The big challenge for manufacturers now is the rising cost of raw materials, largely driven by growing demand from Asia. These costs are hitting corporate profits, not to mention share prices, and pushing up consumer prices. There are no quick fixes here, soaring raw material prices reflects a profound shift in the balance of economic power across the world.
So far, for example, the price of rubber has risen nearly 74% this year. This is after it climbed 92% in 2009. Rubber’s rally has been driven by booming demand in China where car sales rose 56% in March compared to the previous year.
Companies like Goodyear have passed on the rising costs through to consumers, a risky strategy when consumer confidence is volatile, retailers are struggling and sales are down. Jean-Dominique Senard, the finance director of French tyre maker Michelin, has reportedly said that the “violent increase (in raw materials costs) is a challenge for the group in 2010.’’
On the plus side, the rising price of commodities has suited Australia. BHP Billiton and Rio Tinto, for example, have notified Japanese steelmakers that the iron ore price for the July-September period will be raised about 23 per cent from the previous quarter. This second consecutive quarterly hike will put iron ore at about $US147 a tonne. Extraordinarily, this is 140 per cent higher than the fiscal 2009 price. Figures released this month show that strong commodity prices pushed Australia into a badly needed trade surplus for the second straight month in May. The data shows that exports were up six per cent in adjusted terms, while imports were up four per cent. Coal made up 17.7 per cent of the nation’s exports in the month, while iron ore and other concentrates made up 18.6 per cent. All other major commodities made single digit contributions. And economists say that is just the beginning. They expect Australia to face a series of surpluses in the coming months. Rising commodity prices have also attracted foreign investment into Australia. The recent multibillion dollar bids for CSR’s Sucrogen sugar division and Centennial Coal show a strong Asian appetite for a wide range of Australian commodities and cashed up Asian investors are keen to back Australia.
On the other hand, data from the Australian Bureau of Statistics shows cost pressures on manufacturers is climbing. According to the ABS, Australia’s producer price index at the final stage of production rose 1 per cent in the March quarter. It was the fastest pace of growth for wholesale prices since the December quarter of 2008, driven by a lift in the costs of building construction, electricity, gas and water supply and petroleum refining which rose by more than 8%. These accounted for two-thirds of the inflation increase in the March quarter. The ABS data also shows that producer prices rose by an annual 6.4 per cent in December, the biggest rise on record in the 10-year history of ABS data. That figure surpassed expectations of a 5.4 per cent increase. All this creates inflationary pressures and that is more likely than not to force the Reserve Bank of Australia to raise interest rates.
Rising raw material prices have hurt manufacturers, even putting some out of business. In 2009, iconic Australian manufacturer Nylex, the name behind brands such as Esky and Nylex hoses and water products, was put in receivership after the company was unable to convince its bankers to renew its lending facilities. Like many manufacturers, Nylex was struggling to deal with cheap Asian imports and rising raw material prices. In February this year, earnings of Blusecope Steel were pushed into the red, partly the result of a strong dollar and the global downturn but also because of rising raw material costs.
Speaking on Lateline Business on the ABC, chief executive Paul O’Malley said: “I think that the steel industry over the last 24 months has had to respond to very big swings in demand and very big swings in raw material costs. And what you see is that those mills that are on the left hand side of the cost curve continue to operate when there’s reasonable demand. As raw material costs go up, if steel prices don’t go up, the steel mills on the right hand side, or bad side of the cost curve, really do start to slow down. So, I think what will happen is if raw material costs go up, iron ore’s likely to. We’ll either see an increase in steel pricing, and we’re starting to see a bit of that now, and some of the more expensive mills might actually close down or not restart.” O’Malley made the point there were three solutions, all of them difficult. First, it put pressure on companies to cut costs. It also meant that there would be more consolidation in the industry. And finally, the industry needed to get more diversified suppliers.
Bluescope is not the only one that is struggling. In May, global steel manufacturer ArcelorMittal said that it paid 80% more for raw materials like iron ore and coking coal, the main ingredient for making steel, a year ago.
It’s a problem confronting manufacturers around the world and from all sectors. With paper, for example, the combination of soaring demand for pulp from China, global recession and an earthquake in Chile sent paper prices soaring. Electronic equipment manufacturers are talking about cost uncertainty as commodity and raw material prices trend upwards. The world’s biggest food manufacturers say ingredient costs are moving higher again after a brief fall. Auto manufacturers are feeling the impact of rising raw material costs on their profits. Raw material prices of gold, oil, aluminum, copper, brass, zinc, nickel, tin, steel and lead have been on the rise and this is having an impact on every company in the electronics supply chain.
This is largely the result of uneven economic development around the world. Emerging economies which are creating the excessive demand are in a better position to absorb price increases as they are expanding faster. In that sense, it reflects the changing power dynamics of the global economy where the growth of emerging economies is eclipsing that of developed nations such as the United States and Europe.
According to the latest International Monetary Fund report, Asia will lift output by close to a record 9.2 per cent, compared to growth in the United States of 3.3% and world growth of 4.6 per cent, tapering off slightly next year. The IMF expects demand from emerging countries to lift commodity prices, other than oil, by 15.5 per cent this year, although there will be a 1.4 per cent fall next year.
A report by the World Bank Global Economic Prospects 2010 says the financial crisis has transformed the world’s economic landscape. According to the World Bank, GDP in developing countries will grow 5.2 percent this year and 5.8 percent in 2011. By way of contrast, GDP in wealthy countries, which declined by 3.3 percent in 2009, is expected to rise by just 1.8 and 2.3 percent in 2010 and 2011.
Whichever economic analysis one chooses, the picture is clear: developing countries will grow much faster than the developed world. With increased wealth, they will be in a stronger position to deal with the price rises while the demand for raw materials will continue to force up costs.
All this is summed up in a note to clients from Dr Sherry Cooper, chief economist at North American financial advisor BMO Capital Markets. Cooper compares the global economy to two ships passing in the night. “ One is a tugboat, pulling along mightily with all its effort, but restrained by the heavy load of a still-weak banking sector, an overburdened consumer and the now-massive fiscal debt burden it must reel in over the years ahead,’’ Cooper says. “The other is a sleek speedboat flying across the water, with none of that excess baggage to hold it back. There are no points for recognizing the US and Europe as the plodding tugboat, while Asia is the super-charged cigarette boat. While financial markets fret about the ongoing Greek fiscal drama, the U.S. housing sinkhole and when the NBER will declare the recession over, Asia continues to come roaring back with all engines blazing …. The main point is that the rest of the world is simply not waiting on the United States and Europe to fully get their acts together. Recall that the emerging world now accounts for more than half of global output, and the rip-roaring recovery in that space is why we are now looking for global growth of more than 4% both this year and next, and a key reason why commodity prices have also turned so forcefully over the past year.”
Part of the problem for many commodities is the change in contracts, switching to quarterly contracts. This means that many manufacturers such as steel makers need to negotiate a new contract each quarter where the price is determined by a combination of factors, including the spot price for imports in China. As a result, costs for steel producers will change every few months, rather than having a fixed price throughout the year for materials processed as before. This creates a conundrum for manufacturers. How can any company make long-term investment decisions if the way raw materials are sold is on a very short-term basis?
More significantly, the changing power dynamics, also illustrates the fragility of the global economy. Rising raw material costs provide the mirror for the shift in the global power balance.
