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First Thoughts
  By Dan Gilmore - Editor-in-Chief  
     
   
  March 13, 2008  
     
 

Supply Chain and $200 Oil

 
 

It hardly seems that long ago, but in 2005 I wrote a column called “Supply Chain and $100 Oil.” At the time, I believe oil prices had increased to more than $60 per barrel, Goldman Sachs analysts had just predicted we might see $100 per barrel oil soon.

Well that prediction turned out to be somewhat premature, but here we are. Those views were certainly more accurate than the predictions of many others who said in 2005 that oil would drop back to the $45 per barrel range. As oil went to $70 and then $80 per barrel in 2006 and 2007, many more said that wouldn’t last.

Gilmore Says:
Think about that for a second. It’s possible we could get a doubling from today’s level of staggeringly high fuel costs. The impact to supply chain strategy would be substantial.

What do you say? Send us your comments here

This week, of course, the price is $107 per barrel or so. That’s up something like 65% from the start of 2007. It’s already causing havoc in our supply chains. Transportation costs are rising despite significant overcapacity in most truckload and less than truckload markets, as we’re stung by the fuel surcharges that have enabled the carriers to push all of the fuel risk on to shippers.

How long will it last, and where is it headed from here? If I knew that for sure, I’d be trading oil futures on a beach somewhere, but all of us in the supply chain need to start thinking through what the impact will be on our costs and operations if we go further north from here.

Legendary investor and oil tycoon T. Boone Pickens, who has made billions understanding the energy markets, said a couple of weeks ago he thought oil prices would drop back to $85 or so for awhile, due to economic slowdown, but had a real chance of getting to $150 per barrel by the end of the year.

Last week, the same Goldman Sachs analyst team now says prices could be headed as high as $200 if the world economy gets revved up again and/or any monkey wrench is thrown into the world oil supply.

Think about that for a second. It’s possible we could get a doubling from today’s level of staggeringly high fuel costs. The impact to supply chain strategy would be substantial.

I think it’s good to understand how we got here.

  • World oil production is basically flat, at something like 86 million barrels per day for a few years now. This is consistent with the “Peak Oil” theorists, who believe that oil production globally has or will soon hit a maximum and then begin to decline. Though there are some fringe elements sometimes involved in Peak Oil topics, there are also many knowledgeable people who agree, and we’re seeing whole industry conferences on the topic.
  • We are adding very little in the way of new oil reserves world wide.
  • The buffer between capacity and demand that used to exist is gone – just a million barrels per day slack or something, as India, China and other developing countries consume more and more oil and reserves and production don’t budge.
  • The reduction of this capacity slack naturally leads to general upward price pressures, and means the slightest supply disruption (let alone a major) sends prices soaring.
  • The price of oil is fundamentally unhinged now from core supply and demand, and is controlled basically by what are called futures traders. One expert recently said there was a $10-15 premium in oil prices from the futures trading versus core supply and demand factors.

So, let’s look at a number of factors. I am going to use $200 per barrel as a potential point, in part because as mentioned, that has now become the new upper target, and because it makes for some easy math in terms of doubling from the $100 level of late. I am also not considering the impact on the economy, which could/would be substantial.

Obviously, the first and probably largest impact is on transportation costs. In order, rising fuel costs impact air carriers the hardest, followed by trucking and then rail. I am not quite sure, but would think ocean would be similar to rail.

Transportation analysts at Bear Stearns believe rising trucking fuel surcharges are the key factor in the increased recent diversion they are seeing of trucking freight going to rail despite the favorable environment overall for companies in the TL market (See Quarterly Bear Stearns Shippers Survey Suggests Trucking Capacity Glut may be Reaching Bottom.)

I have recently spoken with both a high tech company and a consumer soft goods company that both moved most product by air, but which are looking at how they can make ocean shipping work in the face of rapidly rising air cargo costs.

On the trucking side, Tiffany Wlazlowski, press secretary for The American Trucking Associations, told me this week “that for the first time, carriers in some cases are telling us that fuel costs are exceeding labor [driver] costs.” She says that for truckload carriers, fuel costs can now be 25% or more of total operating costs.

Also consider that by my estimate, based on available data, oil costs represent about two-thirds of the price of a gallon of diesel fuel.

So, this means that if oil goes to $150 (a 50% increase), truckload shipping costs, however they get there (base rates or fuel surcharges), would rise about 8.5%. If it goes all the way to $100 (a 100% increase), TL costs would rise about 17% - an incredible number. Think of the impact on the bottom line of most shippers. For those interested, here’s how I got there for scenario 1: .25 (fuel as percent of TL carrier cost) x 50 (percent increase if oil goes to $150) x .67 (percent of oil in current diesel cost).

I am almost out of space, so we can’t take a much deeper dive than this here. But we will soon – Dr. David Simchi-Levi of MIT and software company ILOG, one of the most respected supply chain industry thought leaders, is working on some analytics models for SCDigest readers on what this might mean for supply chain network design and trade-offs among transportation, inventory and distribution costs.

I haven’t seen it yet, but he told me just today some of the results are not what you might expect. I’m looking forward to it, and hope you are too.

What do you see happening if fuel costs rise by another 50% or more? Do you think this is likely?  What should transportation and supply chain managers be doing to prepare for this possibility?  Let us know your thoughts at the Feedback button below.

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