Making Crude Decisions

Oil prices are unstable and unpredictable. How does this affect buyers and what do analysts think will happen next? Anusha Bradley finds out.

September 04, 2008 - supplymanagement.com - A sigh of relief could be heard from purchasing offices nationwide as the price of oil fell from its July peak of $147 a barrel. But while the price of oil has softened in recent weeks, the conflict between Russia and Georgia caused it to spike again in August over fears that supplies from the Caspian Sea may be disrupted. And at the time of going to press, the price had swung up again as Hurricane Gustav threatened operations in the Gulf of Mexico. Oil remains volatile.

Prices are still high - double what they were 18 months ago - but the recent drop has been welcomed by buyers as high oil prices have been reflected in an array of commodities and services. Unlike most other items, the cost of oil is largely out of buyers' control. Prices are set by producers and international markets, which some suggest have been manipulated by speculators - from airlines to hedge funds - driving up the price for profit. This has been such a concern that a group of MPs is now investigating the effect of speculators on the oil market.

Forecasting oil prices has been likened to crystal-ball gazing - purchasers are having to plan for the unknown. "The supply and demand data is not transparent, or even available," says Simon Wardell, an economist at Global Insight. "China, which has been gobbling up oil, does not even know how much it uses because it does not have the capability of measuring it. While some countries, such as Saudi Arabia, do not allow their oil fields to be audited."

HARDEST HIT

Airlines and manufacturers have been among the hardest hit as the cost of fuel has rocketed. Manufacturers who buy gas to run their plants say they've have been hit with a double whammy as gas prices have risen in line with oil. "The most difficult part is the uncertainty," says Paul Alexander, head of procurement at British Airways (BA). "We're in the unprecedented situation where costs are going up at the same time as the economy slows."

It's a sentiment that is echoed throughout the purchasing community. CIPS energy committee member and energy consultant Chris Lewis says energy buyers are currently faced with an "agonising" choice. "The question is now that oil has come down, will it keep falling? For large energy buyers the big decision is whether they buy a fixed 12-month contract - which is good for budgeting but you risk being stuck with high prices if oil falls - or do you buy on the spot market and risk prices going up?"

MITIGATION TACTICS

In a bid to allay cost rises buyers have adopted three main strategies: pass the costs on, change the way they buy products influenced by oil prices and mitigate cost rises by squeezing savings out of other parts of their supply chain. The first approach is the simplest and the most widely used. Official figures for factory gate inflation show more and more manufacturers are passing cost increases onto their customers.

When oil reached its July peak of $147 a barrel, Wolverhampton-based Tarmac, a major purchaser of oil-related products like bitumen, gas, diesel and coal, saw its annual energy bill rise to £200 million a year.

"Some of our products are very energy intensive and can account for half of the input cost. Ultimately our margins cannot absorb this level of inflation so we have to focus on reducing the amount of energy we use and to recover increased costs from our customers," says Robert Turner, head of procurement for energy and fuel at Tarmac.

"The issue for us is volatility because if we don't get the forecasting right there is a lag in our ability to reflect our costs in our sales prices. We can be constantly playing catch-up but we are working on a number of ideas to manage this more effectively while remaining close to our supply markets."

The unpredictability of oil and gas prices also means Turner is now spending more time forecasting and making sure internal clients are aware of market trends. "More of my time is now spent on first ensuring internal communications are such that our finance teams and commercial managers have the information they need to dynamically reflect energy costs in financial forecasting and commercial contracts and, second, exploring innovative ways of helping to reduce the consumption of energy."

FUEL INCREASES

Goodyear, though reluctant to talk about its procurement strategy, has been forced to raise the cost of its products by 3 per cent. Oil makes up 20 per cent of the ingredients used to produce its tyres, while about two-thirds of its raw materials are oil-dependent. The company says it has also been hit by what it calls "hidden costs" - such as distribution - as fuel costs have risen.

Transportation costs have severely impacted manufacturers and retailers as petrol prices have soared. A typical fast-moving consumer goods manufacturer spends about 3 per cent of its annual turnover on freight, which means margins and profits are being squeezed as fuel prices climb.

A common approach being used to mitigate these costs is for buyers to install fuel price mechanisms in their fixed-price freight contracts. "Buyers are increasingly including clauses in their contracts allowing them to review the fixed price they are paying at different points in time," explains Gary Mansell, president of Trade Extensions.

His procurement software firm, used by companies including Coca-Cola, Heinz and Volvo, matches buyers with freight suppliers.

"For example, they may have a clause that states the fixed price, but says that if it goes up or down by more than 5 per cent the price they are paying must be reviewed. "This removes the uncertainty for suppliers but also ensures buyers receive a continuous service because they don't want their suppliers going out of business."

He adds slowing economies in the UK and Europe have resulted in more freight capacity in the market, which means buyers are also now able to negotiate a better price.

Meanwhile, rocketing oil prices have thrown the aviation industry into turmoil. Many have gone out of business while carriers such as easyJet and Ryanair have reduced their schedules in a bid to boost profits sapped by fuel costs. Most larger airlines use hedging - complex financial tools such as futures and options - as a means of protecting themselves against high oil prices.

Earlier this month BA said its fuel costs, which are expected to top £3 billion this year, rose to £706 million in the first three months of 2008, compared to £233 million during the same period the previous year. At the time chief executive Willie Walsh said the airline's hedging programme meant every dollar rise in oil would reduce profits by £8 million, rather than by the £16 million the firm would have experienced without the programme.

"We are hedged so the airline will break even at $130 a barrel," says Alexander. "The amount that we hedge fluctuates. The issue is when do you buy? When do you make that call? Oil has come off [reduced in price] in recent weeks but there is talk that it might go to $200 [a barrel]. So the dilemma is when do you make that call?"

BA has an established committee chaired by the chief financial officer that meets regularly to review the company's hedging policy and decide at which price it will buy.

"Procurement plays a direct role in discussions with our colleagues in finance but ultimately it's up to the CFO," says Alexander.

BA's procurement team has also adopted a four-pronged approach to mitigate fuel price rises elsewhere in its supply chain. "We are reviewing the terms and conditions of suppliers, optimising what we buy and buying less where we can, while listening to and acting on supplier initiatives when they bring cost-saving ideas to the table," Alexander adds.

It's a long-term approach since he believes oil prices will remain volatile for at least the next couple of years.

WHAT'S NEXT?

Experts are split over whether oil will continue to fall, or if it's merely a temporary blip in a continuing upward trend.

The current fall is due to a prediction of weaker demand, following concerns that the US and British economies are on the brink of recession while other developed countries are also headed for a prolonged slowdown. Investment bank Lehman Brothers forecasts oil to fall back to $93 a barrel as the Organization of the Petroleum Exporting Countries (OPEC) increases supply alongside the softening demand.

Meanwhile, energy market data published in July showed that for the first time since February 2007 investors believed oil had ceased to be a good long-term investment because prices would continue to fall.

"There is greater cause for optimism than at any other time in the past 12 months that prices will continue to come down," says Damien Cox, senior energy analyst at John Hall Associates.

Analysts say we are in unprecedented territory. Previous oil spikes, caused by events such as the 1973 Israeli-Arab War, the 1979 Iranian Revolution and the First Gulf War in the early 1990s, were all supply-driven shocks.

"We are currently in a demand-driven shock and one that has built up gradually over time," says Global Insight's Wardell. However, he believes oil could fall to as low as $80 a barrel over the next 18 months as production is beefed up.

"Once prices start falling, speculators reduce their bets, which has a snowball effect on the market. We think prices will continue to fall, either from now, or later this year after another peak."

But he believes they will rise again after that: "Prices will get worse in 2011-12 and thereafter because there are not enough supply projects coming online. Unless global demand hits a wall we will find ourselves in another tight spot - perhaps even tighter than we are in now."

Think-tank Chatham House said last month government and company failure to invest in production and new exploration could result in oil hitting $200 in the next 10 years. It predicts that a massive "supply crunch" could hit as soon as 2013.

This is something industry lobby group Oil & Gas UK is eager to avoid. It wants to make sure the government adequately supports the industry so it continues to invest in production and exploration, ensuring the UK maintains a secure supply of oil.

It adds the public often thinks oil companies are reaping huge profits from the current elevated price, but points out the cost of exploration and developing increasingly challenging fields, particularly for Britain, is becoming more and more expensive.

Norman McLennan, commercial and supply chain executive manager at Oil & Gas UK, says it's vital the industry receives government support, such as tax incentives, to ensure production is maintained in future. He adds: "We are just a little cog in the wheel on an international scale and our ability to influence oil prices is limited, but we can ensure that in the long term there is production in the UK. It's a question of sustainability and ensuring we can supply our own companies with oil."

Ensuring Britain is self-reliant in oil will take years to achieve, which leaves businesses at the mercy of a highly volatile market.

BA's Alexander concludes: "We've never been in a situation like this before. It's clearly a challenge for us all."

Anusha Bradley is a freelance journalist

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