United States

Manufacturing and energy industry outlook

A new wave of globalization, EV market growth and commodity prices

Volume 7, Spring 2021

Some of the dust has begun to settle for the manufacturing and energy sectors following the severe volatility of 2020, but that doesn’t mean either is returning to how they looked before the pandemic began.

A rising China’s role in global trade and the way governments around the world are responding to it is shaping a new wave of globalization. Continuing supply chain disruptions are triggering new policies to prevent shortages of goods. Interest in the electric vehicle market is heating up, from automakers and investors alike, and suppliers will need to assess what that means for them as auto demand returns.

As the global economy reflates, commodity prices have led the recovery. But we do not believe the supply and demand outlook will play out in a way that results in what’s known as a “supercycle” in which commodities trade above their price trend, as has happened several times in the past.

Key takeaways

  • Global trade may have plateaued, but globalization is evolving. Industrial customers increasingly demand speed and customization, requiring manufacturers to be closer to their customers and to adopt tech-enabled distributed manufacturing solutions.
  • There has been a flurry of capital market activity in the electric vehicle space, which is also garnering significant investments from legacy automakers.
  • We expect automotive supply chains to increasingly revolve around the geography of the battery and electronic component production, leaving suppliers that are located closer to production with a competitive advantage.
  • Some analysts have suggested that we are in the beginning stages of a commodity supercycle. In our view, however, this hypothesis is premature.

GLOBALIZATION

The fourth wave of globalization

Recent geopolitical conflicts and pandemic disruptions have reignited the debate on the future of globalization. Geopolitical dynamics, with a rising China at the center, continue to reshape many international relationships and consequently, trade policies. Globalization is being redefined and facing new pressures, and that brings new considerations for the global manufacturer.

Shortages of goods ranging from medical supplies to semiconductors have forced many governments around the world to take action, waking them up to critical supply chain vulnerabilities. Countries are formulating new plans and policies to achieve self-reliance for critical supplies. The U.S. government, for one, is reviewing critical supply chains, funding research for securing rare earth minerals for domestic production of EVs, and investing in domestic manufacturing, clean energy, infrastructure and advanced technologies. The goal is to reshore production in these areas that are too risky to depend on foreign supply chains. The European Union is pursuing “strategic autonomy” at the core of its trade and foreign policy and is proposing to target 2030 for reducing reliance on foreign-sourced semiconductors.  China is pivoting toward “dual circulation,” a policy focused on encouraging domestic consumption instead of reliance on exports.

This latest rush to self-reliance can largely be attributed to a rising China. Other countries’ response to China’s increasing dominance will be a critical factor in shaping domestic manufacturing policies and international trade. Although some countries like the United States, India, Australia and Japan are considering forming an alternative trade block or alliance, there is not yet a cohesive response to address growing polarization.

The U.S. approach as summarized by Secretary of State Antony Blinken is that “our relationship with China will be competitive when it should be, collaborative when it can be, and adversarial when it must be.” It is safe to assume that this mirrors the approach of most other significant economies. Boris Johnson, while positioning China as “the biggest state-based threat to the U.K.’s economic security,” is also promising greater cooperation with China for efforts related to climate change and economic ties.

What does this mean for globalization and global trade? Total self-reliance in today’s global world is a myth. And yet, global trade has plateaued over the years. After having more than doubled from 1970 to 2008, global trade as a percentage of world gross domestic product has not surpassed the highs of 2008. Trade volume too has been flat to down, based on the World Trade Volume Index assembled by the CPB Netherlands Bureau for Economic Policy Analysis. Meanwhile, other measures show global trade has been stable. The DHL Global Connectedness Index, which tracks trade, capital, the exchange of information and movement of people to determine whether globalization is increasing or declining, showed that globalization held steady in 2019. While it will decline in 2020, it “is unlikely to fall below levels seen during the 2008–09 global financial crisis.”

Global trade may have plateaued, but globalization is evolving.

Global trade may have plateaued, but globalization is evolving. Industrial customers increasingly demand speed and customization, requiring manufacturers to be closer to their customers and to adopt tech-enabled distributed manufacturing solutions. Servitization models—in which manufacturing is provided as a service rather than a product—and distributed manufacturing models mean more information and knowledge sharing between locations while manufacturing is localized.

The multiple supply chain disruptions countries are experiencing right now (although temporary) and the development of government policies aimed at achieving self-sufficiency will encourage and foster more regional manufacturing and regional supply chains. 

MIDDLE MARKET INSIGHT

Large industrial companies have for a long time manufactured close to customers. They now expect their smaller suppliers to be able to deliver in different locations across different channels. Suppliers beyond tier 1 and 2 suppliers—mostly small and mid-sized companies—may need to set up or expand operations globally to support a distributed manufacturing model that is global and local.

Many mid-market suppliers have set up overseas operations as a response to a customer’s request. Companies that can intentionally and proactively cater to their customers’ global footprint will have a competitive advantage. Multichannel delivery capabilities powered by the use of Industry 4.0 technologies to enable efficiency and resiliency across supply chains will be critical.

Middle market companies that need to catch up in order to meet these shifting expectations might want to consider:

  • The right location(s) in alignment with a broader global strategy so that they can expand their regional and global customer base
  • Warehousing and logistics implications of more regionalized supply chains, incorporating cloud computing and enhanced IT infrastructure solutions that can provide the supply chain visibility required to respond to market changes
  • Proactively addressing regulatory compliance matters that accompany global growth to take advantage of cost and operational efficiencies

Marc Levinson, author of Outside the Box: How Globalization Changed from Moving Stuff to Spreading Ideas, talks about what is essentially the end of the third wave of globalization (the first started in the 19th century, the second after WWII) and the beginning of a fourth wave. He notes that the third has largely been about engineers and designers in advanced economies creating products that are manufactured in economies where wages are lower, which are then sold around the world. In the fourth iteration of globalization, “it is the research, engineering and design work that is being globalized.”

EV SUPPLY CHAINS

Electrification and the evolving automotive supply chain

Automakers continue to experience pandemic-induced supply chain challenges, but that’s not stopping some companies and investors from zeroing in on electrification and the acceleration of the EV market as auto demand returns.

Automakers continue to experience pandemic-induced supply chain challenges, but that’s not stopping some companies and investors from zeroing in on electrification and the acceleration of the EV market as auto demand returns.

The auto industry overall has mostly bounced back after taking a hit last year, and is now experiencing sales growth in China and the U.S. This is especially true in the EV sector, which is benefiting from continued advancements in technology and increasing regulation to curb emissions from gasoline and diesel-powered vehicles. The EV space is also garnering significant investments from legacy automakers, who have historically taken a wait-and-see approach to embracing electrification, given the unprofitability of some EVs compared to legacy internal combustion engine products.

We have also seen a flurry of capital market activity in the EV and battery space; EV startups raised $7 billion in venture capital last year, according to data compiled by PitchBook. Sixteen EV startups representing a combined enterprise value of nearly $78 billion merged with special purpose acquisition companies or were in the process of doing so at the end of 2020, according to PitchBook. (April has brought a slowdown in SPAC IPO activity and an SEC warning that some special purpose acquisition companies may have improperly accounted for warrants issued or sold to their investors.)

All of this activity in the EV space signals that the world’s largest automakers are doubling down and accelerating their electrification efforts at a time when U.S. automotive sales recently skyrocketed to a seasonally adjusted 17.8 million units, a 21-year high for the month of March. (That’s after sales hit their lowest levels in a decade last year at 14.6 million, according to data from the International Organization of Motor Vehicle Manufacturers.)

The acceleration in EV investment began in November, when General Motors announced plans to increase the rollout of its EV lineup. The Detroit-based company committed to spending $27 billion on electric and autonomous vehicles through 2025 with a goal of selling 1 million EVs by 2025, ultimately transitioning its entire lineup to EVs by 2035. Not to be outdone, GM’s crosstown rival Ford announced plans in February to invest $22 billion on EV technologies and $7 billion on autonomous vehicle technologies, but stopped short of announcing plans for an all-electric future.

We believe that these investments stem in part from the impending entrance of Rivian’s R1T electric truck and Tesla’s Cybertruck into what is estimated as a $125 billion pickup truck market, according to Bloomberg Intelligence. Legacy automakers such as GM, Ford and Stellantis will need to defend this highly profitable segment of the market, which accounted for about $22 billion in operating income and accounted for a record 75.9% of U.S. auto sales in 2020. To do so, these companies will need to maximize profits on current models while also preparing their electric lineups as Tesla and Rivian’s production capacity ramps up in 2023.

Policy factors at play

U.S. automakers’ move toward electrification also may benefit from the recently announced American Jobs Plan, which includes $174 billion to “win the EV market.” The plan is designed to promote EV production domestically, as well as build out a national EV charging network. The plan also calls for the replacement of 50,000 diesel transit vehicles and the electrification of at least 20% of the country’s yellow school bus fleet.

While the federal plan does not specify when the sale of new ICE vehicles will end, recent action in some states may provide a preview of what’s to come: Massachusetts announced a plan to ban the sale of new cars powered by fossil fuels by 2035, California Governor Gavin Newsom signed an order banning sales of new gasoline cars by 2035, and the New York State Senate recently introduced a bill requiring new cars and trucks to be zero-emissions by 2035.

Government influence on automakers' EV strategy varies widely by region, and it is clear the European Union is leading with some of the world’s most stringent targets. This might explain recent moves announced by Germany’s Volkswagen Group, which may have the most ambitious EV plans of all legacy automakers. The company aims to be the market leader for electric mobility by 2025 and has stated its goals to produce 1 million EVs per year by 2023 and 1.5 million per year by 2025. To support these lofty ambitions, the company has committed to investing around €46 billion (~$54.3 billion) in electric mobility and the hybridization of its fleet in the next five years. At its Power Day event in March, the company announced plans to build six battery factories in Europe by 2030, each with a capacity of 40 gigawatt-hours.

Can current supply chains handle EV growth?

Recently, semiconductor shortages have dominated the news, exposing the fragility of global automotive supply chains and causing shutdowns at numerous U.S. automotive production facilities. Given the shutdowns experienced by original equipment manufacturers at the beginning of the pandemic, chipmakers shifted their focus away from the automotive sector in favor of the consumer-electronics sector, which was benefiting from increased demand in light of pandemic-induced lockdowns. And with recent stockpiling by Chinese manufacturers, combined with a near-term boost from sales of vehicles with advanced infotainment systems and EVs that require a greater number of chips, it would appear that challenges and potential production disruptions will persist in the near term, especially given that most capacity for the year is already accounted for.

In addition to the supply chain challenges automakers are facing, there are growing head winds related to lithium battery development and production that could threaten EV growth prospects as well. China currently has around 77% of the world’s lithium-cell manufacturing capacity, according to Bloomberg New Energy Finance. Around 60% of the world’s cobalt, the most expensive raw material in lithium batteries, is produced in the Democratic Republic of Congo and is mainly processed in China, for both batteries and steel. Organizations are increasingly focusing on ethically-sourced cobalt, as stakeholders have increased their expectations surrounding environmental, social and governance (ESG) indicators, so this may present challenges for companies using longtime mining techniques that some would consider defeating the purpose of EVs.

These challenges will continue to put pressure on OEMs and their suppliers, especially middle market manufacturers. As batteries are the heaviest component in EVs and transporting them is both difficult and expensive, we expect automotive supply chains to increasingly revolve around the geography of the battery and electronic component production, leaving suppliers that are located closer to production with a competitive advantage.

Some key questions middle market manufacturers should be asking themselves to make sure they are prepared to deal with these ongoing changes include:

  • To what extent has your company developed a long-term strategy, including identifying the technological capabilities required to compete in the EV sector?
  • How will your strategy and supply chain be affected by growing nationalism, including Biden’s proposal to “win the EV market”?

For middle market manufacturers, the electrification shift will make or break their future. 

MIDDLE MARKET INSIGHT

As the drive train for an EV uses very different parts and reduces the number of components required compared to an internal combustion engine vehicle, this will completely remake supply chains. Middle market manufacturers will need to need to be intentional about how they carve out their place in the market.

They must become more agile, focus on differentiating their products, and continue to utilize data and technology to create flexibility in their manufacturing operations. Ultimately, the organizations that are most effectively able to leverage Industry 4.0 technologies across their organization to transform all aspects of their business will be best positioned to prosper in the growing electric vehicle segment.

COMMODITIES

Commodity supercycle not likely in near term

As the global economy reflates following the pandemic, commodity prices have led the recovery. The early move upward in price has been so large, in fact, that some analysts have suggested that we are actually in the beginning stages of a commodity supercycle. A commodity supercycle is defined as an extended period of time, usually a decade or more, during which commodities trade above their price trend. A supercycle is basically a bull market where a shortage of commodities such as crops, oil and gas, and metals results in a long period of high prices.

“Our assessment of this hypothesis is that is entirely premature to label pricing action across the commodities complex as a supercycle,” says RSM US Chief Economist Joe Brusuelas. “While it is clear that the U.S. and China will be the primary growth drivers early in the post-pandemic global economy, we anticipate an asynchronous international economic recovery where the U.K., Europe, Japan, Australia and Brazil lag the early stages of recovery and expansion. Thus there is simply not going to be the necessary global demand this year and likely in early 2022 to support the tentative claims that underscore calls of a commodity supercycle.”

Key market conditions that shape a supercycle are extended periods of underinvestment in supply followed by significant demand return. It’s the extent and duration of each of these phases of supply/demand imbalance that determines whether the magnitude of the upswing is enough to be considered a true supercycle (rather than, say, a year or two of an upswing). The supply/demand imbalance currently showing up in the market for commodities such as oil, natural gas and copper coupled with loose fiscal policy and depreciation of the dollar, presents some indicators similar to those of previous supercycles.

One of the most notable commodity supercycles occurred from the early 1970s, as a result of booming oil prices and lasted until the early 1980s. Another cycle happened between 2000 and 2014 largely due to rising demand from emerging markets, predominantly China. Both cycles were marked with high oil prices, with oil peaking in July of 2008 when West Texas Intermediate landed at over $145 per barrel. Although some current market indicators are similar to these previous cycles, the source behind the increase in demand is less likely to be as strong from China as they have shifted to boosting domestic consumption/development. Additionally, the push toward the energy transition will fundamentally hinder demand patterns for fossil fuels in the long term.

“While, yes, there have been disruptions to global supply chains during the pandemic that are currently behind the move in prices across the commodities complex, those chains will over the next 12 to 18 months move back to full production and pricing will adjust accordingly to the rise in supply to meet demand and inflation concerns will most likely abate during that time,” says Brusuelas.

According to a recent Bloomberg survey of institutional and retail investors, 40% of respondents felt that we are, in fact, entering a commodity supercycle, while 50% responded that we are not entering supercycle but were bullish on commodity prices. The slim margin in responses demonstrates overall optimism around market conditions, countered by market uncertainty and potential head winds related to demand return.

It is important to note that, at a more granular level, the outlook across commodities varies. Here are three key factors at play right now in the oil and gas space that lead us to believe a commodity supercycle for oil, at least, is unlikely.

  • Return of U.S. shale supply slow but on the horizon: The speculation around a potential supercycle involving high oil prices is largely driven by expected post-pandemic demand growth coupled with producers’ major pullbacks in capital spending over the last year. Although oil prices have recovered significantly since this time last year, the focus on liquidity and paying down debt is taking precedence over production investments in the near term, meaning that we have not seen the return of U.S shale drilling traditionally associated with prices above the break-even point.

    While this type of underinvestment in oil and gas exploration activities could be considered a precursor to a supercycle, the duration of the supply stall is what is key. The longer prices stay above the break-even range, the more likely we are to see a significant return of shale production, meaning that even if the supply comeback is slow, it is likely to return to levels adequate to meet demand in the next two to three years.

  • OPEC’s role in balancing the market: OPEC, the Organization of Petroleum Exporting Countries, plays a key role in balancing oil prices. The organization has agreed to setting production limits on its member countries in order to balance the world supply of oil with the downward pressure on demand. This artificial method of stifling production also means that OPEC has spare production, in fact of up to 8.9 million barrels per day, according to Bloomberg, that could be released if the demand warrants it—which contradicts the conditions present in a true supercycle.

  • Potential for demand head winds: The demand for oil will no doubt rise as the COVID-19 vaccine rollout continues and fiscal stimulus is pumped into the economy. However, the long-term demand for fossil fuels is structurally dented by both the pandemic and the continued acceleration of the energy transition. According to Bloomberg, developed countries’ gasoline and diesel use could remain 10% to 20% below pre-pandemic levels. Additionally, OPEC has lowered its 2021 oil demand growth forecast by 300,000 barrels per day, reflecting concerns about the market’s recovery amid a wave of new coronavirus lockdowns, according to Reuters.

While we are certainly in for a year of strong growth, it is our view that current conditions do not lend themselves to a true commodities supercycle like those we have experienced historically.

While we are certainly in for a year of strong growth, it is our view that current conditions do not lend themselves to a true commodities supercycle like those we have experienced historically.

MIDDLE MARKET INSIGHT

We expect that energy companies in the middle market should plan for market conditions in which oil prices will remain in the upper $50, low $60 range (per barrel), allowing them the flexibility to pay down debt and make strategic investments. Specifically, companies should consider what types of advanced technologies would be beneficial to invest in now.

The Biden administration’s focus on clean energy and the overall accelerated focus on ESG should guide middle market companies to focus on minimizing the environmental impact from their core operations. Along with that comes the challenge of navigating the data that surrounds the impact of such investments and determining how to accurately report on measures taken to meet emission targets and reduce the overall carbon footprint. As middle market companies mature along the ESG path, the data and reporting aspect will become increasingly important.


Industrials Insights

RSM CONTRIBUTORS