Oil Firms: Lower Sales Producing Earnings?

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.

Equation #1:

DM @ Start of Day + P – DM @ End of Day = DM Used in Production

Equation #2:

DM Used in Production (from #1) + DL Used in Production + OH Used in Production = Total Manufacturing Costs (TMC)

Equation #3:

WIP @ Start of Day + TMC (from #2) – WIP @ End of Day = Cost of Goods Manufactured (CGM)

Equation #4:

FG @ Start of Day + CGM (from #3) – FG @ End of Day = Cost of Goods Sold (CGS)

Equation #5:

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.

Risk Management: Is Rubin to Blame for Citi?

Have you read Robert Rubin’s retirement letter? Three days ago, he walked away from a Citigroup role that paid him $115 million since 1999. Rubin, of course, is a former co-chairman of Goldman Sachs and Secretary of the Treasury. Here is an excerpt from his statement:

“My great regret is that I and so many of us who have been involved in this industry for so long did not recognize the serious possibility of the extreme circumstances that the financial system faces today. Clearly, there is a great deal of work that needs to go into understanding exactly what led to this situation and what changes, regulatory and otherwise, must now be implemented to reduce systemic risk and protect consumers.”

Rubin previously told the Wall Street Journal that he was not to blame for Citi’s collapse; he asserted that “what came together was … a cyclical undervaluing of risk … a housing bubble and (mis-guided) triple-A ratings … there was virtually nobody who (fore)saw that low probability event …” Nevertheless, he did acknowledge his involvement in a board decision to increase risk in 2004 and 2005, and at least one major Citi investor believes that Rubin is “resigning in disgrace.”

Whether or not you blame Rubin personally for Citi’s collapse, isn’t it a bit disconcerting that he told the Journal “there is a great deal of work that needs to go into understanding … this situation”? Indeed, perhaps Rubin couldn’t foresee Citi’s challenges. But shouldn’t we expect him to understand them by now?

The Four Questions

What exactly do risk managers do, any way? How does risk management work?

The fundamentals are actually quite simple. A competent risk manager comes to work every day and asks himself four questions. If he can supply four reasonable answers, then he is likely doing all he can to manage risk. But if he can’t … watch out! Then he isn’t doing his job.

Let’s run through these four questions briefly:

1. What can go wrong?

This step is called event identification. Risk managers must keep laundry lists of every major potential problem that might occur in the foreseeable future. If a problem isn’t foreseeable, though, it cannot make any lists; then risk managers can’t be blamed for failing to address it.

2. How bad will things get?

Risk managers can’t possibly address every problem on their laundry lists, so they must prioritize and focus on the worst potential problems. This step is called risk assessment; it classifies a problem as high priority if it is relatively likely to occur and relatively costly if not prevented.

3. What’ll be done if it happens?

This step is called risk response. Risk managers focus on the highest priority problems and then work with operations managers to confirm that the organization’s responses will be effective if prevention fails.

4. What’ll we do to prevent it from happening?

This step is called internal control activity. Risk managers confirm that operations managers continually train their employees, test their systems, inspect their products and services, and audit their administrative processes in an attempt to avoid (or, if avoidance fails, to detect and address) the problem.

The COSO Cube

Did we simply conjure up these four questions out of thin air? Of course not! Five major accounting, auditing, and financial executive trade associations have sponsored the development of COSO, an organization that has created an integrated framework for enterprise risk management.

To explore the intellectual origins of our four questions, download COSO’s free Executive Summary (which is available in over a dozen languages — even Finnish and Thai!) and look for an image of a three dimensional cube. You can also find this cube on numerous risk management web sites, such as those maintained by the FDIC in Washington and UCal Berkeley in California.

Have you found one of the cubes? Great! It has eight boxes across its front, four across its top, and four along its right side. Now look at the middle four of the eight boxes across its front: they are labeled event identification, risk assessment, risk response, and control activities. Yes, they represent our four questions that lie at the very heart of risk management.

How About Rubin?

So what does this tell us about Robert Rubin’s level of responsibility at Citi? You are welcome to develop your own opinion, though we encourage you to assess the issue after considering our four questions.

Was this cataclysmic confluence of events foreseeable? If it was, then someone at Citi must be to blame for failing to identify it during their event identification activities. On the other hand, if it was identified but not highly prioritized, then someone must be to blame for misjudging the likelihood that Rubin’s perfect storm scenario would in fact occur.

If Rubin is responsible for these risk management tasks, then perhaps it is best that he has resigned. But if someone else is responsible, then perhaps Rubin’s departure is Citi’s loss. That would also be a loss for the American taxpayers who have placed billions of bailout dollars in Citi’s hands.

About This Blog

Would you like to earn an MBA degree from Yale University? You had better check your savings account; it’ll cost you over $140,000.

Is that too rich for your blood? Are you willing to settle for a respected state institution like the University of Connecticut? That’ll cost you over $80,000 if you’re a non-resident, and over $50,000 if you’re a state resident.

Heck, even Baruch College of the City University of New York will charge you almost $20,000 for four terms of tuition. And that doesn’t cover student fees, textbooks, living expenses, and the hours and hours of time that could otherwise be dedicated to earning money.

In an era of limited resources, why do so many men and women spend so much money on academic business degrees? And how do so many academic business programs manage to attract these men and women to their doors?

You may be a skeptic who believes that they only enroll in these programs because academic degrees look attractive on professional resumes. After all, it’s certainly true that degrees from prestigious institutions can lead to better employment opportunities.

And yet, even if you don’t believe that the educational content of their courses can help them become better managers in the real world, you must acknowledge that employers must think so. If they didn’t, then they wouldn’t hire any graduates of these programs!

Our Dedication

This blog is dedicated to business professionals who believe that the tools and techniques that are taught in academia are valuable to practitioners in the real world. Likewise, it is dedicated to academics who produce research that guide the application of these tools and techniques, and who labor in real and virtual classrooms to help their students learn these tasks.

In other words, this blog is positioned at the nexus of business practice and academic theory. Whenever we see a business problem that calls for a solution that is taught in academia, we’ll write about it. And whenever we encounter an academic theory that can be converted into a pragmatic solution, we’ll cover it too. Metaphorically speaking, we’ll do our best to explain how to use hammers when we see nails that need fixin’ … and we’ll also do our best to help those proverbial carpenters locate the loosest nails.

But why is our blog titled AQ/PQ? What meaning does that mysterious acronym convey? It is a euphemism that we are using to describe professionals who possess qualifications as both academics and practitioners. As a publication that transcends the boundaries of theory and practice, our blog focuses on integrating the work of such AQ and PQ individuals.

Who Are “We”?

But who, exactly, are “we”? Who are the writers and publisher of this blog? And why do we care about developing and applying academic solutions to “real world” business problems?

“We” are the professionals of Enterprise Management Corporation (EMC), a boutique management consulting practice that was founded by Michael and Maureen Kraten in 1995. At that time, Michael was employed at one of the eight largest accounting and consulting firms in the world, and Maureen worked at one of the world’s ten largest banking institutions. EMC has since evolved into a multi-faceted firm that includes management consulting and content production and distribution of business training and development materials.

EMC is still led by the two of us, Michael and Maureen Kraten; we are the writers of this blog. We teach accounting, finance, and business economics courses at a pair of AACSB accredited colleges of business in the northeastern United States as well. We now define ourselves as “academics first” in terms of where we spend most of our time, and we measure our success by the number of business practitioners whom we help to succeed in the classroom and in the boardroom.

What Comes Next?

So where do we go from here? Considering that 2008 — the year that just ended — in many ways posed the greatest challenges to society since the Great Depression, we certainly do not suffer from a scarcity of topics to cover!

Nevertheless, we will do our best to address the questions that our colleagues, students, and clients pose to us. Casual readers of this blog are welcome to use the contact information in the margin of this web site to send us their own questions, thoughts, suggestions, and opinions.

The general length of each blog posting (with some modest variation on rare occasions) will be approximately 800 to 850 words, i.e. the length of a typical New York Times column. We will generally publish each new posting every Monday morning at 12:01 am Eastern (USA), though we always reserve the right to issue brief mid-week postings as well.

If you’ve made it to the end of this posting, then you must indeed be interested in our work. We welcome you to join us in the weeks and years to come!

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