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By Robert Rapier on Aug 22, 2006 with no responses

Inventory Management

I have been engaged in an e-mail exchange with a journalist overseas who is writing an article on gasoline pricing in the U.S. I don’t want to give anything away, so I won’t be any more specific than that. However, I do want to share a couple of responses that I sent regarding some questions of price-gouging. In one response, I commented on the writings of Tim Hamilton and Jamie Court at the FTCR. I have documented their cluelessness in a previous essay:

Another Uninformed Consumer Watchdog

This time, I was asked about this particular document by Court and Hamilton:

Low gasoline inventories set the stage for $4 at the pump in 2006

Their claim is that oil companies are engineering price spikes by purposely keeping inventories low. I am really stunned at the level of ignorance displayed here. I looked back at some of their earlier writings, and they were advocating steps that we need to take to keep gasoline under $2.00 a gallon. Do they really think cheap fuel is a good thing? Apparently they do, which tells me they haven’t thought through the implications. I guess they don’t understand that low gasoline prices will simply enable us to run through our fossil fuel endowment at the maximum possible rate.

First, they seem to think that oil companies exist primarily to serve the public’s desire for cheap gasoline. However, oil companies exist to make a profit, and have a responsibility to their shareholders. Court and Hamilton also criticize the oil companies for their profits, even though oil company profit margins are about average for all industries.

What they did get right is that inventory levels do dictate pricing. However, the suggestion that oil companies are purposely keeping inventories low in order to maximize profits is ludicrous. Lack of refining capacity required to meet the (too) strong U.S. demand is a serious issue. Just look at refinery utilization, which is a number that is publicly available at the Energy Information Administration. Prior to Hurricane Katrina, utilization was running at 95%, which is close to the maximum possible level. (Some capacity is always offline for maintenance). Following the hurricane, some very large refineries were knocked offline and utilization dropped to about 85%. However, those refineries that were unaffected were still running just as hard as they could. Fall maintenance was postponed in order to supply needed product to the market. By spring, that deferred maintenance had to be completed, and this again reduced capacity. (Spring is a very popular time for maintenance, because summer demand hasn’t yet picked up, and the weather is usually cooperative.)

However, let’s assume for a minute that refinery capacity is not an issue. What if we could make as much gasoline as we wanted? Would we run with completely full inventories? Do you know of any business that runs with grossly excess inventories? If we maintain a 100,000 barrel gasoline tank 95% full all of the time, instead of 75% full all of the time, there are 20,000 barrels of product constantly in inventory that exist merely as additional cost to the company. Those 20,000 barrels represent oil that was purchased, but is just setting there earning no dollars. The only reason for maintaining extremely high inventories would be to make sure the public is never inconvenienced, and is always able to purchase cheap fuel, regardless of the costs to the oil companies.

Even thought on rare occasions it might be nice if the tank was 95% full, that additional 20,000 barrels is an added cost on all other occasions. Businesses do not manage inventories in the way that Hamilton and Court believe they should. When there is a hurricane in the Gulf of Mexico, businesses quickly run out of flashlights and bottled water. Does this mean that all Gulf Coast businesses should stock twice as much inventory at all times, just in case a hurricane hits? It would not be profitable to tie up that much money in inventory, in anticipation of an event that will only take place on a multi-year cycle (for a given location).

I would point out that a recent report by the California Energy Commission refutes the outrageous claims of Court and Hamilton. Taken from a recent OPIS report:

Parts of California’s high profile report on the huge gas price spikes in the state last spring read like a re-run of some past probes.

The report, by the California Energy Commission, puts down refinery outages leading to a supply squeeze, coupled with a surge in exports, as the key factors behind record high prices in the state this year.

The lengthy report cites a stunning number of planned outage days at California refineries in the first six months of 2006 compared with same period last year – 175 vs. 58. Most of the unplanned outages, comparing the same periods, lasted twice as long this year.

Also, it found port congestion a factor, as well as high additives costs and the introduction of the new ultra-low-sulfur diesel fuel (ULSD).

It dismisses the notion held by some that pump prices dashed to $3.33/gal because refiners practiced price gouging (dubbed goug-onomics by some consumer groups).

Refiner group WSPA cheered the CEC’s findings saying that they confirm its assertions that market condition is behind the price volatility this year.

Not surprisingly, the FTCR cried foul:

The Foundation For Taxpayer & Consumer Rights, an industry watchdog, called the CEC’s findings a “whitewash.”

“Oil companies are ripping off Californians in exactly the same way electricity profiteers did by artificially shorting the market,” snapped FTCR President Jamie Court.

I guess they can’t handle the truth, which is that market forces dictate prices. In conclusion, it is clear that Court and Hamilton know nothing about running a business, nor do they understand basic economics. They project their views as to how oil companies should be run, and then criticize them for not running in this way. However, if oil companies operated as they believe they should, shareholders would flee the company, profits would plummet, and new capital for capacity expansions would be hard to come by.