the next few weeks, they also bring fears of heating oil shortages and price spikes in the US Northeast and stratospheric natural gas prices for the South and Southwest.

Consumers, already smarting from the summer's high gasoline prices, are starting to flinch even before the blows hit. A few will listen to explanations; many, however, will look for culprits.

Reasons abound, for both high gasoline prices this summer and high heating oil prices last winter. Oil & Gas Journal has thoroughly documented the myriad of events that have combined to drive them up.

After last winter, international shipping and commodity brokers Poten & Partners, New York, offered an explanation for high heating oil prices that bears revisiting as next winter approaches.

Inventory philosophy

The company traced what happened in the 1999-2000 heating season to a point in the 1980s when oil companies participated with other US industries in a radical revision of inventory philosophy.

At that time, said Poten, corporate America in general viewed inventories as a short-term asset on the balance sheet, ranking third after cash and accounts receivable.

Treating inventories as nearly equivalent to cash meant that inventories were sized to maximum "just-in-case" expectations.

Poten then used US Department of Energy data to plot the historical relationship between distillate consumption and inventory.

The change in oil companies' attitudes took place in the early 1980s when rising consumption was no longer matched by rising inventory (see chart). In fact, distillate inventory has been steadily trending downward, said Poten.

Moreover, expressing inventory in terms of coverage of days' consumption shows that the cushion provided by inventory to meet an unexpectedly severe cold snap has been cut almost by half since the early 1980s.

Poten credits-or blames-Japanese companies for leading the attitude change: To them, inventory is not a short-term balance sheet item but a cost to be minimized.

Carrying costs include the return of funds tied up in inventory plus the costs of insuring, keeping track, and storing inventory. Inventory carrying costs must cover the risks of spoilage, obsolescence, and pilferage.

Poten estimates annual inventory carrying costs at 25-35% of value; carrying costs of oil fall near the bottom of this range.

If carrying inventory is costly, a great deal of effort must be made to minimize inventories. Poten notes that "just-in-time" manufacturing nearly eliminates inventory by delivering components and parts directly to assembly lines shortly before the final product is built.

Sales disruption

What amount of finished-goods inventory is adequate? The amount necessary to prevent sales disruptions, according to Poten.

US distillate consumption is primarily diesel fuel for trucks and locomotives and heating oil for homes and businesses. The latter is responsible for the winter peak in demand.

But reducing inventory increases the risk of a disruption.

An unexpected cold snap can reduce inventory to a dangerously low level and create transient shortages that affect prices.

Rising prices benefit both oil traders and oil companies. Thus reducing inventory not only results in savings in carrying costs, said Poten, but also enhances revenue.

Facts behind facts

Is Poten suggesting oil companies are now using inventory management to enhance profits while risking supply disruptions?

North American consumers, warily watching weather systems move down from the north, may believe so. Then, they may be even less inclined to listen to reasons this winter and more inclined to look for culprits.

Oil & Gas Journal this winter, however, will continue to track supply, demand, and inventories for its readers. And consumers must continue to look for explanations, not culprits, because sometimes it's the facts behind the facts that matter.