Inside Logistics

Materials Handling: Ready for an oil price shock?

Recent events in the Middle East also affect DCs


April 18, 2011
by Dave Luton

MM&D MAGAZINE, MARCH/APRIL 2011

For decades, we’ve been fortunate with inflation. But recent events in the Middle East may mean an end to favourable times. Along with obvious influences on transportation costs, petroleum-based products have significant impacts on warehousing.

While petroleum cost inflation has direct influences on warehousing, indirect costs are also worth noting. For example, gasoline in North America is no longer 100-percent gasoline, but often contains five to 10 percent ethanol. The ethanol is commonly made from corn and should be immune to petroleum price hikes. But farms consume large amounts of fuel. The yield is also strongly dependent on fertilizer use, which has petrochemical components like ammonia.

Indirect market effects can also influence price, so let’s use ethanol as an example once again. Brazil is one of the world’s largest producers of sugar cane. Sugar prices have greatly increased and, as a result, sugar cane is being diverted to produce sugar and Brazil is starting to import ethanol from North America, again driving up the price.

The typical warehousing budget consists of space and non-space (mainly labour and equipment) costs. Or, we can look at warehouse costs by dividing them into the areas of capital and operating.

Looking at these classifications, the following are the main areas potentially affected by a major oil price increase.

Capital

The prices of roofing and asphalt—both new and replacement—are directly affected by oil price increases. Asphalt is produced from petroleum and the common tar and pea gravel roofing also has a significant petroleum component. Some forms of building insulation have a petrochemical base (Styrofoam) and while there are non-petrochemical substitutes many of these are energy intensive.

As well, although to a lesser degree, a wide range of other building materials, such as cement and steel, are affected by oil prices. This is mainly because of freight and energy costs.

Even some things that don’t normally spring to mind do, in fact, contain petrochemical elements. Windows, for example, can contain vinyl. As well, many elements of office interiors and washroom finishing have plastic components. Some floor sealants and lighting elements also contain plastic. While each item may represent only part of a warehouse’s costs, collectively they add up.

Operations

This can be divided into two areas. First is costs associated with space, such as the energy for heating and electricity. The second category is non-space costs, such as the price of equipment fuel. The space costs associated with heating carry the most significant price tag affected by the oil and natural gas industry. Electricity is usually produced by other forms of energy, although some petroleum-related energy (mainly natural gas) is used to cover power requirements during peak demand times. Propane is probably the biggest petrochemical element in the equipment field, aside from plastic used to produce various components.

Oil vs natural gas

In the US, there is a significant market price divergence between oil and natural gas, as plunging natural gas prices have resulted from a shale gas boom. While oil prices have risen, natural gas has stayed flat.

Natural gas comes from organic matter within fine-grained rocks classified loosely as “shale.” Shale is very fine, with small pores. We haven’t been able to produce gas from shale because there are no pathways for the gas to escape fast enough. A new process that fractures the shale allows the gas to escape and be captured.

Shale gas has pushed down US natural gas prices to under US$4 per million BTU from their record high of US$13.69. A thousand cubic feet (mcf) of US natural gas once sold for a tenth of the price of a barrel of oil. Now that gap has widened tremendously: one mcf of natural gas sells for a twentieth—or less—of the price of a barrel of oil.

Because of shale gas, some interesting differences emerge between warehousing and other logistics areas. While transportation energy sources are mostly petroleum-based, warehouses are not so dependent on this source.

With the exception of some capital costs such as asphalt and roofing, warehouse energy is mainly natural-gas based. Lift truck propane is more complex because it’s sourced both as a by-product of petroleum and natural gas production. Therefore, it’s price has increased this winter, unlike natural gas’s flat pricing.

Even warehouse energy needs like electricity production are mainly natural gas-based (for peak power) rather than petroleum-based. Thus, electricity should only experience limited cost inflation in the shorter term.

In my next column, I’ll examine strategies for dealing with petroleum inflation. For example, the owners of propane powered lift truck fleets have options both in the short and long term, such as switching to natural gas or hydrogen fuelling or electricity-based battery power.

Dave Luton (dluton@cogeco.ca) is a consultant in the greater Toronto area.