Oil inventories are soaring! According to last week’s January 13th Short Term Energy Outlook, published by the U.S. Government’s Energy Information Administration, “commercial inventories are well above average historic levels, and EIA projects that they will remain there through the end of 2010.” And OPEC agrees; in its Monthly Oil Market Report for January 2009, it notes that “US commercial oil inventories increased a further 2 mb in December, resulting in a contra-seasonal build in the fourth quarter, with stocks at the highest level since September 2007. Inventories at the WTI delivery point of Cushing, Oklahoma, stood at a record level of 33 mb, approaching maximum storage capacity…”
But if oil is piling up — unwanted and unsold — at delivery points around the world, then how do oil companies remain profitable? Exxon’s most recent earnings were a record $14.8 billion, and Business Week noted that Exxon’s Production Falls As (Its) Profits Soar.
Let’s think about that for a second. Oil companies are producing less. And whatever they do produce is piling up in gigantic storage areas of unsold inventories. So … how can they still be profitable?
The key to answering that question lies in understanding how costs flow from: (a) the moment that money is committed to be spent, to (b) the moment that it is actually recorded as a business expense. Management accounting professors have developed very helpful theoretical explanations for this phenomenon; now let’s discuss an explanation that pragmatically addresses today’s oil industry.
A Simple Scenario
Let’s assume that an oil refinery buys crude oil from a source that pumps it out of the ground — like OPEC, for instance. When it receives deliveries by boat — from oil tankers, let’s say — it stores the crude oil in temporary stockpiles until the refining operations are ready to process it.
The stockpiles of crude oil are then fed into the refining process, which are designed to produce refined products like heating oil and gasoline. In the real world, of course, the process is somewhat more complicated — additives like ethanol might be added to the refined product, and byproducts like naphtha might be produced as well — but let’s keep things simple for now!
The refined products are then stored in their own temporary stockpiles until the customers — oil distributors, chains of gasoline stations, and others — pick up their orders and carry them away. Customers of floating refineries pick up their refined products by boat, while customers of land-based refineries use trucks and rail networks.
A refinery needs to spend money on equipment, of course, and on engineers to keep the machinery humming. It also needs to spend money on non-manufacturing activities to keep its businesses alive — customer relationship representatives, for instance, and accountants to crunch the numbers.
Words, Words, Words
Now let’s review some simple vocabulary words. From the refinery’s perspective, the stockpiles of crude oil are Direct Material (DM) inventories to be transformed into the refined product. The stockpiles of refined products are Finished Good (FG) inventories. And the volumes of oil that are literally coursing through the machinery, on their way from being crude oil to being refined products, are Work In Process (WIP) inventories.
The barrels of crude oil that are purchased and received are classified as Purchases (P). The engineers are classified as Direct Labor (DL), the machinery as Overhead (OH), and the non-manufacturing activities as General Expenditures (GE).
Whew! That’s a lot of terminology, isn’t it? But it’s really just semantics, just learning a handful of words from the language of management accounting. That’s really all you need in order to understand the equations that explain why an oil company’s earnings are so heavily dependent on inventory balances.
Five Simple Equations
The method that we use to explain how inventory affects earnings is called job order costing. There are many different ways to express this method; we prefer to use five simple equations, the type that any elementary school arithmetic student can grasp.
DM @ Start of Day + P – DM @ End of Day = DM Used in Production
DM Used in Production (from #1) + DL Used in Production + OH Used in Production = Total Manufacturing Costs (TMC)
WIP @ Start of Day + TMC (from #2) – WIP @ End of Day = Cost of Goods Manufactured (CGM)
FG @ Start of Day + CGM (from #3) – FG @ End of Day = Cost of Goods Sold (CGS)
Revenue – CGS (from #4) – GA = Earnings
Sounds complicated? Relax! It’s a lot simpler than it appears. Let’s talk through these equations one by one.
I. How much crude oil do we use in production each day? We begin by refining whatever was stockpiled in storage at the start of the day. Then we refine whatever we purchase during the day, except for the portion of our purchases that we stockpile until tomorrow.
II. How much of our resources in total do we burn through in production each day? We burn through our crude oil usage (which is calculated in the first equation), our direct labor usage, and our overhead usage.
III. What is the cost of the resources that we burn through to produce the refined oil that enters our FG stockpile each day? This is admittedly a tricky calculation because some of the resources that were used to produce today’s ending FG stockpile were actually burned through yesterday; that is why we have WIP @ Start of Day! And some of the resources that were burned through today will actually remain in WIP @ End of Day, and will be a part of tomorrow’s FG stockpile.
IV. What is the cost of the resources that we sell each day? We begin by selling whatever was stockpiled in storage at the start of the day. Then we sell whatever enters our FG stockpile today, except for the portion that we continue to stockpile until tomorrow.
V. What do we earn each day? This one is easy; it’s the difference between all revenues and all costs.
That’s All You Need!
Believe it or not, that’s all you need to understand why rising inventories — unused and unsold — can result in higher earnings. Let’s review the formulas one more time.
Let’s assume that DM @ End of Day is a lot higher than DM @ Start of Day. Well, then, DM Used in Production would be a lot lower … as would TMC … as would CGM … as would CGS. And if CGS is a lot lower, then Earnings would be a lot higher.
Likewise, let’s assume that FG @ End of Day is a lot higher than FG @ Start of Day. Well then, CGS would again be a lot lower, and thus Earnings again would be a lot higher.
The key insight is that each formula must be calculated before the subsequent one is calculated, for the simple reason that each formula relies on a number that is calculated in the previous one. Thus, if all of the End of Day inventories are increasing rapidly, the effect cascades down to an increase in Earnings.