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Globality: Harold L. Sirkin

Escaping the Commodities Choke Chain

With some 3 billion people in Asia, Latin America, and Africa breaking the yoke of poverty and becoming real consumers for the first time in their lives, the world suddenly needs more of everything. And “more” doesn’t happen overnight.

The U.S., Europe, and Japan already consume most of the world’s resources. When demand exceeds supply, prices for everything from coal to the so-called rare earth elements (some of which increased in price by more than 2,500 percent last year) have nowhere to go but up.

Consider the most basic fossil fuel: coal.

Since 2005, China’s need for coal, which already ties up some 45 percent of the country’s rail capacity, has outstripped its ability to produce it, according to Craig Richardson, a Winston-Salem State University professor who monitors the Chinese economy for the American Institute for Economic Research. So China, already the third-largest coal consumer in the world, must import coal to meet its growing demand.

Worsening Problem

With 500 new coal-fired power plants scheduled to come on line in China in the next decade, the problem will only get worse. “In 10 years,” Richardson writes, “China will need to import the equivalent of the entire coal production of Australia, Indonesia, South Africa, and Russia.” Huge questions remain about where this needed coal will come from, how much it will cost, and what effect China’s needs will have on its own and the global economy.

Coal is just one small part of the equation. With the U.S. and European economies still recovering from the Great Recession and the Japanese economy suffering from the great earthquake, tsunami, and nuclear-power crisis, little excess capacity exists in the energy and commodities pipeline. Supplies are stretched. Prices are rising. The specter of significant inflation looms ahead.

Americans understood the supply-demand cost equation when our own booming economy was driving things. Gasoline at more than $3.50 a gallon seemed tolerable when Americans had jobs. But now Americans are paying such prices (and some are predicting future highs of $6 a gallon) to support jobs in China, India, Brazil, and other fast-developing countries. For most Americans, that’s a lot less tolerable.

The commodities choke chain has few safety valves. Increasing supplies is neither quick nor easy. It takes years to open a single new mine. Finding substitute commodities is an arduous, costly process.

Algae Fuel’s Potential

Consider the effort to substitute algae fuel for fossil fuel. Kenneth Green, a resident scholar at the American Enterprise Institute in Washington, calls algae-based fuel “the most promising liquid replacement fuel on the horizon.”

Government and industry have already invested hundreds of millions of dollars in algae-fuel research and technology. In 2009, for example, ExxonMobil (XOM) poured $600 million into a research partnership with Synthetic Genomics of La Jolla, Calif.; the investment could grow to the billions.

“The industry is still young,” says Stephen Mayfield, director of the San Diego Center for Algae Biotechnology at the University of California, San Diego, and one of the founders of Sapphire Energy, a pioneer in algae-based fuel. “But we have made so much progress in the last three years that I now see commercialization reachable in the next five years.”

Meanwhile, the choke chain will continue to tighten. Limited supplies and rising prices can push us in only two directions: toward price inflation or a slowdown, as companies and individuals curtail their spending as a result of higher prices.

So what can companies do to improve their competitive position today while longer-term solutions make their way through the pipeline?

1. Invest now. If you believe Brazil, China, India, South Africa, and Vietnam will continue to grow faster than other countries, requiring more resources in the process, try to lock in long-term supplies of needed commodities at today’s prices. With billions of new consumers and a burgeoning middle class, demand for infrastructure improvements, industrial equipment, and consumer goods will increase significantly as these countries prosper. This will fuel further increases in commodity prices. There are many ways to lock in supplies, from hedging on the commodities market to investing in asset production—by acquiring mines, for example. This is common in the aluminum, copper, gypsum, steel, and tin industries, where manufacturers often own and operate mines. Why shouldn’t a giant utility similarly own a coal mine? Why shouldn’t a major construction company own quarries? Whatever path you take, you are betting that market prices will continue to increase over time while your own costs will stabilize or increase less.

2. Find substitutes. Natural gas is plentiful, cheap, and less polluting. Many companies are converting oil- and coal-fired power plants to natural gas. Why wouldn’t they? Substitution needs to become a way of life. If the price of one metal increases relative to another, use the other. Substitute plastics for metal, fiber for plastics. Economists call this the “substitution effect.” This is not simply the musing of economic theorists. Businesses should consciously put this into practice.

3. Be nimble. Be quick. If the financial health of your company can be determined to some significant degree by prices on the commodity markets, monitor those prices carefully, constantly watching for opportunities to make a deal. Even in a runaway market, where prices seem to go nowhere but up, opportunities occasionally present themselves. Be prepared to take advantage when they do. Example: A commercial construction company wins a government contract and places a large order for cement, rebar, and rolled steel. Facing huge deficits, the government agency delays the project indefinitely. The construction company needs to find a buyer for the unneeded materials. For another company, a good deal is waiting.

4. Pass along higher costs wherever feasible. The airline and trucking industries pass along higher fuel costs to customers, so why shouldn’t you do the same? But do it honestly. Don’t hide the increases or disguise them, as many consumer companies have done, by reducing the size of the product. Steelmakers, according to news reports, are now including clauses in long-term sales contracts that allow them to increase the delivery price if raw material costs increase. Other companies should follow suit.

The commodities choke chain can be a killer—if you let it. You’re not helpless. Use strategies for minimizing the effects of the relentless upward cost spiral. And in some cases, turn them to your advantage. Be a victor, not a victim.

Harold L. Sirkin is a Chicago-based senior partner of The Boston Consulting Group (BCG), a professor at Northwestern University’s Kellogg School of Management, and co-author, most recently, of The U.S. Manufacturing Renaissance: How Shifting Global Economics Are Creating an American Comeback (Knowledge@Wharton, November 2012).

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