Peak Oil is You
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Page added on December 22, 2014
The pricing challenge posed by oil’s decline
“Trying to forecast oil demand, supply and price in today’s market is like trying to paint the wings of an aeroplane in flight. Even if one succeeds in covering the subject, it’s unlikely to be a tidy job.”
Howard Kauffmann, then president of Exxon, was speaking in 1982, as the price of crude declined from its post-oil-shock high, but his comments may as well apply today, with prices weak and pundits who warned of ‘peak oil’ a year or two ago fretting instead about ‘peak demand’.
Oil majors are price takers: the level at which they sell their product is largely dictated by the market. Not surprisingly, when the price falls, they have to adjust other costs. BP last week heralded big cuts and job losses; ConocoPhillips said it would reduce capital spending by a fifth in 2015.
But what about the price makers, the companies for whom oil is one of many raw materials for their product? Their management challenge is more complex.
Despite the efforts of economists to boil the pricing question down to essentials (Alfred Marshall famously used a fish market to illustrate ‘perfect’ competition), and centuries of experience, even large companies sometimes seem to flounder.
One reason is that organisations flout the Kauffmann Principle by switching to autopilot and ignoring any risk of turbulence ahead. After a long period of commodity stability in the 1990s, some managers simply forgot how to adjust the paint-pots in flight, according to one former executive at a multinational. They had lapsed into a complacent view that the cost of commodities was predictable, projected prices accordingly, and duly suffered when raw material prices misbehaved.
The recession and online competition have pushed pricing to the top of the board’s agenda at many retail businesses. But AlixPartners reckons fewer than half of companies put price analysis and negotiation in the hands of a dedicated senior team
The textbook answer to the question of how to smooth commodity volatility is to hedge. But hedging can be a dangerous game if it is not your core activity. In 2012, Delta Air Lines actually bought a refinery near Philadelphia as part of its effort to manage fuel prices. The decision perplexed analysts, one of whom said it was ‘like a rabbi buying a church’. Glory be, Delta said last week that, partly as a result of its unorthodox strategy, it expected lower fuel prices to yield an annual net cost benefit of $1.7bn. But some critics still believe the refinery gambit — launched when oil was costly — will not work as well now that crude prices are weakening.
At least Delta is trying. Francesco Barosi of AlixPartners, the consultancy, says most companies ‘instead of looking ahead, are looking back’. Very few are good at both tactical pricing, which depends on managing existing contracts and orders, and strategic pricing, which involves keeping an eye on the horizon. Most ignore even valuable internal information from customers and suppliers that could allow them to anticipate volatility and be less reactive.
Knowledge of the consequences of a shift in raw material costs remains patchy. Some companies examine only the potential impact on their top three products; some look at their whole portfolio; some remain in the dark. The recession and online competition have pushed pricing to the top of the board’s agenda at retail businesses, according to one chief financial officer. But AlixPartners reckons fewer than half of companies put price analysis and negotiation in the hands of a dedicated senior team.
Such lapses are surprising, given that pricing the product properly is one of the basic imperatives of business. One of the great pleasures of watching The Apprentice is seeing how novices mess it up. In one recent episode of the UK version, the teams competed to create candles (which in their commercial form depend, as it happens, on paraffin wax, an oil by-product). To call their pricing strategies naive would be a gross understatement. In the end, the candidates with the better product were trounced because their opponents, despite having made various moronic errors, had used cheaper ingredients and sold their candles at a higher margin.
Some manufacturers will get lucky as the cost of crude oil falls. They may be able to hold prices and bank a higher margin. Congratulations if that decision was thought through. If, however, you did not know, let alone anticipate, how that windfall occurred, you deserve to be ranked with the blunderers on The Apprentice: you are neither price taker, nor price maker, but a price faker, whose bluff will eventually, and expensively, get called.
10 Comments on "The pricing challenge posed by oil’s decline"
Perk Earl on Mon, 22nd Dec 2014 11:31 am
No posts yet, so thought I would toss this in to get things started. Kunstler goes after Yellen for int. rate hike fail, and the future prospect of QE:
http://kunstler.com/clusterfuck-nation/if-wishes-were-loaves-and-fishes/
“Janet Yellen and her Federal Reserve board of augurers might as well have spilled a bucket of goat entrails down the steps of the mysterious Eccles Building as they parsed, sliced, and diced the ramifications in altering their prior declaration of “a considerable period” (that is, before raising interest rates), vis-à-vis the simpler new imperative, “patience,” with its moral overburden of public censure aimed at those too eager for clarity — that is to say, the assurance that the Fed will not pull the plug on their life-support drip of funny money for the racketeering operation that banking has become.
It will be at least a couple of months before the Fed dares to start “printing” again and a lot can happen before it does. If and when it does resume QE — and it will be sorely tempted — all its credibility will finally be lost.”
rockman on Mon, 22nd Dec 2014 11:59 am
“Trying to forecast oil demand, supply and price in today’s market is like trying to paint the wings of an aeroplane in flight.” One doesn’t have to go back to the 80’s to see such difficulties. Look back just 5 years ago.
Set aside the $145/bbl price spike in late 2008. The average price for that year was $99/bbl. Then the crash and the average price for the entire year of 2009 was $58/bbl. So given the y-o-y 40% drop in the price of oil how much did consumption increase in 2009?
It didn’t: oil consumption for the entire year in 2009 was several hundred million bbls less than 2008. To be clear: US consumers bought more $99/bbl oil in 2008 than the bought $58/bbl oil in 2009. Lower oil prices will help the general economy…in time. But before then a great many good paying oil patch jobs will be terminated, state revenue income is already cooked into the books, state and federal taxes will take a little slice along with the retailers who were benefiting from the redistribution of those higher salaries and the royalty checks landowners were getting. And that will be a fairly immediate effect on the general economy.
Nony on Mon, 22nd Dec 2014 12:04 pm
I don’t work for Alix (a turnaround consultancy), but am actually working with a company that is experiencing some of these commodity purchasing issues now (in metals, plastics). As with any type of purchasing initiative, you can gain from spending time/effort on purchasing. Looking at volume versus price, cross-quoting, looking at freight versus low price, quality/delivery versus price, etc. Other things possible are changing inputs (e.g. steel is down in cost and aluminum is up). Unfortunately these types of chnges involve R&D (are not quick) and have feature-benefit impacts. Still, companies will adjust given enough time/outlook.
Nony on Mon, 22nd Dec 2014 12:08 pm
demand for oil is relatively inelastic, Rock. Especially near-term. The benefits of lower prices are not in doing more driving, but in having that money available for blow and hookers, I mean other worthy purchases. You ought to understand that especially given how you emphasized how hard high prices hit the overall economy and how limited the benefits of employment in one sector were back when oil was 100. It’s just the flipside
eugene on Mon, 22nd Dec 2014 1:08 pm
Personally, I think there’s a whole lot of hot air speculation/opinions going on. One thing I’ve learned in life is the farther from people actually involved in a situation the more BS flows. I have been a professional in a couple of different fields and have spent many yours listening to people tell me all about the field I was trained in. At first I’d argue which was senseless as opinions can always out argue facts so now I just excuse myself and walk away. The energy situation, to me, appears to be immensely complicated involving politics, economics, the realities of drilling and tons of public gossip.
shortonoil on Mon, 22nd Dec 2014 3:50 pm
Howard Kauffmann, then president of Exxon, was speaking in 1982, as the price of crude declined from its post-oil-shock high, but his comments may as well apply today, with prices weak and pundits who warned of ‘peak oil’ a year or two ago fretting instead about ‘peak demand’.
Between 1979 and 1982 crude prices increased from $12.64 in 1979 to $28.52 in 1982. An increase of 227% in three years. When an author begins an article with a completely erroneous piece of information he, and it tends to lose credibility. But the author is correct in asserting that pricing of a product, present and future, is critical to the survival of any enterprise.
We have developed a pricing model that is the best one that has ever been created, and we will challenge anyone to demonstrate one that is better:
http://www.thehillsgroup.org/depletion2_022.htm
But, our model is also challenged by the extreme volatility that is appearing in the crude market. The variance in prices has increased by 412% over the last decade, and it looks like it is still increasing.
This extreme volatility must be turning the planning phase of any project into a nightmare. Even though we have not identified the mechanism driving this erratic behavior, we do know it began when conventional crude hit its peak in 2005. Extractive industries are by their very nature extremely risky; the petroleum industry must now rank among the highest. Expect investors of the future to demand very high returns in exchange for their participation.
Petroleum has had access to a very large portion of the the world’s capital for almost a hundred years. That access has been instrumental in creating the largest industry in the world outside of food production. Gaining access to the needed capital to fund ever increasingly costly projects is likely to become much more difficult as time progresses.
http://www.thehillsgroup.org/
Perk Earl on Mon, 22nd Dec 2014 10:57 pm
“The variance in prices has increased by 412% over the last decade, and it looks like it is still increasing.”
I hadn’t thought much about the increased volatility of price as it increases investment risk until your posts on the topic, Short. Just another pressure reducing future supply as I figure it.
Northwest Resident on Tue, 23rd Dec 2014 12:41 am
“Even though we have not identified the mechanism driving this erratic behavior…”
Let me take a guess at what that mechanism is.
Human behavior. Fear. Greed. Uncertainty. Opportunism. Deceit.
We’re at a point where every step forward that BAU takes is that much more difficult and laborious than the previous step. It has always been that way, but now that we’re approaching the zero net energy gain point for oil extracted the difficulty of each succeeding step forward is going parabolic. The result is BAU creaking to a halt. Within the economic and financial environment that BAU represents, humans are reacting to stimuli generated by BAU as it slowly grinds down. It is an extreme situation, and humans are reacting in extreme ways, leading to erratic behavior in the oil and other markets.
The plotted line showing the inevitable decline from point A (today) to point B (collapse) might look fairly smooth, but the human reactions as we ride that decline downward is going to be anything but smooth, and will probably result in a not-so-smooth rate of decline once we have a chance to look back on it — if we have a chance to look back on it.
Kenz300 on Wed, 24th Dec 2014 10:19 am
The sooner the world moves away from using oil for transportation the less we will worry about oil price spikes and drops……..
It is time to end the oil monopoly on transportation fuels.
Bring on the electric, flex fuel, hybrid, CNG, LNG and hydrogen fueled vehicles.
Better yet cities need to become less auto centered and more people centered by providing more safe walking and bicycle paths that connect homes, schools, work and businesses. Combine that will a good public transit system and you have the making of a more livable city.
————————
Despite Cheaper Gas, Public Transit Ridership Is Up, Trade Group Reports – NYTimes.com
http://www.nytimes.com/2014/12/22/us/despite-cheaper-gas-public-transit-ridership-is-up-trade-group-reports.html?emc=edit_th_20141222&nl=todaysheadlines&nlid=21372621&_r=0
Kenz300 on Wed, 24th Dec 2014 11:21 am
Buy a bicycle – it will give you many years of use without stopping at those pesky fueling stations….
Worry less about the price of oil by decreasing your use of it….