Daily News for Energy & Environment

Supply chain bull whip effect in the oil & gas industry

Regardless of the reason behind the initial shocks, the variation from a steady state historical demand induced the “bull whip 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.

Variability also comes from changes and updates of the demand forecasts.

After all, we are aware that the bullwhip effect is the tendency of small variations in demand to become larger as their implications are transmitted backward through the supply-chain.

Between the 1940s and the 1970s, the average annual price of oil fluctuated within a 6.5 %
band, but from the 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 a sharp increase/decrease in demand

This bull whip 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 9% 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 R&D investments would result in greater oilfield productivity.
The million dollar question then becomes – What can oil companies and their equipment suppliers do?

Over the long term, this volatility costs the equivalent of 9% of the cost of producing a barrel of oil

Passing all risk to suppliers is a “winlose” strategy that only works well for buyers and then only when demand is decreasing because buyers can drive prices lower. In contrast, “going long” minimizes 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 futures contracts.

If you “go long,” be sure to sign long enough agreements to bridge the upend-down cycle. Many buyers think a long-term agreement is 3-5 years in duration. Because this is shorter than it takes for an initial demand shock to reverberate through the supply chain, the contract has a significant risk of painful and premature failure. Past consulting experience working with NOCs/IOCs/Independents and other oil field equipment suppliers, indicates that if you are going to go long, you may need a much longer agreement in order to fully mitigate the impact of production-inventory- capacity cycles. And the optimal length varies according to the category of purchased equipment or services.

Several oil companies have demonstrated their faith in long term collaboration 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 test of a strategic, rather than transactional, supplier is how much damage would be done 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 (excess capacity, obsolete inventory, price inflation, and lost orders) by more tightly coordinating their demand and capacity planning activities. This could include, for example, 1) sharing production, sales, and inventory information among exploration and production companies, refiners, OEMS, and component manufacturers, 2) sharing supply risk by indexing prices and using options and futures contracts, and 3) 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.

Vinod Raghothamarao – Who is who

Having a background in Engineering and coupled with MBA, Vinod Raghothamarao is a strategy
and management consulting professional with 14+ years of work experience in oil and gas, power,
refining and petrochemicals, mining and heavy industries. Worked on strategy, market intelligence,
investment advisory, supply chain & operations, technology, Capex/Opex advisory, HSE and risk management consulting assignments for energy and mining clients across USA, Latin America, Europe, Middle East, Africa and Asia Pacific. Consulted for clients such as Saudi Aramco, ADNOC, Shell, BP, Exxon Mobil, Petrobras, DNO, Petro Masila, Oman PDO, KNPC (Kuwait), First Solar, Qatar Petroleum, Vale (Brazil), Alcoa and Rio Tinto and also for few energy related PE firms. Currently, Director of Energy Wide Perspectives & Strategy (EWP) at IHS Markit. As director of EWP, work across Upstream, Mid-Stream, Downstream and Power, Gas, Coal and Renewables. EWP provides advisory, research and consulting related to Upstream, Downstream, Mid-Stream, Integrated Energy View, Inter-fuel competition, Long-term Energy Scenarios, Corporate Strategy, Country Energy Planning, Climate and Carbon and integrated energy market understanding forfinance and service sectors.

Source: Energyworld magazine, issue No 21/November-December 2017

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