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SpirE-Journal 2008 Q2

Oil at Boiling Point

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Oil at Boiling Point

With oil prices hitting an all-time high of more than USD 135 a barrel from merely USD 54 in early 2007, businesses are facing tremendous pressures to pass higher costs onto customers while minimizing loss of volumes and market share. The extent of oil price increases, and the inflation it has bred, has made this a pressing concern for marketers outside the sectors that are traditionally tied to energy prices, like airlines and logistics. While distributing the burden of rising costs is important, high energy prices are also throwing up surprising business opportunities.

Black gold at unprecedented prices

Crude oil prices have risen to levels not seen since the 1970s. Many analysts forecast prices in the region of USD200 a barrel in the not-too-distant future, though others claim that the equilibrium price should be closer to USD100. However what is not in doubt is that demand from emerging markets is outstripping supply.

Global economic expansion is driving what the International Energy Agency says is the biggest increase in oil demand in nearly 30 years (see Table 1).

This demand is fuelled, most notably, by the rapid and continued economic expansion of China and India. Over the past decade, China has nearly doubled its oil consumption.

Global demand reached 85.6 million barrels per day in 2007, almost tripling the consumption level four decades ago. The world is having a hard time expanding oil supply fast enough to keep pace with growing demand. Today, 70 percentof oil is produced from fields more than 30 years old. These mature fields, also known as brown-fields, are past their production peak, while new sources of oil tend to come from sources where it is more expensive to extract, such as tar sands or marine locations.

The Middle East is a major source of crude oil supply but the geopolitical environment in the regions where much of the oil is produced remains fragile. The region has been plagued with border disputes as well as terrorism. The Turkish incursions into Iraq in early 2008 affected oil production in northern Iraq, for example. Such tensions will inhibit much needed oil investments in the region.

All this adds up to the thesis that oil demand is outstripping supply, particularly in the context of diminishing returns on the most well-established and cheapest-toexploit oil-fields and with political tensions in the Middle East continuing to run high. High oil prices are here to stay.

And businesses world-wide are just beginning to grapple with the problem of managing substantially increased energy and transport costs. The impact of high oil prices in most Asian countries has thus far been blunted by government subsidies. However, this is rapidly changing. In recent months, China, Indonesia and Malaysia have substantially reduced fuel subsidies.

In June 2008, for instance, China raised prices of petrol and diesel by about 18 percent and 17 percent respectively, the largest one-off hike ever. Malaysia removed subsidies for fuel in May 2008 leading to a 40% increase in oil prices at the pump.

At current levels, oil subsidies are projected to cost developing countries such as Malaysia, Indonesia and India between USD11 billion and USD17.5 billon. Asian countries like Taiwan, Malaysia and Indonesia have already pledged to cut back on oil subsidies and other countries may follow suit.

Implications of high oil prices to businesses

How will today’s oil prices affect the general economy? There are signs that the general economic impact of the oil crisis today will not be as severe as in the 1970s. While oil is more expensive today than in the 1970s, even after adjusting for inflation, it accounts for a much smaller percentage of global GDP. The global economy has become more resilient to oil price fluctuations through improved energy efficiency and decreased oil dependence (See Table 2).

However at the micro-economic level, high oil prices will have significant and far-reaching implications for business, not only in terms of higher fuel costs for transportation companies but also in terms of increased logistics costs and higher energy prices for general business.

The changing economics of logistics

The transportation sector will likely be the hardest hit by rising oil prices. Fuel accounts for around a third of airline budgets, up from 20 percent a year ago. The global airline industry is estimated to spend USD72 billion more on its fuel bill in 2008. The escalating price of jet fuel is forcing airlines to pass on costs to consumers – a recent example being hikes in fuel surcharges.

The automotive industry will have to brace itself as well. In the United States, it was amongst those hardest-hit by both oil shocks in the 1970s (1972-74 and 1979). As fuel prices quadrupled, consumers opted for smaller cars with better mileage over the gas-guzzling cars that US carmakers were producing. This was a significant turning point for Japanese carmakers, who successfully entered the US market with their small, fuel-efficient designs.

Rising fuel prices also mean it costs more to ship raw materials and deliver finished products, placing pressure on the bottom line of most businesses. For most merchants, transportation of goods is the highest operational expense. Inbound freight costs for domestically-sourced products typically range from 2 to 4 percent of gross sales, and 6 percent to 12 percent of gross sales for imports. Outbound transportation costs typically average 6 to 8 percent of net sales. Express couriers Federal Express and UPS have already announced increased shipping rates to address the reality of sharply increased fuel costs.

High oil prices will also affect the current landscape of the logistics industry. At times of sky-high aviation prices, more companies will be looking at moving volumes via more fuel-efficient sea freight rather than air freight. Nova Nordisk, a leading life science product manufacturer, at present moves 60 percent of its product using overland transport, a quarter by air and 18 percent by sea. But in terms of shipping costs, air freight makes up the bulk at 60 percent, road freight a quarter and sea freight at barely 10 percent. There will be a trend for multichannel merchants like Nova Nordisk, as well as marginal airfreight customers, to switch to more energy efficient sea freight. Novo Nordisk’s manager for shipping and customer services, Derrik Lenzner, added that in the coming years, even traditional air freight customers will begin to consider the benefits of sea freight.

Fuel costs and general inflation

Aside from the special case of logistics costs, higher fuel prices is a key factor driving the general increase in inflation rates seen across the world. In the Asia Pacific region, inflation has surged to breathtaking levels since 2007 (see Table 3), driven by rising fuel, agri-food and commodities costs. It should also be noted that rising fuel costs are a major contributor to rising agri-food costs, since the agriculture industry is very transportation-intensive.

Higher energy prices might fuel spiraling inflation rates as manufacturing plants and mills – among the main users of fuel oil – factor the increased energy cost into their product prices.

For example, Dow Chemical, a leading US chemical manufacturer, has plans to raise its prices by up to 20 percent to offset soaring energy costs. Its energy bill was USD8 billion in 2002 and could climb four-fold to USD32 billion in 2008. Dow Chemical’s price increases will affect a wide range of industries as its products range from the propylene glycols used in antifreeze, coolants, solvents, cosmetics and pharmaceuticals to the acrylic, acid-based products used in detergents, disposable diapers and wastewater treatment.

Marketing strategies to deal with escalating cost

Businesses are grappling with ways to cope with substantially higher cost structures in these turbulent times. Airlines have become masters at price discrimination as a means of maximizing revenue from passengers. Consumer product companies are focused on increasing customer loyalty to discourage consumers from ‘trading down’ when prices increase. Businesses are also changing their product portfolio by selling products in smaller portions as well as moving into higher margin businesses.

Price discrimination

Price discrimination is nothing new in the airline industry, which has been hard hit by the need to pass fuel price hikes onto customers.
Low-cost carrier Ryanair, long been regarded as the gold standardfor budget airlines, started the trend. In a bid to drive down operating costs, Ryanair introduced a check-in charge to increase the number of customers checking in online

[bullet text=”Asian budget carriers have not been lagging behind. Low-cost carriers Air Asia a

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