Almost 70% of the world’s international currency reserves—the money that nations use to finance international trade—takes the form of U.S. dollars. Because the United States has a major share of world trade and financial assets, certain commodities, in particular oil, are denominated in it. The net result is a large diversified demand for dollars.

Any discussion of rising fuel costs and the effects on U.S. trade should be prefaced by acknowledging that the U.S. dollar continues to hold its place of esteem as the “International Reserve Currency.” All transactions in the world crude oil markets are conducted in U.S. dollars, all major oil-producing countries receive U.S. dollars for their oil, and most of them hold their countries’ surpluses in the form of U.S. dollars. 

The majority of nations choose to conduct their international trade in U.S. dollars because of the dollar’s relative stability and to protect themselves against financial speculators. These facts strengthen the U.S. dollar and provide a great economic advantage to the U.S. (it has been argued by some analysts that in essence, the U.S. dollar is backed by oil).

The macro-economic effects and importance of the U.S. dollar’s role as the International Reserve Currency should not be underestimated. As a result of this position, there exists a large and constant global demand for U.S. dollars. (Three factors make up the “virtuous cycle” experienced by the U.S. economy as a result of the dollar being the official “International Reserve Currency”: (1) Intrinsic benefit from the international oil and fuel markets being conducted in U.S. dollars (no exchange-rate fluctuation risks); (2) Increased demand for oil means increased global demand for dollars, which raises the value of the U.S. dollar; (3) Inflationary pressures are kept at bay within the U.S. economy, increased investment in U.S. assets and holdings, expanding commercial output, increased employment and increased stability in U.S. financial markets.

When crude oil prices rise, there is an increase in global demand for U.S. dollars, since importing countries will need more U.S. dollars to purchase crude oil and gasoline in the international markets. This rise in demand for dollars increases the value of the dollar with respect to other currencies.

It follows that when non-oil producing countries wish to import goods from the U.S. when the dollar is rising, they will have to pay more for these goods (it takes more of the local currency to purchase one U.S. dollar, or to purchase oil, exports and other commodities that are sold in U.S. dollars). 

Thus, generally speaking, U.S. exports become more expensive when fuel prices rise. I inserted the term “non-oil producing countries” above, because the effects on trade are different for oil-producing countries, especially those countries in which oil comprises the majority of exports. For example, if Nigeria (an oil-producing country) sells its crude oil in the international marketplace, they receive U.S. dollars for their oil. If world crude prices are rising, then Nigeria will receive more U.S dollars in return for their oil exports. If Nigeria then wishes to purchase exported goods from the U.S., they will not actually be paying a premium for these exports as a result of the higher fuel prices. 

U.S. imports, in general, will become cheaper with an increase in fuel prices. With the exception of oil and commodities that are sold exclusively for U.S. dollars, countries exporting to the U.S. will receive the same amount of their local currencies in exchange for the goods being exported. However, since the oil markets are conducted in U.S. dollars, and rising oil prices increase the value of the dollar, it takes less U.S. dollars to pay for those goods imported from other countries. 

From a micro-economic perspective, when fuel prices rise, commodities and other goods inside the U.S. become more expensive. With higher fuel prices, it becomes more expensive to manufacture and transport goods. The increase in costs to produce and transport the goods must be factored into a higher price for the products. U.S. sales of the products affected, and particularly the volume of U.S. exports may decline as a result of the higher prices that producers must now charge for their goods.

As stated earlier, when fuel prices increase, generally U.S. imports become cheaper. However, from a micro-economic perspective, the volume of U.S. imports may decrease significantly, even though they have become relatively cheaper. The reason for this is that demand for oil (and fuel) is inelastic in the short term. 

To help explain this inelastic demand, consider the following: Truckers are still expected to haul, and commuters must continue to commute. If fuel prices go up, our economy doesn’t just stop. People still have to go to work. The result of an inelastic demand for fuel is that people will continue to buy and pay more for the fuel (because they have no immediate alternatives), but will change their spending behavior elsewhere because of their fixed amount of income. If individuals and companies are forced to pay higher prices for fuel, then naturally there is less money available to purchase discretionary items, including imported goods. As a result, we can expect the volume of U.S. imports to decline in response to higher fuel prices.

We don’t need to look far to see the tangible effects that rising fuel costs have on the American economy and on international trade. We need only look back to 2005 and early 2006 to observe the market movements and economic ripple effects that occurred after Hurricane Katrina. The heavy economic impact the hurricane had on U.S. citizens and businesses was felt most immediately through the rising fuel prices including crude oil, gasoline and their many derivative products. U.S. crude oil production in the Gulf of Mexico area came to a halt and some off-shore operations suffered severe damages from the hurricane. Some important inland crude oil refineries were also damaged and U.S. Gulf Coast crude oil refinery inputs decreased significantly.

In the weeks and months after the hurricane, the international crude oil markets reacted with speculation. The reduction in the worldwide supply of crude oil caused a short-term rise in the prices of all petroleum-related products. Increased fuel prices caused commodity prices to increase in response. As markets reacted to the increase in commodity prices, we witnessed increased prices for a wide range of products, and prices for U.S. exports increased. 

As we saw in late 2005, when fuel prices increased dramatically, the trucking, air cargo, sea and rail carriers were all forced to work within a new financial framework. Profits were squeezed (and may have been non-existent in the short-term) as businesses adapted to the new environment. Following Hurricane Katrina, many businesses found that by simply incorporating their increased fuel costs into the prices they charged for products or services, they risked losing their competitive position in the marketplace. As more industries struggled with increased fuel costs, the costs were passed down to consumers in the form of higher-priced products. Now not only was fuel becoming more expensive, but to the average consumer, almost all goods and products were becoming more expensive including food and basic materials. Consumer behavior and small business operations changed as people were forced to adapt in response to price increases on a wide array of products. 

The dollar/oil relationship must be maintained to keep the dollar as the International Reserve Currency. However, the price of oil is expected to rise steadily as the supply/demand imbalance increases and the value of the dollar declines. Rising oil prices result in increasing inflation, negatively impacting the global economy, particularly oil-dependent economies such as the U.S. An increase in inflation could negatively affect the demand for the U.S. dollar. If the demand for the dollar decreases substantially, the dollar/oil relationship could be challenged by the major oil producing countries.

As we have seen throughout this essay, the relationship in the U.S. between fuel prices and trade is extremely complex because in part, of the special position the U.S. holds within the oil industry and the global marketplace. We are fortunate to be currently experiencing a relative calming of the fears and market pressures that drastically increased fuel prices in 2005 and early 2006. We hope that Congress will one day soon enact legislation protecting American citizens and businesses from the effects of erratic price fluctuations in the fuel markets. WT

This article is excerpted from Alan Bernard Enzo’s award-winning essay from the 2006 MBA Essay Competition sponsored by the World Trade Council of Middle Tennessee. To read the complete essay, please visit: http://www.tnstate.edu/oibp/partnershipnbc.htm

Sidebar: "A Policy Recommendation for Reasonably Priced Fuel"

Most of what makes up the price we pay for diesel fuel and gasoline is taxes. The remainder should be made up ideally of production costs, transportation and a reasonable profit figure. However, a large part of the price we have been paying recently for fuel is based on fear, and not on the laws of supply and demand.  <p>
For this reason, legislation must be introduced that limits profit-taking by producers, and that creates an “economic buffer” for individual citizens and businesses. It is not only the individual citizens and manufacturers who are hit hard by rising fuel prices. The bill would force internal U.S. market “corrections” to take place when global crude oil prices rise erratically as a result of fears or from collusion-induced profit taking by OPEC partners. <p>
Specifically, in the event of an unexpected price hike in fuels, the Secretary of Energy (or another appointed authority) would as a first option, mobilize supply from the U.S. Strategic Petroleum Reserve. (The U.S. Strategic Petroleum Reserve is the largest stockpile of government-owned emergency crude oil in the world. Established in the aftermath of the 1973-74 oil embargo, the SPR provides the President with a powerful response option should a disruption in commercial oil supplies threaten the U.S. economy. At the end of 2006, the reserves held nearly 700 million barrels with near-term plans to stockpile up to 1 billion barrels for future needs.)  <p>
When global supply of crude oil is tight, creating pressure to increase prices, the U.S. would release some of our strategic reserve into the U.S. supply chain to the point where upward price pressures are negated. In addition to using our reserves as a continuous economic buffer, production of fuels from tar sands, oil shale and other methods could be increased.  <p>
The above proposed legislation could also include subsidies (since the methods of producing diesel fuel and gasoline from tar sands and oil shale are more costly) to refiners in the case that supply from these large internal U.S. sources is needed to replenish our Strategic Petroleum Reserve.  <p>
This plan alone is sufficient for solving the problem that individuals and businesses face in controlling production and transportation expenses, while trying to operate within a budget in times of uncertain fuel prices.   <p>
The U.S. should continue to fund and place high priority on research into alternative energy sources. Alternatives include tar sands, oil shale, coal liquification and gasification, and coal-based fuels. Also, biofuels like corn-based ethanol could reduce or eliminate our need for oil imports. Measures have already been taken to increase ethanol production in the U.S.

Sidebar: "Variable Energy Costs and Strategic Sourcing"

Editor’s Note: Boston Logistics Group’s 2007 study of executive perspectives on strategic sourcing focused on how to manage energy expenditures given recent price volatility. This annual study has received approximately 350 responses since its inception in 2003, many of which come from major global companies. It involved a survey of shippers and carriers, interviews with over 50 practitioners and subject matter experts, and simulation modeling of the cost effectiveness of eight different sourcing strategies.

With oil prices topping $75 per barrel last summer, energy has been on the mind of supply chain professionals. Fuel surcharges and related price increases, and the indirect economic effects of rising energy costs, made 2006 a challenging year.

Experts are concerned about the long term. Researchers at the Massachusetts Institute of Technology (MIT) have cautioned about the possibility of extreme oil price scenarios. The Stern report, commissioned by the United Kingdom, has also stimulated awareness of fossil fuel consumption and possible regulation. Economists at Global Insight project a further increase of about five percent during 2007.

Practitioners are taking action. Innovators such as Dell have restructured operations to minimize shipping distances. At a recent Council of Supply Chain Management Professionals (CSCMP) forum in Cleveland, Ray Archer, Vice President of Americas Manufacturing for Dell, outlined how Dell has adopted a more flexible manufacturing strategy to decentralize to reduce transportation costs. Airports and airline-related ground handling companies are weaning themselves from a dependence on conventional fuels. Combined with instability in the Middle East and OPEC’s production quota reductions, energy has become a hot topic.

Despite the visibility of energy and the recent price spikes, only 25 percent of the companies surveyed for this report had established specific purchasing functions for energy.

•            Gemalto, a manufacturer of security card solutions, analyzed its energy expenditures and found that it was spending 20 percent more at one manufacturing plant than at an identical one in another state.

•           K. Hovnanian, a U.S. homebuilding company, has 18 regional business units in the U.S. and each one is responsible for its own energy expenditures, according to Bryan Warshofsky, Director of Purchasing Applications. K. Hovnanian also pays for many energy related expenditures through its subcontracts, and energy is not broken out on the bills.

•           Latham Plastics has just begun to examine the impact of energy costs across its 22 manufacturing plants, according to Director of Purchasing, Joe Valerio.

•           A corporate purchasing manager at a U.S. consumer electronics retailer described the energy purchasing function as having “a lot of gray area.” It is often fragmented among facilities, transportation, indirect, manufacturing, logistics, and operations.

The collapse of lean?

Are companies increasing buffer stocks and shipping larger loads to save money on transportation due to fuel surcharges? Are they shifting manufacturing closer to the point of consumption to minimize transportation cost? High transportation costs can result in sourcing closer product, even at higher prices.

If so, this substitution of inventory and asset costs for operating costs could represent a structural adjustment to high energy costs. That could wash away the gains from the lean movement. Lean supply chains depend on cheap transportation to bring down inventory requirements. Lean theory and practice evolved when oil, which accounts for 98 percent of transportation energy consumption, was around $25 per barrel.

Supply chains could feel the pain. Carriers especially are extremely sensitive to the price of fuel and heavy manufacturing has seen escalating energy surcharges applied in the recent past. But manufacturers are not immune, either. Massachusetts-based Instron Corporation, a manufacturer of materials testing solutions, says that its casting and plating suppliers are passing on surcharges. K. Hovnanian has seen a stream of 5-10 percent surcharges, according to Warshofsky.

The level of long-term price uncertainty in the energy market is a concern to most supply chain professionals. High or uncertain energy costs contribute to the growth of inventory. As transportation becomes more expensive, managing a just-in-time supply chain becomes more challenging. In response, shippers carry extra inventory, order less frequently, or choose a slower and cheaper mode of transportation. Survey respondents cited these as their second and third most popular strategies behind passing the cost on to their customers.

European smart cards manufacturer Gemalto’s purchasing manager Jacques Lalauze explains that, with millions of dollars of spend every year tied up in fuel-intensive freight and air travel, fuel cost impact is unavoidable. Switching to more energy-efficient modes can save money. The logistics director at a U.S. paper products company notes that switching from truck to intermodal helps to mitigate the impact of fuel surcharges. But, the most common strategy for dealing with energy cost increases is to pass the increases along to customers. Sixty percent of companies interviewed for this study pass the cost on to their customers in one way or another.

As the cost of transportation is a significant factor in global sourcing, increases in transportation, and hence, landed cost, can influence sourcing decisions. When the price of oil was about $30 per barrel, transportation was 20 percent of the cost of importing from Asia, according to Boston Logistics Group’s 2005 State of Strategic Sourcing Study. It has increased since then. Several manufacturers interviewed acknowledged the potential impact of freight rates on their sourcing and logistics decisions.

Minimal impact of offshoring decisions

Even now with oil prices at more than $60 per barrel, consumers and businesses seem willing to pay for the transportation needed to support just-in-time inventory. For branded products, the costs of transportation are viewed as negligible. One retailing executive explains: “We are not going to shift brands because of fuel cost.”

Direct energy costs typically represent approximately 3 percent of a company’s sales, and indirect energy purchased as part of other external materials represents about 3-4 percent, according to this year’s survey. Only one company surveyed reported that natural gas expenditures accounted for as much as 12 percent. Indirect energy costs—those that are embedded in a company’s purchasing math—often amounted to approximately the same figure. As such, energy comes out below the top spend categories that get visibility to senior management. Manufacturers will be affected by expensive energy more than most, as they consume more energy-intensive materials and operate on typically thin margins in competitive industries.

Our analysis shows that transportation cost increases can be passed through the supply chain to consumers with almost no price elasticity due to their small net effect. Transportation makes up approximately 6 percent of the economy, and fuel about 20 percent of that. A 15 percent increase in the cost of fuel would thus only pass along a 0.2 percent total cost increase. In fact, simply passing on cost increases was shown to be the most common and the most effective method of dealing with energy cost increases across the board. Full truckload carriers have passed through 18-20 percent surcharges in the last year, according to Rich Walters, Manager, North American Distribution for U.S.-based Air Products and Chemicals, Inc., a manufacturer of industrial gases and chemicals.

The cost of carrying inventory will not increase appreciably as long as obsolescence remains an important driver and interest rate growth is slow and incremental, which it has been over the past two years. Interest rates, which determine 86 percent of changes in inventory carrying cost according to our analysis, are projected to rise only slightly.

The savings that most companies realize by using China as a low-cost sourcing platform far exceed the recent energy cost impact, so offshore sourcing will not be affected in the near term due to energy prices unless a major geopolitical or economic event occurs. Based on Boston Logistics Group’s 2005 analysis of the Asian sourcing boom (which was conducted when oil was about $30 per barrel), freight from China represents 20 pecent of the landed cost, on average. Therefore, assuming fuel at 20 percent of transportation costs (one auto manufacturer estimated fuel costs at 15-25 percent of its freight bill), a 15 percent increase would only raise the cost of goods sourced from China by 0.8 percent. Compared to the 18 percent cost savings many companies get from outsourcing this loss is not significant enough to change behavior. Richard Goyette, Materials Manager at Speedline Technologies, says the total cost of sourcing from China would have to rise more than 25 percent before his company would even take a second look at its decision to source offshore.

Bill Northup, Director of Sourcing at U.S. electrical supplies manufacturer Hubbell Incorporated, adds, “I don’t see them talking about needing to change D/C strategies due to fuel costs.” Moreover, offshoring sourcing at most companies is driven at least in part by the desire to increase sales in fast-growing markets like China. This motive would further mute the impact of fuel costs on the sourcing decision.

However, companies are beginning to consider the impact of fuel costs in their logistics decisions. When evaluating direct-to-store shipments recently, one U.S. electronics retailer we spoke to analyzed fuel as one of the components of the decision.

Despite the overall ability of supply chains to withstand today’s higher energy costs, volatility has hurt companies in the past and continues to be a source of concern. Natural gas has been subject to extraordinary volatility over the past year. Survey respondents expect gas prices to rise by 13.5 percent in 2007, and oil and coal to rise at about half that rate; however there is wide variance around expectations, given past price volatility.

Shippers, carriers, and policy makers can and should take action regarding energy price trends, to gain a competitive edge and to build a competency that could serve as an eventual long-term compounding of price increases.

What shippers should do

Any strategy for managing energy spend is preferable to none, with savings ranging from ten to more than one hundred percent of price increases.

1. Don’t reverse Lean. Energy price concerns dwarf in comparison to the benefits of being lean.

2. Establish a balanced program to manage energy spend that includes supply chain, financial, and pricing strategies. 3. Re-assess transportation mode and frequency quarterly. With unpredictable fuel prices and surcharges, shippers need to be on alert.

4. When making offshoring decisions, consider whether a doubling of oil prices would change the decision. Dual sourcing becomes necessary at higher oil prices.