What does it mean for procurement when Oil price drops?

20150831-OPWhen we look at main cost driver like fuel steeply dropping its price, the first reaction is to rejoice because the cost of goods or services we offer will lower and compete better! Not so fast, after the celebration on ultra-low oil prices, we can sit down and understand what really happens when such thing takes place.

To understand a commodity such as oil and the fuels, in procurement, first we have to understand the supply chain. Not just all the players in the chain but all the characteristics of this category. In order to illustrate the oil supply chain and the fuel business let’s look at an oil mayor that started business some 130 years ago, Royal Dutch Shell. See the business for their oil productions was good at the beginning but it was until they joint venture with a mayor oil shipping company that the business flourish into the big player it is today. Oil needs to be assessed from the goods perspective but also from the shipping, storage and handling. All the oil or fuel derives will need special shipping, storage and handling and it will make up a big part of the final cost TCO. You will deal with a shipping market that responds to ships routes and availability. Also storage availability and inventory and the handling of hazardous materials.

Now what happens with a sharp decrease in price? For procurement it will turn into a situation that needs to be address very wisely. The first thing to take into account is that you will have inventory to manage. Fuel will always have an inventory to manage because of its nature in storage of hazardous specific handling needs. You buy fuel, you store the fuel, and you manage an inventory. When the price drops you need to be careful that the inventory price will be relatively higher to the new price. This matter can be address in different ways: Try to keep low inventories while prices are dropping, manage your inventory with a future price scheme or use hedging. The idea is to take into account your inventory actual cost, today cost and forecast cost and try to mitigate while prices are on dropping.

Remember fuel always has inventory to manage and when prices change you need to manage future inventory cost. Also a very personal recommendation: don´t try to “beat the market” not unless you are willing to take big risk. There is no crystal ball and when you might think you have the market figure out it just might surprise you.

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