Manufacturing and energy industry outlook
Tax, trade and environmental policies, oil demand and risk management
Volume 8, Summer 2021
As more parts of the United States and other countries have eased pandemic restrictions, manufacturers continue to recalibrate in order to best serve their customers in the months and years to come. Middle market companies reevaluating the resilience of their supply chains will need to pay close attention to evolving government policies on trade, tax and the environment, as these shifts will have implications for global operations. The energy sector continues to deal with volatility and an elevated level of uncertainty as the industry both rebounds from the pandemic-driven recession and continues to transform in order to meet changing demand dynamics. As this uncertainty continues, manufacturing and energy companies alike need to ensure they have an updated, robust approach to risk management
- Manufacturing companies should factor in new proposed tax costs while reevaluating and modeling their supply chain strategies.
- Western countries are increasingly aware of the need to invest in infrastructure, manufacturing capabilities and advanced technologies. The United States and others are providing incentives to companies in key sectors in order to modernize infrastructure.
- We don’t expect $100-a-barrel oil would impact today’s world the same way it did 20 years ago, mostly due to structural changes underlying demand.
- As the energy mix changes from fossil fuels to renewables, the direction of capital spend will need to change along with it. Agility, diversification and preparation will be key for energy organizations to take advantage of opportunities in the post-pandemic, lower-carbon future.
- As manufacturers rapidly increase investments in technology to drive collaboration and productivity across their organization, they will also need concerted focus and formality around enterprise risk management in order to respond with speed and agility to growing cybersecurity and supply chain risks.
Governments focus on trade, tax, and environmental policy
Governments around the world are focused on bringing back critical supply chains and achieving strategic autonomy by rebuilding their domestic capabilities. The rebuilding is also taking on a “green” color as environmental concerns get factored into national, industrial and corporate objectives, and significant investments are needed at the national level to achieve these objectives. Accordingly, government policies and proposals are focused on trade, tax, infrastructure, and environmental policies that will better enable these goals.
These changes will introduce new opportunities for prepared middle market manufacturers, especially alongside expectations for significant economic growth. RSM forecasts U.S. gross domestic product to grow by 10% for the second quarter of 2021 and by 7.5% for the year. Bloomberg forecasts world GDP to grow by 6% in 2021 and 4.5% in 2022.
“The American economy is on the cusp of growth not seen in decades, but the sustainability of that growth will depend on decisions made today concerning taxes, spending and infrastructure” says Joseph Brusuelas, chief economist of RSM US. Industrial companies should harness technology and take into account the lessons learned from the pandemic and shifting government policies to position themselves to take advantage of what some are calling the Roaring ‘20s of the 21st century.
Countries are targeting self-sufficiency in critical supply chains such as semiconductors and advanced materials used in the production of electric vehicles and batteries. Western countries are increasingly aware of the need to invest in manufacturing capabilities and new-age technologies such as artificial intelligence and microelectronics. Countries want to win the technologies-of-the-future race since they understand the winner will have a national security advantage. Significant investments are needed at the national level to achieve these objectives.
In the wake of COVID-19, various countries are investing in advanced manufacturing capabilities and providing incentives to companies in key sectors. The Australian government, for instance, is now funding companies that operate in areas such as critical minerals, defense and space, and advanced technologies. Japan is investing in alternative manufacturing locations to help its companies shift facilities out of China. Europe, which traditionally does not provide favorable tax and other incentives due to state aid concerns, is specifically providing incentives to promote research, innovation and manufacturing of semiconductors and microelectronics.
These policies will affect the choices that manufacturers catering to these key sectors should make while considering global expansion, including whether to establish new manufacturing operations or export to new locations, as well as their determination of the best regions to expand to.
The Biden administration is taking a whole-of-government approach to assess vulnerabilities and strengthen supply chains in areas including semiconductors, advanced packaging, large-capacity batteries, and critical minerals and materials. The approach includes financing programs, updating restrictive regulations and statutes, strengthening engagement with domestic and foreign partners, and creating policies that give preference to domestic manufacturing. Biden’s $1.2 trillion infrastructure proposal aims to modernize the country’s aging infrastructure and enable growth. This will not only provide opportunity for industrial manufacturers that can cater to modernization efforts but will also enhance the country’s competitiveness in global trade.
These policies will affect the choices that manufacturers catering to these key sectors should make while considering global expansion, including whether to establish new manufacturing operations or export to new locations, as well as their determination of the best regions to expand to. While manufacturing companies setting up operations in these countries can benefit from such incentives, companies that are currently only exporting to these countries and don’t have plans to manufacture there should monitor the journey to self-sufficiency, with the goal of reducing reliance on overseas suppliers.
Corporate taxes are arguably the preferred method to finance the above initiatives. The Biden administration wants to bring back manufacturing, but few U.S. tax proposals target reshoring. This makes sense because reshoring decisions encompass much more than tax policy and are based on operating costs and accessibility to talent, suppliers and markets. At the same time, the global tax policy framework—i.e., how to tax and how much to tax—is itself undergoing a paradigm shift, toward taxing companies based on the location of their customers instead of the taxpayer’s country of residence. Also, countries that have long competed with one another to attract corporations by lowering tax rates are coming together to agree on a global minimum tax proposal to stop this race to the bottom.
Should a global minimum tax be implemented, it would even out the playing field to a large extent as far as taxes are concerned. The United States is a proponent of this global minimum tax and has been able to garner support from the G-20 countries. While companies obviously don’t favor higher taxes, they probably favor simplicity and certainty as much as, or sometimes more than, a tax rate reduction. There is a long way to go before these proposals may be finalized, but given the focus on building back their economies, governments will be increasingly focused on discouraging tax base erosion.
Infrastructure and environmental policy
Environmental, social and governance issues continue to get attention and are shaping countries’ regulatory, economic and tax policies as they race to meet their net-zero emission targets. The recently released tax proposals from the Biden administration provide a host of credits and incentives for investments in clean energy and eliminate existing tax preference items for companies in the oil and gas and coal industries. The European Union is considering a carbon border tax—a tax on imported goods based on the greenhouse gases emitted to make them—initially for steel, aluminum, cement and fertilizers. The EU has garnered broad support from its members and has been more aggressive on environmental policy initiatives—but its trading partners that don’t have robust environmental policies to begin with may find these measures unsettling.
Carbon pricing policies—aimed at applying a market price or a monetary value to carbon emissions—are already in place in many countries, including Canada, Europe and even some parts of the United States, forcing companies to take the impact of these emissions into account in their decisions to make carbon-intensive goods. Making green products can be more expensive than the status quo, but also creates the opportunity for companies to invest in advanced technologies to garner a greater share of the market. But given the focus on sustainability by countries around the world, companies ranging from glass to steel to automotive are left with no choice but to rethink product design and process.
MIDDLE MARKET INSIGHT
Middle market companies reevaluating the resilience of their supply chains will need to pay close attention to evolving government policies on trade, tax and the environment, as these shifts will have implications for global operations.
Here are some key strategies for middle market manufacturers to keep in mind:
- Factor in new proposed tax costs while reevaluating and modeling supply chain strategies.
- Be aware of the impact of changing environmental policies on operations and factor this into product design, pricing, and supply chain structuring given the various green regulations in each country.
- If considering global expansion, be aware of various countries’ sector priorities, not only to take advantage of any incentives but also to understand where specific sectors might be out of favor, thus potentially affecting company operations and customer base.
$140 is the new $100
The world is watching as oil prices continue to climb, with Brent crude exceeding $75 a barrel in mid-June for the first time since April 2019. This price hike is underpinned by a swift increase in demand as the pandemic has eased in many countries, coupled with concern around supply-side ability to meet these extraordinary needs—a typical supply-demand imbalance in a period of economic recovery. While many market watchers anticipate $100-a-barrel oil as global demand outstrips supply, the more pressing issue is how long prices will stay elevated and at what level high prices will significantly affect the economy.
“$140 oil is the new $100 oil,” says RSM Chief Economist Joe Brusuelas. In other words, we don’t expect $100-a-barrel oil to impact today’s world the same way it did 20 years ago, mostly due to structural changes underlying demand. Specifically, the composition of demand today is fundamentally different than in recovery periods of the past. The global economy is now more diversified than ever, thanks to the accelerating energy transition that has brought with it many options for energy sources not directly linked to oil, such as wind energy, solar power and natural gas. Additionally, the increased efficiency of oil products we enjoy today reduces the effect of high prices. For example, the use of gasoline, the most consumed petroleum product in the United States, has become significantly more efficient in the past decade, allowing consumers to travel farther with less fuel. So while we may see $100-a-barrel oil on the horizon as a result of current supply-demand conditions, we expect the duration and impact of such a price spike to be moderate.
Conditions behind rising prices
Global oil demand is expected to return to pre-pandemic levels of 100 million barrels per day in the second half of 2022, according to the International Energy Agency. Economic growth and related expectations drive demand, and we are certainly living in a period of recovery and growth, especially as many COVID-19 restrictions have eased. That said, there is still significant uncertainty around the trajectory of the global recovery, given the varying vaccination rates across the globe. Variables such as different strains of the COVID-19 virus can lead to a less-than-synchronous recovery across the globe. This type of uncertainty will temper long-lasting price surges.
The supply side of the equation is laced with uncertainties and complexities as well. OPEC+ continues to cap production limits for its member countries while U.S. shale producers—specifically public exploration and production (E&P) companies—have shown production constraints as they focus on capital discipline and free cash flow due to pressure from investors. OPEC+ is considering easing oil cuts starting in August, which will in effect raise supply, in reaction to demand recovery. The extent and velocity of the resulting supply increase will depend on the ability of the member countries to ramp up production.
On the U.S. shale side, a major hurdle to overcome is the underinvestment, or decrease in capital expenditure dollars, in the E&P space over the past year. Companies will need to overcome this stifling of investment in supply in order to make up for the natural decline in shale production, and this cannot happen overnight. Another wild card in the supply outlook is geopolitical and trade issues, such as the ongoing negotiations to revive the nuclear deal between the United States and Iran, which could result in Iran exporting an extra 1 million barrels of oil per day—or 1% of global supply—for up to six months, according to Reuters.
While there is a risk that demand may outstrip supply, causing a price boom in the short term, we expect the duration and impact of the surge to be moderate. Nonetheless, it is clear that the industry is still dealing with an elevated level of uncertainty and will face continued volatility as it both rebounds from the pandemic-driven recession and continues to transform in order to meet changing demand dynamics.
MIDDLE MARKET INSIGHT
Looking to the future, understanding demand undercurrents will be key for players at all points in the energy value chain. As the energy mix changes from fossil fuels to renewables, the direction of capital spend will need to change along with it. Agility, diversification and preparation will be key for energy organizations to take advantage of opportunities in the post-pandemic, lower-carbon future.
Hindsight is 2020: How manufacturers are rethinking risk
In the wake of navigating significant supply chain disruptions and a rise in cyberattacks over the past year, organizations need to find a path forward that helps them become more resilient. Doing so starts with rethinking entity-wide risk management.
As middle market manufacturers recover from the pandemic and take advantage of robust economic growth prospects through new business models and technologies, they should also reassess their approach to risk governance. This will involve modernizing their risk management practices to critically evaluate risk more broadly across the enterprise and beyond their own sphere of influence. A 2019 Forrester Research report found that only 36% of organizations had a formal risk enterprise program. This means companies need a concerted focus and formality, as well as speed and agility, in the areas of third-party and supply chain risk management, cybersecurity, and overall risk governance practices.
Third-party and supply chain risk management
Companies with complex operations and extended supply chains have borne the burden of the challenges posed by engaging suppliers that also rely on third parties. We commonly see this structure with the automotive industry’s original equipment manufacturers (OEMs), which rely on tier 1 suppliers, which in turn contract with tier 2 and other suppliers for vehicle components. The current semiconductor chip crisis in the auto industry is one recent example, which in several ways resulted from OEMs’ reliance on tier 1 suppliers to work with chip manufacturers rather than directly involving the manufacturers in the production planning process.
Organizations need to consider investments in technology that will help them identify all their critical suppliers and also continuously evaluate the performance of other providers and sub-suppliers throughout the supply chain.
As seen from this example, it can be difficult to fully assess risk and potential exposure in these deep, multilayer supply chain networks, and most middle market manufacturers have not invested in the necessary technology to gather the data to efficiently perform this analysis on a continuous basis. Therefore organizations need to consider investments in technology that will help them identify all their critical suppliers and also continuously evaluate the performance of other providers and sub-suppliers throughout the supply chain. With industrial companies relying heavily on third parties throughout the supply chain, visibility and connectivity across the extended ecosystem will be essential in mitigating future disruption and building resiliency.
Along with the rapidly changing landscape of manufacturing supply chains, organizations are facing new cybersecurity challenges. Although companies have greatly benefited from advanced technologies that have driven operational efficiencies, innovation and collaboration, these technologies have also created new opportunities for potential cyberattacks. Hackers have had more susceptible networks to attack, a captive audience and more time on their hands to create chaos, as noted in our RSM US Middle Market Business Index 2021 Cybersecurity Special Report.
With a surge in the remote workforce, a significant increase in the use of Internet of Things devices, and a general drive toward greater connectivity to utilize data-driven decision-making, traditional cyber measures and tools are not always enough for an organization to manage visibility and control of security. In the last year, 28% of middle market executives claimed that their company experienced a data breach, according to first-quarter 2021 MMBI data used in the cybersecurity report. That is the highest level since 2015, when RSM began tracking this data and a sharp rise from 18% just last year.
Manufacturers and third parties alike need to continue to evaluate cybersecurity protocols and programs in order to protect intellectual property and critical data. While an attack or even a pandemic is an unforeseen risk, being prepared begins with having a strong plan or program in place. And given the continuous news of ransomware attacks, including the recent attack on Colonial Pipeline, the importance of this could not be greater.
As the economy picks up steam, it is essential for organizations to not only assess the lasting, material impact of COVID-19 but also evaluate the future of their overall risk governance practices. More specifically, risk management functions will have to be able to better identify, measure, monitor and control existing as well as new and emerging risks. Beyond merely categorizing and quantifying an individual risk, companies must think critically, evaluate complex relationships, and consider upstream and downstream effects of risks within the universe to establish an enterprise view. We are already seeing middle market organizations reappraising their approach to risk management, with many now adopting a more agile strategy. This can include a continuous monitoring approach in the evaluation of existing, new and emerging risks. Staying agile not only allows for earlier detection of risk, but enables a speedy and accurate response.
Manufacturers will need to continue prioritizing and developing competencies in areas of third-party, supply chain and cyber risk management, as well as enhancing their overall risk governance practices.
In order to embed and execute an effective risk management program, there needs to be a clear value proposition to drive buy-in from leadership. While executives often recognize the importance of risk management’s role in value creation, it is not common for value creation to be cited as a goal of an organization’s risk management strategies. With the proper governance, buy-in and strategy alignment, organizations are able to truly unlock the value of enterprise risk management and improve overall resilience.
Manufacturers will need to continue prioritizing and developing competencies in areas of third-party, supply chain and cyber risk management, as well as enhancing their overall risk governance practices. This will ultimately improve resiliency and provide a competitive edge as the economy picks up steam. Each of these priorities should be viewed as a leg of a stool—without one, operations or even the entire company can fall.
MIDDLE MARKET INSIGHT
As middle market manufacturers recover from the pandemic and take advantage of robust economic growth prospects through new business models and technologies, they should also reassess their approach to risk governance.
How middle market manufacturers should approach risk:
- In response to the changes and challenges brought by the pandemic, manufacturers have accelerated investment in and adoption of technology, and now must work to understand the new and emerging risks in order to build resiliency across their organization and entire value chain.
- To combat rising third-party, supply chain and cyber risks, companies need concerted focus and formality around risk management in order to respond with speed and agility to the changing and competitive manufacturing landscape.
- Prioritizing risk management can boost performance and continuity, giving an organization the ability to maintain a competitive edge.
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