Oil inventories should be based on margins, supply reliability

Kevin Waguespack, Brian D. Cantor
Arthur Andersen LLP
Houston

U.S. oil inventories have plummeted to their lowest recorded levels this year, leading industry observers to conclude that refiners have adopted new just-in-time (JIT) inventory policies.

Total crude oil inventories are about 300 million bbl-8% below the 10-year average. Distillate inventories posted similar declines this year because of unusually cold winter temperatures and refiners' reluctance to build sufficient stocks in the autumn months. Gasoline stocks are 20% below the 10-year average at 200 million bbl, despite forecasts of record-high gasoline demand this summer.

Many consultants and journalists presume that refiners are following the example of their industrial manufacturing counterparts in a concerted drive to minimize inventory costs. Companies relying on JIT strive to minimize base feedstock and finished goods inventories in an effort to maximize bottom line performance.

The sudden drop in crude and product inventories this year is widely considered a sign that refiners have implemented JIT, signaling a permanent shift to reduced stocks.

In the U.S., the number of days of supply in inventory, known as stock cover, has fallen significantly since the early 1980s, particularly for refined products (see Fig. 1 [ bytes]88823). This decline in oil storage volumes was no doubt driven in part by tighter cost management practices. But are lower stocks really the result of the adoption of JIT by U.S. refiners?

The authors submit that the shift towards reduced oil inventories is not related to a concerted adoption of JIT by U.S. refiners, and that oil inventory management decisions should instead be based on refining margins and supply reliability.

The JIT revolution

U.S. refiners have become more comfortable with less crude and product stocks. But low inventories are not equivalent to a true JIT program.

JIT was first implemented in Japan following World War II. In an effort to curb costs and benefit from vertical integration, Japanese industrial companies kept a close eye on base feedstock and finished goods inventories. Production was meant to meet current demand so that valuable capital could be reinvested in the company.

JIT arrived in the U.S. in the early 1970s, and was adopted primarily by industrial manufacturers struggling to compete against their more efficient Japanese counterparts. A key feature of JIT is close supplier/manufacturer relationships.

Unlike traditional supply arrangements, manufacturers relying on JIT agree to purchase the bulk of their unfinished feedstocks from a few suppliers who have intimate knowledge of the manufacturer's operations. In many cases, the supplier actually has direct access to, and manages, his customer's inventory.

These strategic alliances allow companies to reduce stocks and pursue additional goals such as improved customer service, shorter lead-times, and zero-defect quality standards. Although low stocks are a characteristic of companies employing JIT inventory management, the policy involves a fundamental shift in management philosophy from the boardroom to the shop floor (Table 1 [43527 bytes]).

Reduced U.S. crude inventories are, in fact, largely the result of increased reliance on short-haul crudes from Latin American producers, and to significant ration alization in the U.S. refining sector. The steady decline in crude and product stocks by U.S. refiners has not been accompanied by a fundamental shift in supplier/refiner relationships or supply acquisition practices.

Major crude producers in the Middle East, Europe, and Latin America have not initiated formal JIT relationships with U.S. refiners. These nations do not stand ready to meet the immediate demand needs of refiners attempting to create a continuous flow of feedstocks and finished products. Neither do they typically provide for much flexibility in adjusting production and loading schedules to better meet the variable demand of U.S. refiners.

Domestic manufacturers in these regions are, in many cases, free to locate their production facilities near their suppliers. By contrast, most U.S. refiners depend either on waterborne crude supplies or pipeline shipments. The time lag associated with these shipping methods prevents refiners from establishing true JIT relationships.

In addition, the U.S. refining sector as a whole has not adopted other key aspects of JIT programs. U.S. refiners are still cost-driven to a large degree, and depend on a variety of suppliers to allow access to a wide spectrum of crude oils, rather than risk profitability by depending on a select few.

Optimal-inventory model

The recent shift to reduced inventories is the result not of JIT, but rather of a decision by U.S. refiners to reap modest earnings gains and free-up working capital by selling a portion of their stock cover.

U.S. refiners are more comfortable operating with less stock cover than ever before, and many observers believe that low stocks will become a permanent characteristic of the industry.

A refiner with 100,000 b/d of capacity holding 20 days of crude supply could save approximately 1.0¢/bbl in the financing cost of working capital following a one time inventory reduction of 10%. The inventory reduction would reduce total capital employed in the business by less than 1%. Overall, return on capital employed would improve by less than 0.2%.

But even this small reduction in inventory carrying costs is not necessarily free. By reducing stored inventory, the refiner takes on greater exposure to lost opportunity due to the increased possibility of running short of crude.

What is absent in the current debate over inventory levels is a consistent rationale for refiners to follow in determining appropriate stock levels. Arthur Andersen has modeled the impact of key economic and operating variables on inventory management decisions to determine the tradeoffs associated with holding different levels of stocks.

This optimal-inventory model suggests that refiners should minimize stock cover during periods of low margins and high supply reliability because the opportunity cost associated with inadequate supplies will be low. Conversely, refiners should hold higher stocks during periods of high margins and low supply reliability because the opportunity cost associated with a supply shortfall will be high.

It is not clear whether refiners are actually basing their inventory management decisions on margins and supply reliability. A careful analysis of Fig. 1, however, demonstrates that product stocks have not declined consistently.

Product stock cover rose appreciably in 1990 and 1991 in response to improved refining margins and reduced supply reliability during the Gulf War. Product stock cover dipped in recent years (along with refining margins), but is no lower than it was in 1989.

The optimal-inventory model considers margins and supply reliability to determine the most economic level of inventory. The most difficult part of any predictive inventory model is the representation of supply reliability.

For crude oil inventory, supply reliability depends on the timeliness and degree of confidence in the supply system (waterborne cargo or pipeline). For products, supply reliability is a function of the major gasoline-producing processing units.

Demand reliability is another variable that determines optimum stock levels; however, it is not a key factor in determining the best inventory position.

In the predictive model, supply and demand reliabilities are represented by a reliability coefficient. Supply reliability must be related mathematically to the number of days that supply might be disrupted and, ultimately, to the margin opportunity costs.

A reliability coefficient of 1.0 indicates absolute supply assurance. If a refiner's coefficient approaches this level, the plant is running at minimal operable inventories to reduce storage costs because there is no chance of supply disruption.

Fig. 2 [85116 bytes] depicts cost curves for a crude inventory system supplying a refinery running 100,000 b/d. For an assumed set of conditions, storage costs, opportunity costs, and the resulting total costs are plotted in relation to the number of days of supply on hand.

The case study conditions were:

• Unit capacity, 100,000 b/d

• Variable margin, $2/bbl

• Supply reliability factor, 0.95

• Demand reliability factor, 0.98

• Cost of capital or interest rate, 10%

• Inventory costs, $22/bbl

• Incremental storage costs above 10-day supply, $0.30/bbl.

Note that, for these conditions, overall costs are minimized when inventory is maintained at about 7 days' supply. Below this level, the lost opportunity costs exceed the savings in storage costs. Above this level, the added costs of increased inventory do not justify the increased insurance against delays in delivery.

It should also be noted that the model is based on usable commercial supplies rather than total inventories. Stocks required to meet minimum operating requirements in primary storage facilities (for example, tank heels) and crude stocks in transit are not included in the model's calculations.

The representative optimal-inventory model can be used to evaluate the effects of changes in margins and supply reliability on the optimal number of days' supply to keep on hand. As noted in Table 2 [23115 bytes], increasing the reliability factor to 0.98 from 0.92 reduces the target inventory level by about 4 days, regardless of whether margins are very high or very low. With margins at $6.00/bbl, for example, the optimal number of days of supply falls from 11 at 0.92 reliability to 7 at 0.98 reliability.

The model also can be used to evaluate the benefit of increased supply reliability on the costs of carrying inventory. And it offers insights into the current role the futures market and traders play in determining price expectations.

As stated earlier, refiners' storage decisions are driven primarily by margins and less by the condition of the paper market. On the other hand, traders who profit from changes in forward prices are forced to make inventory decisions based on the cost of carrying inventory.

Market "backwardation" occurs when prompt prices are greater than forward prices. The recent surge in the level of backwardation in crude and products markets-with prompt prices at a significant premium to forward prices-has increased pressure to maintain low inventories.

A recent survey by Petroleum Intelligence Weekly found that worldwide usable levels of commercial stock cover for crude and products are, respectively, just 8 days and 2 days. Stock cover in the U.S. is at or slightly below these averages.

The massive shortfall in product stock cover has helped to sustain a high level of backwardation and a consequent rise in prompt prices. The shortfall in crude inventories also has led to unexpected price strength, pushing WTI prices from about $18/bbl at the beginning of the year to a peak of $24/bbl in mid-March.

The willingness of refiners to begin building stocks, however, is dependent on margins and supply reliability. Healthy margins increase the opportunity cost of missed sales resulting from inadequate supplies.

The dismal refining margins realized during the first quarter have not provided refiners with much incentive to increase inventory levels. Continuing relative security of crude supply also suggests that refiners have no incentive to increase inventories.

Low inventories, however, are by no means permanent. They are a function of margins and supply reliability, not of JIT management strategy.

The future

If refining margins improve in the short term, with inadequate stock cover, the margin reduction associated with reduced crude throughputs likely will result in a push toward higher inventories, reversing recent trends.

Low inventories, like low margins, are not here to stay. Refiners likely will continue to manage their inventories based on the economic benefits of carrying forward stock cover. The real challenge is to determine what impact the inevitable restocking of inventories will have on the worldwide oil supply and demand balance.

The Authors