Risk Management: How High Will Oil Prices Go?

It wasn’t too long ago that crude oil prices peaked at US$147 a barrel. That was in the middle of 2008, before the fall of Lehman Brothers and the hurricane that was the global financial crisis. Oil then fell to the US$40 level as economic activity churned to a near halt, before recovering to the US$70-US$90 range on signs last year and so far this year that the U.S. and other major economies are returning to growth.

 
Last week, crude briefly broke through US$100 a barrel as the revolution in Libya and unrest in other oil producing nations inflamed fears about supply shortages. The North African country is the ninth largest oil producer in the 12-member Organisation of Petroleum Exporting Countries (OPEC), accounting for 5.3% of the group’s crude production of 29.7 million barrels a day in January this year.
 
Oil is certainly a big concern for Asia’s CFOs, on top of worries about raw material prices, labour costs and inflation. In the CFO Innovation Asia Business Outlook survey for the first quarter of 2011, cost of fuel surged to the fifth spot in the list of top-three external concerns, up from No. 10 in the survey for the fourth quarter of 2010.
 
It’s not just the hit on direct costs. A sustained price rise can have knock-on effects on domestic consumption and other economic activities, and thus on the nascent global economic recovery. In forecasting global GDP growth of 4.4% this year, the International Monetary Fund assumed oil prices of US$95 a barrel. Analysts at Bank of America Merrill Lynch and Deutsche Bank say the expansion can come under threat if oil ends up at US$120 a barrel instead.
 
Triple-Digit Threat
For now, oil has not yet reached that point. On February 25, prices fell back to around US$97 as Saudi Arabia (share of OPEC crude oil production in January this year: 28.4%) announced its readiness to fill any shortfall in production. As well, the International Energy Agency, comprising 28 nations including the U.S., France, Germany and Japan, pledged to release emergency oil stockpiles if needed.
 
But triple-digit oil prices remain a distinct possibility. While a popular revolt appears unlikely in major oil producer Saudi Arabia, one cannot be ruled out. On February 27, 119 academics, activists and businessmen signed an open letter to King Abdullah complaining of corruption and nepotism, and demanding reforms. A Facebook campaign has been launched calling for a ‘Day of Rage’ in Saudi Arabia on March 11.
 
Youthful protestors are also trying to force regime change in Algeria (4.3% of January 2011 OPEC production), with rumblings in Iran (12.3%), Iraq (8.8%) and non-OPEC oil producer Bahrain. If they succeed, there will almost certainly be a period of uncertainty as new power holders settle into the business of governing and the deposed elite try to get back in.
 
Even if the status quo is maintained, there could also be volatility as the wounds of the recent past fester and the surviving rulers come under pressure to deliver on new expectations. President Hosni Mubarak of Egypt and President Zine el Abidine ben Ali of Tunisia have stepped down, but the political wrangling in the two countries continues to rage.
 
A rise in oil prices is expected, in any case. Merrill Lynch said in January that it saw oil “potentially breaking through $100 a barrel as we enter 2011” because of a global economic recovery. But analyst Francisco Blanch also wrote that he expected prices to average US$78.50 a barrel in the first half of this year. If the average price, in fact, is much higher, there could be economic repercussions around the world, including Asia.
 
Winners and Losers
Rising oil prices will benefit oil companies, of course, because they would be making more money from their products. “Generally, higher selling prices for oil should feed directly into wider margins for upstream producers,” says Moody’s Investors Service in a new report. The exploration side should also benefit because operating costs such as expenses for labor and rigs tend to rise more gradually than increases in oil prices.
 
But that’s just about it. For most companies, whether in transport and aviation, manufacturing, materials, consumer goods or retail, persistently high oil prices will cause disruptions. Even downstream refining and marketing (R&M) energy companies will be negatively affected, since they use crude oil as input for their end-products. Persistently high oil prices will require more working capital and put pressure on cash flows.
 
Airlines will also be hit by sharply higher aviation fuel prices. The lucky ones are those carriers that decided to hedge and there are apparently many of them. “Most airlines are hedged,” Willie Walsh, CEO of International Consolidated Airlines Group, told Bloomberg. In fact, says Lufthansa, the German carrier, it will save money if the price of crude oil goes above US$88 a barrel, the level at which it had presumably hedged its contracts.
 
If oil prices continue to surge, though, finding hedging counterparties will become prohibitively expensive – and perhaps even impossible, at least in the short term. Carriers can pass on the extra cost to travelers in the form of fuel surcharges. But consumers can take only so much. Major airlines posted huge losses in 2008 as passengers stayed away in part because of the massive rise in fuel surcharge and other fees.
 
It takes time for corporate buyers and end consumers to accept and adjust to higher pricing, particularly when the increase is steep and swift. This is true of airlines as for other companies, including those riding the boom in domestic consumption in China, India, Brazil and other growing emerging markets. If they are forced to temporarily absorb the higher cost of energy and the associated increase in the price of other inputs, CFOs will see margins narrow or even turn negative.
 
What to Do?
By now, companies should be updating their contingency plans. One key plank is probably a temporary cut in production while waiting for things to settle down. That’s what S. Venkateswaran, CFO of Hong Kong garments maker and trader Mulitex, is doing, for example, in response to sharply higher cotton prices. “Cotton has gone up close 300%,” he says. “It’s gone up too fast and too soon.”
 
The CFO anticipates one season where buyers who want to order 10,000 dozens of a product will buy 5,000 dozens instead, in the hope that cotton prices will come down or stabilize. “That’s the cycle that you have to go through,” says Venkateswaran, who has decades of experience in the garments business. The rise in cotton prices “is not exclusive to us, it affects the entire industry,” he adds. So garments makers need to anticipate cutbacks, but should be ready to resume full production when the market has absorbed across-the-board cotton price increases.
 
Oil price increases affect a much wider swathe of industries and markets. But some sectors and countries are better able to deal with them than others for various reasons, such as having their own oil fields and the efficiency of their energy usage. Merrill Lynch estimates that India, Indonesia and South Korea could start hurting if oil averages US$110 to US$120 in 2011. Japan and China will feel the pinch if oil prices average out above that range.
 
There’s also the dynamics of price caps. “State control of product prices for refined oil in large Asian countries such as China, India and Indonesia will mitigate the impact of higher crude prices for consumers,” notes Moody’s. This can give companies some breathing room.
 
In the long run, however, subsidies can become too heavy, especially if oil prices surge to record highs. The deterioration in government finances could affect business confidence and prospects, and force a policy change that could have disruptive economic and political consequences.
 

Operational Excellence

Still, there are things that companies can do internally to prepare for a possible oil-induced economic crisis. One is to step up energy conservation and efficiency efforts. The prospect of higher oil prices should underline once again the importance of these programs, which could have fallen between the cracks when oil was at US$40 a barrel.
 
At the World Economic Forum in Switzerland earlier this year, some CEOs spoke of how their company was able to reap savings of 30% to 50% through energy efficiency programs. Experts at a panel on business energy efficiency note that US$10 billion a year is wasted in the U.S. alone to power computers and other electrical devices while on stand-by mode, a situation that can be rectified by simply unplugging those devices from electrical outlets when not in use.
 
In a report, Accenture, the international management consultant, urges companies to focus on “operational excellence – building the right operating model (the ‘what,’ ‘who’ and ‘where’ of business operations) and excelling at execution (the ‘how’ of business operations).” Across industries, the report says, “productivity improvements through shorter lead time or better production planning can reduce costs by up to 40%.”
 
“If we see continued disruptions in the Middle East and oil prices increase, that will have a major impact on the strategy [of global companies] moving finished goods from China to European markets and American markets,” says Jonathan Wright, a Senior Executive at Accenture. “Several years ago, Accenture did some research that looked at crude prices at around US$150 a barrel. You do start to see that [price point] having a major impact on supply chain strategies.”
 
Being lean and at the same time also mean is something that companies should strive to achieve, in any case, regardless of where oil prices are going. The current environment of rising inflation, interest rates, and commodity and energy prices just adds more urgency to this mission-critical endeavour.
 
About the Author
Cesar Bacani is Editor-in-Chief of CFO Innovation.

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