Costs and Profits

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 United States, toward consolidation of the industry through mergers and acquisitions has helped in this regard.   Every gas station, terminal, refinery, etc., must have some oil in inventory.   As consolidation has led to facilities being closed, the minimum amount of oil needed to keep the system operating has fallen.

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 New York, and in Northwest Europe, especially in the Antwerp-Rotterdam-Amsterdam (ARA) area. That is because the world’s two active families of product futures contracts are based on these delivery areas: the NYMEX on New York Harbor and the International Petroleum Exchange on the ARA area.

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.

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