by Vinod Raghothamarao, Director Consulting, Energy Wide Perspectives, IHS Markit
Between 1940’s and 1970’s, the average annual price of oil fluctuated within a 6.5 per cent band, but from 1980’s until the last 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 sharp changes 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 in one week and almost zero in following next week. This amplification of demand fluctuations from downstream to upstream in a supply chain is called the bullwhip effect.
Consequences of bullwhip
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 it
• 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 nine per cent 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 re-hiring. Perhaps most importantly, more stable research and development investments would result in greater oilfield productivity.
Strategies to counteract bullwhip effect
The million-dollar question then becomes – What can oil companies and their equipment suppliers do? Passing all risks to suppliers is a “win-lose” strategy that only works well for buyers and only when demand is decreasing because buyers can drive prices lower. In contrast, “going long” minimises 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 of capital investment; and sharing of 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 between three to five years in duration. As this is shorter than the duration 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 NOCs/IOCs/Independents and other oil field equipment suppliers, it indicates that if you are going to go long, you may need a much longer agreement in order to fully mitigate the impact of productioninventory- capacity cycles. The optimal length varies according to the category of purchased equipment or services.
Several oil companies have demonstrated their faith in collaboration for the long-term by establishing long-term agreements with strategic suppliers, often locking in long lasting relationships. Companies which do the above must remember that a supplier is strategic if there is a comparatively large amount of external expenditure on the supplier, if the planning and engineering time horizon of the projects is long, and if there is synergy between the buyer’s and the supplier’s businesses. Ultimately, the removal of the supplier can cause plenty of damage if the supplier were removed. Highly asset-intensive utilities, power generation and logistics heavy transportation companies have inked many long-term concession agreements that can serve as models.
Whether their contractual commitment is long or short, buyers and suppliers in the oil and gas supply chain can mitigate the costs of the bullwhip effect (through excess capacity, obsolete inventory, price inflation, and lost orders) by more tightly coordinating their demand and capacity planning activities. This could include, for example, firstly sharing production, sales, and inventory information among exploration and production companies, refiners, OEMS, and component manufacturers; sharing supply risk by indexing prices and using options and futures contracts; and sharing the risk of building new capacity by assuring minimum levels of usage or availability.
It will be worthwhile to watch how the oil and gas industry adopts the mitigation strategies, especially in this era of low oil prices.
About the Author
Having a background in Engineering and coupled with MBA, Vinod Raghothamarao is a supply chain and operations strategy and management consulting professional with 14+ years of work experience across different industry sectors. He has also worked on supply chain and procurement strategy and implementation consulting assignments across the US, Latin America (Brazil), Europe, Middle East, Africa and Asia (including Southeast Asia).