Optimal Mix: Managing a Portfolio of Supply Contracts
hen an oil refining company spends billions of dollars to build or upgrade a refinery, one of its main concerns naturally is how to get a good return on such a massive investment. In particular, the company would like to make sure that it sells the refinery’s products—mostly gasoline—in markets that would maximize its profit. A guaranteed long-term contract to supply gasoline seems most desirable, but the company may also want the flexibility of pursuing higher profit margins offered by shorter term contracts.
This is the dilemma faced by BP, one of the world’s largest oil and gas companies, as it completes a multi-billion dollar upgrade of its Whiting refinery in Indiana that is expected to increase the refinery’s production by 1.7 million gallons of gasoline and diesel a day. To help BP find the best way to sell the refinery’s output year after year, Chicago Booth professor Dan Adelman and Shanshan Wang, PhD ’11, developed a model that would allow gasoline companies to optimally adjust their portfolio of supply contracts over time, in anticipation of changing market conditions. This model is discussed in their recent study titled “Contract Portfolio Optimization for a Gasoline Supply Chain.”
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While the work is motivated by BP, it has broad application to gasoline suppliers across the industry, which generates around $300 billion in annual revenue in the United States.
Gasoline, which is produced by processing crude oil in a refinery, is marketed to three distinct channels. The first is the branded channel where gasoline with specialty additives is sold through stations that bear the name of a major supplier such as BP, and are owned by independent firms or so-called branded “jobbers.” A BP jobber is obligated to sell only BP gasoline and BP is obligated to supply all the gasoline that the stations need. The contract typically runs for 10 years but virtually lasts forever, since an industry law called the Petroleum Marketing Practices Act prohibits BP from terminating the contract.
Gasoline also can be sold as a generic commodity through the unbranded channel, such as gas stations at Costco, Walmart, and Safeway. These outlets will typically negotiate a price to buy a specific volume of gasoline from a supplier for one year. The spot market is the third channel, and that is where the major suppliers, unbranded jobbers, and other distributors come together to buy and sell gasoline. Refiners can sell any leftover product to the spot market after satisfying their contract commitments.
The key to maximizing profit is in choosing how much of the refinery’s output should be sold to each channel given the uncertainty in the price and demand for gasoline. “If BP sells its gasoline through an inappropriate mix of channels, then it may either not sell out its capacity or end up selling at a much lower profit,” says Adelman. Indeed, Adelman and Wang find that by adjusting the share that each channel receives over time to reflect changing business conditions, as opposed to a strategy of simply fixing the shares, the company’s expected profit can increase by more than 40 percent under some scenarios.
The Suppliers’ Dilemma
There has been an ongoing debate within BP about how to sell the refinery’s production, according to the authors. One group holds the view that the refinery’s output should be sold through the branded channel as much as possible, while the other group favors putting more weight on other markets. Entering into a long-term contract with branded jobbers seems very appealing, because it lowers the risk that the refinery will be unable to find an outlet for its products. Especially after spending billions of dollars on a refinery, the company may feel more secure if it commits its production to a very stable source of demand.
However, BP might be leaving profit opportunities on the table if it commits solely to the branded channel. Given the volatility in the price of crude oil in recent years and changing market conditions within the different channels, profit margins sometimes may be higher in the unbranded outlets and in the spot market. BP cannot take advantage of such attractive profit margins if it has committed its gasoline to branded stations only.
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