High U.S. Crude Oil Inventories Have Little To Do With Excess Supply

According to Bloomberg’s March 9 FuelFix blog, U.S. petroleum inventories reached record levels of 444.4 million barrels nationwide in late February. This coincides with record levels of crude oil production, which rose to 9.32 million barrels a day and is expected to remain at those levels through 2015.

If commodity management was just about balancing volumes, there would not be a ‘high inventory’ problem. Petroleum refineries in the U.S. have the capacity to consume between 18-19 million barrels per day, so regional balances could easily be managed by reducing foreign imported oil if things were that simple.

Here are some of the complications:
• The surge in U.S. production from shale formations yields product that is “light and sweet” with low sulfur content, while refineries in the Gulf Coast are designed to maximize profitability by processing “heavy and sour” crude (purchased at a discount) from places like Mexico and Venezuela.

• Crude oil from the Canadian oil sands is very heavy, more closely matching the capabilities of the Gulf Coast and West Coast refineries. This creates the need for transportation solutions to enable the displacement of water-borne imported crude with supply from Canada via land-based pipeline or rail modes.

• New production of light oil coming from places like Texas and North Dakota apparently exceed the operating capacities of East Coast and Midwest refineries best suited to consume it. Crude-by-rail has provided the flexibility to direct this new supply to regions of the country that yield the best value.

• To make matters more complex, current US regulations prohibit the exportation of crude oil even if inventories are full. So there is no place to go with excess production other than into storage, which is expensive and increasingly scarce. My previous post from February expands further on the details of this constraint.

Some facts to support the above: The petroleum industry characterizes the specific gravity of crude oil using a measure known as API. In the spirit of counter-intuitiveness, heavy crudes have a low API and light crudes have a high API. According to the EIA, East and Midwest refineries processed crude with an average API of 33 in 2011, signifying lighter petroleum than processed in the Gulf Coast and West Coast (with average API’s of 30 and 28, respectively).

A few lessons and conclusions can be summarized as follows:
• Managing commodities is about more than balancing volume. Maximization of profitability and free cash flow return on capital (the ultimate optimization objective functions) drive operating decisions.

• All commodities are not uniform and equivalent. Quality matters, impacting value and ultimately economics and logistics. This is increasingly true, not just for crude oil but for water, gasoline, coal, corn and other commodities which we’ve traditionally regarded as ‘one thing’.

• In commodities (like in real estate) location matters, which makes logistics important. The value of a refinery asset can also be impacted by its location. If you are a Gartner client, my research note “Key Considerations for Managing Commodities in Your Supply Chain” might be of interest.Constraints create complex operating decisions, and cannot be overlooked. Some unfortunate capital allocation decisions overlooked (or did not foresee) the impact of refinery designs limiting their ability to monetize upstream investments.

• Constraints are not only physical and economic, but organizational. Policies and regulations, such as those prohibiting the exportation of crude, also impair supply chain decisions. This is an extreme (and highly public example) but these are more common than you’d think, and often promoted for their intrinsic value rather than fully recognized for the handcuffs they place on operating leaders.

I’m interested in hearing your views. Please comment below or email me at paul.lord@gartner.com