All it took was the March 25 shutdown of a single North Sea oil platform to boost Brent crude oil prices $1 a barrel. The European crude oil benchmark fell just as quickly, but the reaction from the loss of one oil rig underscores the increasing volatility in fuel prices supply chain managers face.
Volatility in fuel markets is here to stay, and is likely to get worse in years to come as demand for petroleum products increases worldwide. Swings in fuel prices will be exacerbated as refinery capacity tightens. Oil and fuel prices ultimately will rise to higher benchmark levels, even if they decline and fluctuate with economic expansion and recession.
Like the 2008 jump in oil prices, the steep escalation of fuel prices this year is a harbinger for transportation operators and shippers. But this time, there isn’t room for shippers and their suppliers to regress to the status quo, as they did when the global recession slashed oil and fuel prices in 2009 from their pre-recession record highs, because supply chains are leaner and more sensitive to a wide host of factors.
That means shippers and transportation operators need to take bold action, and not allow growing fears to be allayed by presidential campaign pledges to bring down the cost of gasoline or memories of the past fuel market crashes. Just as increasing domestic drilling in the U.S. will barely dent high prices, promises of the next oil bonanza under ice or ocean come with a heavier extraction price tag.
There is no more cheap oil, and that will have a huge impact on supply chains, mainly because more than 95 percent of transportation modes run on petroleum products. Rising fuel costs will provide additional impetus to ongoing supply chain trends: slow-steaming by ocean carriers, tighter truck capacity, greater use of intermodal rail and near-sourcing of production as rising transportation costs crimp far-flung supply lines.
Sustainability initiatives increasingly will focus on limiting the risk volatile fuel costs pose to profits, not just reducing a company’s carbon footprint. And, while global transportation providers such as FedEx and UPS experiment with alternative fuels, there really is no immediate alternative to oil and diesel.
Despite booming natural gas production in the United States, the transportation sector is years away from tapping the alternative fuel and weaning itself off oil. That cost of dependence will increase as oil price volatility rises on real and threatened supply chain disruptions.
The war in Libya and clashes between Sudan and South Sudan choked supply, while Iran’s threat to close the Strait of Hormuz, through which 20 percent of the world’s oil is shipped, sent jitters throughout the market that cascaded down to everyone who drives a truck or operates a ship.
But aside from politically caused volatility, the basic economics of oil point to rising costs. “This stuff is simple arithmetic. The fact is the world’s supply of cheap oil is being used up, and being replaced with more expensive oil and products that aren’t oil,” said Chuck Taylor, a logistics and oil analyst.
Recent discoveries of oil, such as those in the Bakken oil shale formation in the western United States or in Brazilian waters, will add supply, but extraction will be far more expensive than in Saudi Arabian fields. Although the U.S. natural gas boom is good news for utilities, few trucking fleets run on the fuel, and the production of liquefied natural gas-powered cargo ships is still in the design stage.
“We’ll have to electrify our transportation systems, and that has to happen soon,” Taylor said. “It should have happened 30 years ago.” That, in turn, however, would mean more demand for electricity and power generation capacity.
Demand also is outstripping supply because developing countries, namely India and China, need more oil to power their growing economies. China, in particular, is using diesel to power electrical plants. The price of West Texas Intermediate crude oil exceeded $100 a barrel for the first time in 2012 on Feb. 13, nearly three weeks earlier than last year. Diesel fuel may become even more volatile than crude oil as global demand for more environmentally friendly low-sulfur diesel mounts and production capacity shrinks.
In the nearer term, diesel prices are expected to increase as U.S. refineries slow production for maintenance. A rash of refinery closings in the U.S. Northeast points to decreasing capacity in the long term. What’s more, industry analysts say refiners are neither updating nor expanding capacity fast enough. One analyst predicts diesel prices will rise as high as $10 a gallon before the end of the decade.
But Philip K. Verleger Jr., president of PKVerleger and a visiting fellow at the Peter G. Peterson Institute for International Economics, also believes fuel prices will drop to as low as $2 a gallon at some point. He said fuel prices are likely to spike four times between 2012 and 2020, and blames lack of coordination between energy and environmental policies for much of that volatility.
At $4.15, diesel prices are already up 7 cents from this time last year — and at the highest level since August 2008. Prices are up about 36 cents from the start of the year. The Department of Energy expects diesel to stay above $4 a gallon through the rest of the year, and WTI crude oil will average about $106 per barrel in 2012.
The speedy rise in prices for fuel of all types has been as hurtful to transportation providers as the higher cost itself because they haven’t been able to keep up with the pace; many ocean carriers, for example, adjust bunker surcharges quarterly, making it difficult to catch up when such rapid increases occur.
Higher diesel prices threaten to tighten over-the-road trucking capacity, which has struck a rough balance with freight shipping demand this year. That’s causing shippers and third-party logistics providers to shift more freight from trucks to the rail, and altering strategic decisions about where companies open factories and distribution centers, said Adam Roth, executive vice president at commercial real estate firm NAI Hiffman.
He said clients are more willing to spend more for real estate if they can gain better access to rail lines, considering their transportation costs are about eight to 10 times that of real estate costs.
Roth expects rising fuel costs and dwindling trucking capacity to drive that ratio up to 15-to-1 in the coming years.
“You have to make your business attractive to transportation providers,” said Richard Thompson, head of the supply chain and logistics team at Jones Lang LaSalle, another commercial real estate company. “If you’re 20 miles off the highway and in a bad neighborhood, when the economy turns, you’ll be the first (the trucking provider) will cut.”
Shippers also can mitigate rising fuel costs by getting more into trucks and improving product packaging, he said. Global manufacturer Procter & Gamble, for instance, plans to cut $4.5 billion out of its supply chain by using cheaper and more efficient packaging. Kraft Foods has shaken more than 60 million truck miles out of its global supply chain since 2005. The $54.4 billion global food producer made transportation and distribution one of its six core sustainability areas.
Higher fuel prices also make near-sourcing more attractive, particularly as Mexican labor becomes as competitive, or nearly as competitive, as workers in China, said Walter Kemmsies, chief economist at Moffatt & Nichol engineers. The near-sourcing trend could give as well as take, however. China and other Asian countries could find it cheaper to import lower-cost goods, such as agriculture products and wastepaper, from Australia than from the United States.
Steeper bunker fuel prices, which rose 35 percent year-over-year in 2011, are adding to the total cost of supply chains and squeezing already ailing ocean container lines, which lost an estimated $6.5 billion last year. Bunker fuel in Singapore, the world’s largest refueling port, has averaged $732.88 a metric ton since Jan. 1, its highest start for a year since 2002.
Carriers have merged services with each other to help offset the higher fuel costs and overcapacity, but even these actions, along with slow-steaming practices adopted during the trade slump, won’t likely be enough. That’s because the ocean shipping industry doesn’t just face the dual market forces of volatility and falling supply.
Government restrictions on emissions in ports in the U.S., China and Europe also will force carriers to burn more expensive low-sulfur fuel, and a scheme to tax carriers for carbon dioxide emissions looms.
The air cargo industry, also suffering from weak demand and overcapacity, faces a headwind from higher fuel prices. Tony Tyler, CEO of the International Air Transport Association, said higher jet fuel prices have supplanted the eurozone crisis as the industry’s major fear. Just as the container industry has traded up for larger vessels, air cargo carriers aim to save on fuel by adding recently launched Boeing 747-8 freighters to their fleet.
Still, shippers should expect fewer services, and when demand and capacity find a better balance, carriers will be more emboldened to pass on higher fuel costs to shippers. Some already will have to pass emissions taxes onto shippers if they participate in the European Union’s new carbon trading scheme.
Trucking is where the rubber meets the road, and higher and more volatile diesel prices challenge carriers. “Higher fuel costs force people to look at every other line item to find increased value,” said Jeff Rogers, president of YRC Freight, the $3.2 billion less-than-truckload carrier. Like many large trucking companies, YRC buys diesel in bulk, fueling trucks at distribution centers.
“At one facility in the Northeast, we take it right off the pipeline,” Rogers said. “I’m not concerned about getting fuel; I’m more concerned about what my employees are paying at the pump. As fuel prices rise, it puts more pressure on the consumer and the broader economy. We don’t need anything hampering the general economic recovery right now.”