Holding inventory costs money. How much it costs varies,
depending on the type of oil being stored, how much storage is available,
whether the storage is owned or has to be rented, the price of the oil, and the
cost of borrowing money. In all cases, the cost of holding inventory can
rapidly become significant compared to the average margins achieved by refiners,
marketers, distributors, and other oil industry participants that might need or
want to hold inventory. Based on average prices in the first half of
the 1990’s, holding crude oil for a year would cost a company about $1.50/barrel
if it had its own storage and $4/barrel if it had to rent storage tank space.
For gasoline, the corresponding costs would be $2 and $6/barrel.
Thus, storing gasoline in rented tank space costs roughly 1 cent per gallon per
month. Companies, therefore, try to operate their supply and distribution
systems in ways that keep their inventories as efficient as possible.
The trend in the more mature economies, like that of the
But stocks should
not be viewed just as a cost of doing business. Stocks can also
be a way to make money; they represent a profitable investment. Such stocks are
truly discretionary stocks. They are built or drawn in response to prices, and
particularly in response to the difference between today’s prices and
expectations about where prices will be in the future -- the forward price
curve. The widespread availability of financial instruments, like futures
contracts, has greatly encouraged discretionary stock movements, partly by
making the economic signals inherent in the forward price curve easy to see, but
especially by reducing the risk of building stocks in a surplus market.
When prices for oil today are lower than prices for oil in the future
–- a sign of oversupply -- the market is said to be in contango. If the contango
is wide enough to cover the costs of holding stocks, namely storage and working
capital, then a company can lock in a profit on the stocks if it, first, sells
oil in the futures market while simultaneously putting the same volume of oil
into storage in the futures contract’s delivery area, and then, subsequently
either delivers the stored oil against the contract or sells the stored oil and
buys an offsetting futures contract. Discretionary stockbuilding
occurs disproportionately in the U.S. Northeast, particularly around
The opposite of a contango is backwardation. A backwardated market has
prices for oil today that are higher than prices for oil in the future –- a sign
that supplies are tight. Backwardation implies that oil in storage will be
worth less later, even if holding it were cost-free. The situation,
therefore, creates an incentive for companies to reduce their stocks, which adds
supply to the market and helps to correct the indicated shortfall.
There are many other situations that also cause companies to adjust
their discretionary stocks because the risk, although not as low as it can be
with building on a contango, is judged to be much lower than the potential
reward. Three examples: when prices are at unusual levels by historical
standards; when prices are moving fast; and when governments’ oil-related fiscal
policies are expected to change. In all three case, stocks can be viewed as a
buffer that enables a company to change the timing of its purchases, with the
high probability that this will lower its costs and, therefore, improve its
bottom line. Consumers sometimes do the same thing. For example, if the tax on
gasoline at the pump is expected to increase on January 1st, motorists rush in
on December 31st and buy early.