Daily Archives: March 25, 2016

Economic Sustentation 09: Oil & Gas Price Shocks

For the last twenty (20) years or so the West Texas Intermediate Crude Oil Price chart has been bouncing up and down like a yo-yo in the hands of a novice who doesn’t know how to work it, but doesn’t stop trying. And any other chart you pull up for international oil and natural gas prices is going to look similar. In other words, as we stated in our damnation post, within a one-year period, prices can double or be cut in half with little or no warning. And either situation will run havoc with your supply chain.

If prices double seemingly overnight, your costs are going up — way up. If you have a contract, you might be able to insist that your supplier absorb the increase since they were, at signing, charging you higher than market cost since they were taking a risk over a predefined period. But, at some point, their margins go to zero, and soon after that, the supplier is not going to put up with it anymore, especially if they are struggling financially. Then the shipments stop.

But it’s not much better when prices drop. While the first to cry foul when prices rise, suppliers are the last to play fair when the prices drop. Arguments that the deal was so good they were losing money on delivery, arguments of higher overhead costs, and arguments of temporary blips are brought to the table whenever you ask for a price concession, even if the contract guarantees you one.

So what can you do?

1. Tie Prices to an Index – Updated Daily, Averaged Weekly or Monthly

Base the contract on index prices, averaged weekly or monthly, and tie the price to that cost on the purchase order date. You’ll pay more if prices rise quickly, but you’ll also pay less when prices fall faster than expected. Then, you can simply acquire good prediction algorithms that have performed well over the long term, and plan for the shocks and not waste time arguing when they happen, leading to much more cordial relationships that can be focussed on service and customer service.

2. Master Predictive Analytics

Don’t just acquire an algorithm, understand it, and run models with slight market changes to see how oil prices shift when other correlated indicators shift. Get better than the competition and over the course of years, you will always, always, always come out ahead.

OR, if this is too mathematically advanced for you, and you are willing to accept sub-optimal outcomes (which will still be better than what you get now)

A. Always Lock Prices in for the Long Term.

So the cost stays the same unless a ceiling or floor, defined as a price percentage, is met. If the average price over a month goes up or down more than, say, 10%, then the price shifts by a fixed percentages, such as half of that. In addition, negotiate for clauses that allow the organization to auto-renew automatically at the current price at an time in the last six months, for the same time-frame.

B. Make sure the ceiling and floor shifts with every price change.

While the cost shift will be absolute, the price should only change every time the price changes by more than a fixed percentage from the price being paid, not the locked-in price.

C. Reduce Oil and Natural Gas Dependence.

Invest in renewable power sources such as solar, hydro, and geothermal so that, over time, you become less dependent on oil and natural gas and the price uncertainty they bring.