Over-accumulation,” explains Patrick Bond, a political economist and professor at South Africa’s University of KwaZulu-Natal, refers to a situation in which excessive investment has occurred. Hence, goods cannot be brought to market profitably — leaving capital to pile up in [sector] bottlenecks or speculative outlets without being put back into new productive investment. Other symptoms include idled plants and equipment, a glut of unsold commodities, an unusually large number of unemployed workers, and an inordinate rise of financial markets.
Bond made his observations almost 17 years ago in an article titled, “What Is the Crisis of Over-Production?” The article’s examination echoed and followed, by more than 150 years, arguments put forth by revolutionary socialist and economist Karl Marx. Jumping forward, the British economist John Maynard Keynes in the period between the two world wars also took a swing at overproduction theory. His rationale involved initiating government stimulus to help gin up demand to absorb overproduction. Keynes acknowledged that such government intervention could only be a temporary stop-gap, not a longstanding solution.
However, all three arguments — from Marx to Keynes to Bond — run counter to the classical theory framed in Say’s Law. Jean-Baptiste Say, the French economist of the late 18th and early 19th centuries, wrote “Treatise on Political Economy.” In it, he advanced that “a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value.” His premise was that a glut cannot occur when goods remain unsold because other goods are therefore not produced.
Economic theory clearly differs on the fundamental issue of whether or not product gluts occur and how to deal with such events even if they do. In the propane industry we see evidence that seems to suggest a glut can occur, and that such an event has the inherent effect of modifying economic valuations surrounding historical supply patterns. Pull up weekly Energy Information Administration propane inventory statistics for much of the last several months and a trend readily emerges from the data — higher and higher inventory levels that set new records every week.
Step back 18 to 24 months to see a strong production growth curve that hit a lengthening stride during 2014 to lead the way toward surplus inventory levels. Production gains did experience a slight reprieve during a few months of winter 2014-2015, fueled by refinery spreads diving to new lows. As winter ended however, production levels rebounded and now stand 100,000 bbld or more above the prior year. Inventory appears to be bursting its seams while production keeps marching forward.
Product costs for propane in western Canada and Upper-Midwest Bakken fields were reported to be in single digits in the middle of this past winter. While that appeared to be a great price, post-winter valuations imply that producers are at a zero-value or paying buyers to take the product out of those regions. Burgeoning storage levels, steady production, and low producer values all appear to be a classic case of product overabundance, or in layman’s terms, a supply glut.
Whether the market chooses to call the current situation a glut or not, one impact has become clear and is changing the historical method of buying propane supply by retail companies. From the beginning of the industry, the strategy has been to lift summer gallons to earn winter supply security. Supporting this approach has been retail firms needing more product during winter than summer. At the same time, suppliers had only a steady and set production stream from which to draw. Absent summer demand, they were forced to bear storage costs, with the expectation of ramped-up purchasing as the heating season approached. Now glut economics are challenging these rules.
To demonstrate this challenge, we could pick almost any region within the U.S. but will stick to the Midwest and Marcellus/Utica shale sectors. Summer or “spot” propane product in either of those regions can easily be landed at retail plants for values that are a dime or more below summer contract values. A dime could be conservative as there are situations where this value reaches a 20 cent/gal. discount versus a full-year supply agreement.
Taking the mid-point of these two scenarios, here is highly simplified scenario:
Retail Firm ABC annual volume = 2 million gallons on a 3:1 ratio
Summer discount of $0.15/gallon = $75,000 savings on summer gallons
Summer savings over winter gallons = $.05/gallon in the winter
The quick run-down above highlights that a retail firm could afford to pay up to a nickel more for winter-only product in order to lift summer spot at a savings of 15 cents/gal. Another view of that is the supplier appears to have a built-in fee of 15 cents/gal. over the summer gallons to provide winter supply security. In more technical terms, the supply agreement has an embedded call option for physical propane.
The embedded call option has actually been there since the strategy of lifting in summer for winter allocation started. This year, however, the market has highlighted that price differences have raised the question in the retail market of whether it should be doling out those premiums for the security.
The short answer to that question is a resounding Yes. The longer answer centers on two important facts.
Fact 1: in order to grab the benefit of the summer spot discount values that have been exaggerated by the supply glut, a firm needs physical infrastructure. The two most important infrastructure items, in order of importance, are storage space and transportation assets. Since early 2015, most storage assets have been fully subscribed. Many firms that own storage are choosing not to lease out such assets in an effort to personally maximize the value, or are raising rates to extreme levels to grab the spreads taking place in the market. We have seen this same situation play out in the push over the last couple years to build rail terminals. Firms building facilities are taking a similar stance as with storage assets — retail firms can purchase product but are limited on using the asset for throughput.
Owning trucks or railcars can still help capture some of the discounts in the market, but retail companies remain limited by the amount of storage space. And the storage discussion should not be limited to only third-party storage. Retail-level bulk plant storage has been woefully low for some time, and the physical costs and time to capture present-day values imply that firms needed to have boosted that storage over the previous one to two years in order to realize the current benefits.
Fact 2: Overabundance typically only happens because the market has some signs of future demand increases. For the U.S. propane market, additional demand on the horizon is in exports. At the end of 2014, expectations for new capacity and expansions during 2015 imply a doubling of capacity by the end of this year. The ability to move an extra 13 MMbbl to 15 MMbbl a month from U.S. shores is what is keeping production levels up. If those numbers could be achieved, a 45-MMbbl product glut could evaporate in about three months, creating a situation where prices surge on strong demand.
These two facts have kept the propane supply market from going into wholesale shutdown mode over the past few months. They are also reasons why the retailer should think long and hard before abandoning a term agreement and be tempted by summer spot gas. Economists may not agree on the definition of a product glut, but one fact is present in all discussions: product gluts are never assumed to last forever. In the present situation, we see a temporary glut that can benefit retailers, but they are highly advised to be well-prepared for what could, and likely will, come after. JD Buss is an adviser to independent propane retailers at Twin Feathers Consulting (Overland Park, Kan.). He previously worked in risk management and marketing and trading at Koch Industries and Enron.