Oil and gas prices: Will sourcing come closer to home?
Sean A. Murphy -- Logistics Management, 9/10/2008
Anyone who pays to run anything on gasoline, diesel fuel, kerosene or other petroleum-based products knows that the price of oil has skyrocketed in the past year. While it may have slipped from its brutal peak above $140 a barrel in July to hover around $120 a barrel a month later, who knows where it's going to go next?
This is certainly cause for concern, especially for companies based in North America that have outsourced to China and other offshore locations with the sole purpose of taking advantage of cheaper labor. Now, ballooning transportation costs pushed upward by oil prices are threatening to erase whatever savings those offshoring companies have enjoyed until now.
Many executives in these companies are considering bringing their operations closer to home, relocating to either the U.S. or Mexico. This potential trend—oil prices forcing overseas operations based on cheap labor to come home—is prompting one financial analyst firm to declare that the entire trend of globalization will be reversed by these higher fuel costs.
But experts and practitioners that spoke about the issue to Supply Chain Management Review say not to pull the curtain on globalization just yet. There are more reasons for a company to go global than just to cut labor costs, they say, and globalization as a trend includes benefits that could far outweigh transportation costs, no matter how high they rise.
Companies striving to make the right decision on whether to move offshore, bring operations back home, or keep things as they are, need to consider multiple factors. This article will explore some of those factors, with particular attention paid to where oil prices fit in to the picture.
Many financial experts are calling the current oil price situation a crisis, and according to a report released this summer by Toronto-based CIBC World Markets, part of Canada's leading banking firm CIBC, it's more than just a bump in the road. The report's authors predict that soaring transportation costs will only get worse, and eventually force an outright reversal of globalization as we know it.
While the report falls short of predicting exactly what oil will cost at any particular time, it warns there is no way that moving operations to a foreign country to cut labor costs will be sustainable when the worst-case scenario of $200-a-barrel oil actually happens.
When the price does hit that mark, the report says, it's going to have effects of landmark proportions on transportation. As an example, according to the report, a 40-foot container shipped from Asia to the east coast of the United States has tripled in price in the last eight years alone, and will double again as oil marches toward the dreaded $200 per barrel mark.
“Unless that container is chock full of diamonds, shipping costs have suddenly inflated the cost of whatever is inside,” writes CIBC's Jeff Rubin. “As oil prices keep rising, pretty soon those transport costs start cancelling out the East Asian wage advantage.”
The Council of Supply Chain Management Professionals (CSCMP) made similarly dire assessments about the price of fuel and its effects in its 2008 State of Logistics Report in June. In that report, economist Rosalyn Wilson calls fuel prices “the largest single factor affecting the transportation segment,” and said fuel was the “driving force” behind a number of logistics providers and shippers going out of business.
“These days, it costs over $1,100 to fill up a big rig with a pair of tanks that hold 250 gallons, compared to about $720 last year,” Wilson writes. “Fuel is close to or has surpassed labor as a trucking company's top expense. At these prices, fuel is eroding profit margins in an industry with historically lean margins to start with.”¹
Jeff Rubin goes even further. Writing in his report under the headline, “Will Soaring Transport Costs Reverse Globalization?” the CIBC analyst says new economic factors make for an economy so dependent upon oil that any change in prices will have profound effects. In particular, he cites heightened expectations among the shipping community. Increased containerization leads to increased speed of transport, which leads to an expectation of faster travel. And if oil prices really do make up half of a company's transportation costs, that could spell trouble.
Rubin goes on to note that many “low-cost” countries such as China and India may have comparatively low tariff rates to encourage trade, but higher fuel prices will take the place of high tariffs, providing just as strong a barrier to global trade.
In 2000, Rubin says, transport costs were the equivalent of a 3 percent U.S. tariff rate, and that was when oil was at a mere $20 per barrel. Rubin predicts that at $150 a barrel, a not-unreasonable scenario, transportation costs could be the equivalent of an 11 percent tariff rate. “And at $200 per barrel, we are back at 'tariff' rates not seen since prior to the Kennedy Round GATT negotiations of the mid-1960s,” Rubin writes.
Rubin recommends global trade be “dampened and diverted” in response to these soaring prices, noting that OPEC-related oil crises in the 1970s caused similar changes in global trade. His conclusion: “Globalization is reversible. Higher energy prices are impacting transport costs at an unprecedented rate. So much so, that the cost of moving goods, not the cost of tariffs, is the largest barrier to global trade today.”
Many experts and practitioners who spoke with Supply Chain Management Review agree with Rubin that skyrocketing fuel prices are causing problems throughout the supply chain, and forcing many changes. But are the high prices enough to reverse the globalization trends of the past decades and bring sourcing and manufacturing closer to home for North American companies? Most experts we spoke with have their doubts.
William Killingsworth, executive director of the Massachusetts Institute of Technology's Forum for Supply Chain Innovation, agrees that higher fuel prices will have an adverse effect on any supply chain that involves offshore operations. But he adds that the globalization movement is just too vast and complex for any one factor, even fuel prices, to simply undo it.
In particular, Killingsworth points out that the size and weight of the goods being transported can make all the difference. Large and heavy shipments will be expensive no matter where they come from, and any shipment coming from outside the country often changes hands—and modes—several times. It's not unusual, he says, to find the final stage of transport, usually by land in the U.S., can be more expensive than the costs of moving the product from the overseas manufacturer to the U.S. port. A company can't fix that by relocating the manufacturing plant to the states.
“The last 10 miles may be much shorter, but they could be pretty cost-intensive,” Killingsworth says.
The increased prevalence and necessity of expedited shipping mitigates against the notion of giving up on offshoring. Killingsworth says some companies rely on being able to get rare parts fast to fix, say, a broken piece of equipment. Unfortunately, he says, the fastest mode—air—is also the most expensive, but companies are willing to bite that bullet when a missing part is threatening to shut an entire production line down. “That happens in this just-in-time world not all that infrequently,” he said.
Killingsworth acknowledges that many companies are moving offshore to save labor costs, and that the rise in fuel costs are definitely threatening to outweigh labor savings. But, he adds, many companies are interested in market-driven globalization and offshoring in order to sell their products to consumers in those foreign countries, not just looking for cheap labor there. Those companies, he says, are far less inclined to pull up stakes and come home.
“These companies are not going to move their manufacturing back to the U.S. and ship back to China,” he says.
Robert Rudzki, president of consulting firm Greybeard Advisors, LLC, and author of the blog “Transformation Leadership” on www.scmr.com, agrees with the CIBC report that fuel and oil prices have risen enough to change the face of globalization—but only in the near term.
Long term, however, is a totally different story. Rudzki notes that while companies should rightfully fear $200-per-barrel oil, there's no way to know what other factors will have changed by the time that ever happens. The CIBC report, Rudzki says, does not indicate when the analysts believe oil will soar to such levels.
The report also doesn't take into account other factors, he says, such as tariffs, government regulations, or production costs in foreign countries. If the rise in oil prices is gentle enough, and other costs steadily increase, too, that will blunt the impact of even $200 per barrel prices. “You can't look at (oil prices) in isolation,” Rudzki argues.
In order for supply chain managers to be sure they understand how transportation and fuel costs are affecting them, Rudzki says procurement managers need to stay on top of a whole range of supply chain developments. Yes, they should have as current information on fuel as possible, but they should also be equally schooled on labor, currency, and other factors affecting overseas divisions.
To effectively track changes in fuel prices and the oil economy, Rudzki recommends hiring one or more expert energy analysts. Their areas of expertise should include but not be limited to regulations (state and federal), energy procurement and delivery, energy financial hedging, and conservation. If a company can't afford a full-time advisor, Rudzki recommends a part-time consultant.
Brad Wyland, senior research analyst for supply chain management at Aberdeen Group, says companies that can't bring offshore operations home may want to consider a restructuring of the global supply chain, or “smart globalization,” as he calls it.
Companies that still need to source and manufacture offshore will find ways to tighten the belt, minimizing the impact of higher oil prices. In his latest transportation management report, “No Excuses! Why Optimizing Transportation Management is Within Reach of Every Company,” Wyland writes that “Best-In-Class” companies will do the following:
· Demand more from solution providers: Work with their providers to emphasize flexibility and integration to accommodate changing landscapes, both in energy and other critical areas.
· Create tighter partnerships with forwarders and carriers: Closer relationships can reveal opportunities such as new routes and other creative cost-saving ideas. Many companies opt for electronic communications systems that offer real-time information to track changes.
· Continue to stretch the bounds of integration, specifically with customer service and warehousing: Maximum visibility in these areas will identify opportunities to improve efficiency and respond to a changing market.
From a practitioner's perspective, Rick Hughes, vice president of global purchases for Procter & Gamble, says supply chain managers need to make sure to balance what they know about fuel with the big picture. “I think it's a lot more complicated than just the cost of transportation,” he says. In particular, Hughes notes six factors every supply chain manager should worry about—in addition to high oil prices:
Quality: When sourcing ingredients, sometimes the quality of material trumps transportation costs. To illustrate, P&G needs phosphate rock to make sodium polyphosphate, a key ingredient in many products. China is the best place in the world to find that mineral, Hughes says, and fuel prices won't change that. In addition, the company needs eucalyptus pulp, which it currently gets from Brazil. It probably would be cheaper to try to source it in the U.S., but a scarcity of eucalyptus trees at home makes this unlikely.
Energy: How a sourced country fuels itself and its factories is just as important as how the sourcing country fuels ships to get there and back. Just four to five years ago, Hughes says, China suffered from frequent brownouts caused by an insufficient power grid, and many Asian countries source fuel such as coal from each other, introducing other potential third-party economic conflicts that bear watching.
Tariffs: The CIBC report mentions that tariffs are dropping, but not everyone gets a free ride. Some countries, Hughes says, have actually grown isolationist in the current economy, and raised tariffs to try to lock foreigners out. All the cheap gas in the world won't matter if the ship can't dock or leave port.
Availability of Capital: Many corporations need venture capital to set up shop overseas, regardless of the price of oil. Some countries have lots of investors with deep pockets, while others do not. Hughes advises to check on the availability of loans, equity, venture capital firms, and private investors.
Supply/Manufacturing Assurance: Do you really know what's going on at the factories that are manufacturing product for you? Lack of monitoring can create the next pet food/lead paint/heart medication scandal. Hughes says P&G annually visits many factories, farms, and other sources of its products and ingredients in foreign countries. Even “low-risk” suppliers that don't need to be monitored as closely are screened carefully before being brought on board. It's not safe to simply fill out a form and start mailing the suppliers checks.
Brad Wyland of the Aberdeen Group said some of his clients who are keeping an eye on these factors have even considered pursuing a course counter to the advice given in the CIBC report: offshoring more operations, not less. If there is a good reason to continue sourcing a component of the manufacturing process offshore, Wyland says, it might be beneficial to actually move more components of the process to that location, opting to build the entire product overseas instead of just sourcing materials. “You're just trying to move that (offshore) choice closer to either end (of the manufacturing process) and find the most cost-effective balance in the long-run,” he said.
According to several consultants, experts, and practitioners, CIBC's analysts got it right when it comes to the facts as they are presented. Anybody outsourcing or thinking about outsourcing to foreign countries has to think about what the higher oil prices mean in the long term. And companies who outsource for no reason other than to save money on cheap labor will be in for a rude awakening if oil prices per barrel ever do hit that scary $200 mark.
For most companies though, there's a lot more to consider than labor costs when sourcing or manufacturing overseas—or at least there should be. The term “globalization” includes many other motivations, from seeking high-quality materials to manufacturing products for sale to indigenous consumers, to expedited shipping of critical parts. Oil prices won't change any of those needs. In some cases, the best way to streamline a company's supply chain will be to bring sourcing and manufacturing closer to home; in other cases, it may not.
It's easy for oil sticker shock to frighten company executives into making hasty decisions on where to source or manufacture their products. In the long run, however, they will make better decisions when considering all the factors connected to offshoring. Doing this will ensure that their world remains flat.
Sean Murphy is associate editor of Supply Chain Management Review, a sister publication of LM.
|
View All Blogs
