Guest Editorial: Counteracting the Supply Chain Bullwhip Effect

Abstract

Guest editorial 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 “bull-whip 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.