The inventory land mine

By casually adopting popular business terminology that doesn't apply, the U.S. oil and gas industry armed a political land mine during the second-quarter dust-up over gasoline prices.

A reason for the price jump was the low level of inventories held by refiners in a winter that turned out to be especially long and cold. To explain why inventories were low, many industry and media sources-including this magazine-said refiners were practicing "just-in-time" (JIT) inventory management.

The phrase, by seeming to define itself, worked well while codified descriptions of complex market changes were in high demand. But the phrase works just as well as a bull's eye for industry critics.

It also happens not to be accurate.

What JIT is

As Kevin Waguespack and Brian D. Cantor of Arthur Andersen LLP pointed out in an OGJ article last week, JIT inventory management requires a formal set of supply agreements that don't exist in the oil business (OGJ, July 8, p. 39). Under JIT policies, a manufacturer agrees to buy a large part of its raw material from a relatively few suppliers who know the manufacturer's operations well. Under the alliance relationships that characterize JIT systems, the manufacturer may in fact take direct control of its suppliers' inventories.

The closest the oil industry comes to such an arrangement is through its use-which is declining-of long-term contracts. The breadth and depth of the oil market offer flexibility that outweighs whatever benefit refiners might find in necessarily rigid JIT policies. Besides, intimacies required by JIT systems would raise suspicions about price-fixing if they developed among oil companies.

While JIT practices have more to do with how companies are managed than they do with inventories, perpetually low inventories are integral to the practice. That's why the temptation was high to attribute low oil stocks to JIT systems.

What refiners have, in fact, been doing with inventories is responding to financial pressures and shifts in trade patterns. Inventories of any kind involve costs, which rise as a function of volumes in storage and interest rates. Refiners must weigh those costs against opportunities lost if and when they run short of product.

The recent trend has been to keep stocks and carrying charges low and to rely on an increasingly liquid market to meet unexpected demand. A broader trend is to seek profits from stock changes, which means that inventories will sometimes rise for financial reasons. This would not happen under JIT.

What's more, rising crude oil flows from Latin America and the North Sea have cut average transit distances for crude oil destined for refiners in the U.S. and Europe. Growing reliance on short-haul crude eases the need to hold oil in inventory.

This all could be dismissed as semantics if JIT did not give industry detractors such a convenient handle. Before gasoline prices subsided, critics were equating inventory management with price manipulation. In their spiels, the words "just in time" can sound sinister.

As always, a droop in oil product prices has silenced the nags-but hardly banished them from the planet. And the latest price cycle gave them a new weapon.

Companies should anticipate criticism for their alleged use of JIT inventory management and demands for minimum industry stock levels. Such mandates would, of course, raise costs for refiners and their customers.

A rhetorical bogey

Management of inventories on an increasingly financial basis is an important element of the modern oil market. It is a market that efficiently distributes supply and keeps prices on average very low.

When they think the time is right, however, industry critics will revive calls for government controls. Inventory mandates will be high on their list, with JIT management the rhetorical bogey. Industry should prepare now for the trap. In any market, prices do occasionally rise.

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