Business/economics

Counteracting the Supply Chain Bullwhip Effect

Companies are feeling reverberations in production, capacity, and inventory throughout the supply chain. But there are several ways that operators and service providers can mitigate this “bullwhip effect.”

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Oil and gas companies operate in dynamic and complex environments, and face constant challenges, especially in terms of supply and demand. After the recent oil price downturn, the time has come to evaluate supply chain and procurement techniques and costs.

Between the 1940s and 1970s, the average annual price of oil fluctuated within a 6.5% band, but from the 1980s until the last few years, the variation has widened to almost 11 times that. A range of factors has contributed to this volatility, including political crises, financial speculation, and sharp increases/decreases in demand.

Regardless of the reasons behind the initial shocks, the turn from steady-state historical demand induced the “bullwhip effect,” in which small changes in demand cause oscillating and increasing reverberations in production, capacity, and inventory throughout the supply chain in markets for oil and gas field machinery and equipment such as generator sets, motors, turbines and electrical equipment, as well as other equipment and supplies.

Small variations in demand at the retail end tend to dramatically amplify as they travel upstream across supply chains with the effect that order amounts are very unbalanced and can be exaggerated. This amplification of demand fluctuations from downstream to upstream in a supply chain is called the bullwhip effect.

Consequences of the Bullwhip

This bullwhip effect has caused the following types of economic inefficiency at oil company equipment suppliers:

  • Equipment manufacturers held excess inventory during the boom and took a long time to draw it down when the recession hit.
  • Equipment manufacturers made excessive capacity investments near the peak and suffered a low or negative return on investment.
  • Component and parts suppliers lost orders that they were not able to fulfill at the peak due to inadequate capacity and long lead times caused by large backlogs.

It is estimated that the bullwhip effect costs the oil industry about $2.8 billion per year. Over the long term, this volatility is the equivalent of 9% of the cost of producing a barrel of oil. Equipment and component suppliers bear even more of this cost than oil companies.
The initial increase in demand for oil raises the production levels of crude oil and refinery products, which translates into increased demand for oilfield equipment such as pumps, compressors, and turbines. Excess output is higher at the refiner level than at the producer level, higher at the original equipment manufacturer than at the refiner, and higher at the component supplier than at the equipment manufacturer.

Refiners and producers pay higher prices that are set when markets are overheated and are not readily de-­escalated when recession hits. Moreover, equipment and service prices keep rising even as the price of oil falls, equipment orders drop, capacity utilization drops, and lead times to manufacturing decline. Capacity adjusts, with a lag, as orders and production fluctuate, which causes capacity utilization to behave erratically.

Smoothing this volatility in demand and prices would result in steadier and more profitable capital expansion and a higher return on assets. Steadier prices would translate to higher operating profits and lower operating costs as companies would go through fewer waves of layoffs and subsequent rehiring. Perhaps most important, more stable R&D investments would result in greater oilfield productivity.

Counteracting Strategies

The million-dollar question then be-comes: What can oil companies and their equipment suppliers do? Passing all risk to suppliers is a “win/lose” strategy that only works well for buyers and then only when demand is decreasing because buyers can drive prices lower. In contrast, “going long” minimizes the cost throughout the supply chain, especially if combined with collaborative supply chain management activities such as sharing production, marketing, and engineering information among exploration and production companies, refiners, and manufacturers; sharing of capital investment; and sharing of supply risk through price indexing and the use of options and futures contracts.

But if you “go long,” you must sign agreements to bridge the up-and-down cycle. Many buyers think a long-term agreement is 3–5 years in duration. Because this is shorter than it takes for an initial demand shock to reverberate through the supply chain, the contract has a significant risk of painful and premature failure. A much longer agreement will fully mitigate the impact of production-inventory-capacity cycles. And the optimal length varies according to the category of purchased equipment or services.

Several oil companies have demonstrated their faith in long-term collaboration by establishing extended agreements with strategic suppliers, often locking in lasting relationships. Companies that do the above must remember that a supplier is strategic if there is a comparatively large amount of external expenditure by the supplier, if the planning and engineering time horizon of the projects is long, and if there is synergy between the buyer’s and the supplier’s businesses. Ultimately, the test of a strategic, rather than transactional, supplier is how much damage would be done if the supplier were removed.

Whether their contractual commitment is long or short, buyers and suppliers in the oil and gas supply chain can mitigate the costs of the bullwhip effect (excess capacity, obsolete inventory, price inflation, and lost orders) by more tightly coordinating their demand and capacity planning activities. This could include, for example:

  • Sharing production, sales, and inventory information among exploration and production companies, refiners, original equipment manufacturers, and component manufacturers
  • Sharing supply risk by indexing prices and using options and futures contracts
  • Sharing the risk of building new capacity by assuring minimum levels of usage or availability
  • Collaborating more effectively with key suppliers particularly when volatility could undermine their survival
  • Establishing direct communication from planner to planner and running forecasting processes jointly with key suppliers
  • Concentrating on smaller but more frequent orders to reduce volatility in demand and therefore inventory levels.
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Vinod Raghothamarao is director consulting–energy wide perspectives with IHS Markit. He is a strategy, supply chain, and operations management consulting professional with more than 17 years of experience in oil and gas, power, refining, petrochemicals, mining, and heavy industries. He earned a BS degree in computer science engineering from the National Institute of Technology Karnataka and an MBA from ESADE Business School.