Andreoli on Oil & Fuel: The trend is not your friend
January 17, 2011
Every aspect of logistics—from the optimal location of production to the mode, timing, and volume of shipments—is influenced by the cost of transportation. As recent oil and fuel price movements elicit painful memories of the 2008 price spike, supply chain managers, shippers, and carriers are becoming concerned about where prices are headed.
In the first three weeks of December alone, the price for a gallon of diesel rose 8.6 cents, and over the fourth quarter of 2010, diesel prices gained 11 percent, climbing from $2.93 per gallon to $3.25 per gallon.
While a few cents here and there may not seem like much, they quickly add up. Last year, combination trucks alone consumed roughly 26.5 billion gallons of diesel fuel. Consequently, over the course of a year, every 4-cent increase drives industry-wide fuel expenditures up by $1 billion. If the 32-cent increase in the fourth quarter of 2010 persists through 2011, the industry could be on the hook for $8 billion.
Looking back at historical data we see that between 2002 and 2008 the price for diesel climbed at an impressive compound annual rate of 24.6 percent per year—from $1.14 per gallon to $4.76 per gallon. Of course, the recession brought down global demand and the price fell to $2.09 by March of 2009. Since then, however, the price for diesel has climbed at a profit-shrinking compound annual rate of 28.3 percent.
Rising prices have been accompanied by rising volatility. Over the last couple months, the price for crude bounced around in a wide band between $80 and $90 per barrel. Highs and lows were separated by mere days. While such rapid price fluctuations may be good news for oil traders (because winning bets are rewarded with larger pots), they leave logistics managers scratching their heads wondering what the future holds in store.
Does $90 or $80 better reflect the underlying fundamentals of supply and demand? Will the price of diesel continue to climb, and if so, at what rate?
A short history lesson
Unfortunately these questions cannot be answered with conviction because a wide range of diverse, unpredictable, and sometimes unrelated phenomenon impact oil and fuel markets. While at times events conspire to move prices in the same direction for a sustained period, they often act as countervailing forces that induce volatility.
Leading into the 2008 price spike, low surplus production capacity, declining net oil exports, a weakening dollar (compared to other major oil consumers), and a bump in China’s oil demand (Olympics) pushed world oil prices to all-time highs. This price move defied conventional wisdom, and few believed $147 oil was possible.
By the fourth quarter of 2008, the bottom had fallen out of the economy. And as the foreclosure crisis mounted, investment banks, which are major holders of oil futures, found themselves in a liquidity trap and headed en masse to sell their most liquid assets. Paper barrels (oil futures contracts) were among the holdings jettisoned from sinking balance sheets. This sell-off was accompanied by a recession-induced decline in demand that magnified the downward pressure already being exerted on oil prices.
By January of 2009, the price of oil fell into a trough far below the upward tilting historic trend line; and just as the market eventually corrects inflationary bubbles, so too does the market correct deflationary troughs. Oil clawed its way back to the $70 to $80 range by the summer of 2009 and has since breached the $90 barrier.
The most important take-away is that recent fuel price movements reflect emerging market conditions. The global economic recovery is causing markets to tighten and prices to rise and become more volatile. While speculation feeds volatility in the short run, long-term trends are driven by the underlying fundamentals of supply and demand. As the world economy continues along the bumpy road to recovery, there are strong indications that oil producers will have a difficult time keeping pace. As a consequence, we should expect rising prices and high levels of price volatility to persist into the foreseeable future.
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