Date: Tuesday, October 18, 2022
Source: American Shipper
There’s an old Chinese curse that goes: “May you live in interesting times.” These are interesting times indeed for the global supply chains. The pandemic effect may be winding down, but importers and supply chain planners looking to 2023 are cursed with enormous uncertainties and threats, as well as costs rising on multiple fronts.
U.S. importers remain heavily reliant on Chinese producers and the relationship between the two nations continues to deteriorate. Globalization is in retreat. The super-lean “just-in-time” inventory model may never recover. The outlook for future fuel costs is ominous.
For perspective on these issues, American Shipper interviewed Paul Bingham, director of transportation consulting in the economics and country risk division of S&P Global.
This question-and-answer interview was edited for clarity and length.
Geopolitical threat to Chinese supply chains
AMERICAN SHIPPER: U.S. importers have been talking about diversifying supply chains away from China for years. Yet during the pandemic, U.S. importers became even more reliant on Chinese manufacturers. This year, we’ve seen Chinese military exercises around Taiwan, as well as China’s continued allegiance with Russia. Given our country’s clearly escalating geopolitical tensions with China, how can U.S. importers remain so exposed?
BINGHAM: “It’s easy to say, ‘Gee, it would be a smart idea to have diversified supply and not just depend on China.’ But it’s enormously difficult after you’ve had two decades of development of very complex tiered supply chains — in some cases all within China — to replicate that entire tiered supply chain elsewhere.
“We became more dependent on China during the pandemic because it had functioning supply chains that could pivot to serve demand growth more quickly than any other sourcing location in the world.
“At the same time, even if companies became more dependent on China during the pandemic, they’re still saying they need to find alternative sources outside of China. It’s very difficult in some cases. But companies with a lot of resources and experience are trying to do it. It’s not just Apple trying to move iPhone production to India. That’s just one of many, many, many examples of companies being very serious about spending significant capital to reduce their sourcing in China.
“This started before 2022. And this year obviously added urgency and attention to this strategy — that at a minimum, companies need to diversify supply chains even if they’re not going to abandon China altogether. What happened this year has amplified and emphasized that you’d be foolish to depend on a steady supply at a low cost from China, given what might happen geopolitically.”
AMERICAN SHIPPER: However unlikely you think it is, there’s just no way you can use the term “black swan” anymore for a military conflict between China and the U.S. at some point in the next decade. And you can’t wait for something so cataclysmic to happen and diversify supply chains away from China afterward. How focused are U.S. companies on this risk? It’s hard to imagine the chaos such a conflict would cause.
BINGHAM: “Right. How do you take the proportion of global trade that moves through the South China Sea today and say, ‘OK, we’re just going to stop that because there’s a live war going on?’
“I think there has been a profound change in perspective on this. Nobody was thinking about this even at the beginning of the pandemic. Today, it no longer seems like something that could never happen.
“I think there are a lot of executives right now saying, ‘If I want to hold on to my job in the supply chain industry, I’d better act on this. Because if something happens with China and I haven’t taken steps to mitigate that risk and my supply chain is completely broken and the company falls apart financially, I’m going to lose my job.’
“I don’t think this is just a casual concern that’s medium to long term and maybe you’ll turn to it strategically if it’s convenient and you don’t have something better to do. I think it’s much more urgent. [Executives] can’t pretend this is something they don’t need to take into account. They need to spend time and effort and capital. This is going to cost money. [By diversifying supply chains] you’re buying insurance, which is really what it boils down to, so that your business can survive if there is ever an enormous disruption in the relationship with China.”
Global trade could increasingly splinter
AMERICAN SHIPPER: There’s not just the hot war risk. There’s the cold war risk. There’s been a lot of talk about a bifurcation of world trade. Particularly as the U.S. weaponizes the dollar via sanctions. You already see Russian trade separating from the West. You already see the tanker sector dividing into two. There’s now a so-called “shadow” fleet of older tankers with opaque ownership that don’t trade in dollars and don’t use Western insurance. The shadow fleet carries crude from Iran, Venezuela and now Russia, mostly transshipped to China. New EU and G7 targeting Russian oil come into force in December. If relations between countries continue to sour and trade increasingly bifurcates, what does that mean for costs? What does that mean for globalization?
BINGHAM: “Economists would quite rightfully argue in terms of comparative advantage and the fundamentals of free trade that we’re not going to optimize the growth of the global economy if we Balkanize and segment ourselves into regional trading blocs. We’d suffer the consequences of not exploiting economies of scale and economies of scope as you can with specialization. We’d roll back the benefits of globalization under the WTO that we’ve had in the 2000s. If we lose some of the gains from trade for geopolitical reasons because we can’t get along as countries and we use sanctions as a proxy for a hot shooting war, we’d have lower potential growth, lower productivity and the cost of living would probably be higher.
“I think we may now be entering a new era. There are so many signals that say there’s not a path back quickly to where we were a decade ago in terms of the pace of trade-related change. And it’s not just because of Vladimir Putin. Think about the national economic perspectives of some of the politicians that are more populist, like President Trump. There were already cracks in the system before we got to what happened in 2022.
“Clearly, we’ve moved dramatically away from a perspective of growing free trade and openness to trade that raises all boats. Even compared to just a few years ago. The path back to that is a long and difficult one and doesn’t look like it will happen anytime soon. In fact, there are a lot of risks that we’ll have further disruptions to trade that make it even more regionalized and less efficient.”
Disruption risks equate to higher inventory costs
AMERICAN SHIPPER: It’s not just geopolitical risks that add to costs. We’re coming out of the pandemic era, when supply chains were thrown into total chaos. The whole concept of “just-in-time” supply chains got thrown out the window. We now have “just in case,” which entails higher inventory costs. Do you ever see us going back to the ultra-lean, just-in-time model? Or are we stuck with higher inventory costs?
BINGHAM: “I still think there’s a pendulum that has moved along a continuum from ‘extreme super-lean just in time’ to ‘just in case and I’d better pad my inventory.’ Because of all the problems during the pandemic with the supply chain, people were advancing orders and placing full orders to minimize the risks of disruption and taking the risk that they’d have to discount to clear those goods if demand didn’t materialize. I believe the pendulum is now moving away from the extreme we hit in 2021. It’s headed back in the direction of ‘just in time.’ But it’s still far from the ultra-lean management in the past. Back then, we took transportation services for granted, and nobody can do that now. There’s still way, way too much systematic disruption.
“I do think that, going forward, there will be consultants who will sell lean-inventory management approaches again. And with some justification. Because we have better technology and information exchange, allowing us to have better visibility and to manage operations and inventories better than we did 10 years ago.
“Yet you’re still going to have disruptions you can’t predict. If there’s one lesson that comes out of the pandemic, it’s that you can set yourself up for big-time failure if you don’t account for low-probability, high-impact risks. You can’t get caught like that again.
“You don’t want to end up like some of the supply chain managers who are now out of a job. That’s what happened during the pandemic. They were fired because the consequences of the [supply chain] failures were so severe for their employers. You had this tremendous upheaval because some of them didn’t plan for risks adequately and didn’t mitigate the consequences. I think the lesson learned by the whole profession of supply chain management is that this vision of having near-zero inventory cost is a fantasy.
“So, I don’t think we’re getting all the way back to that ultra-lean point. But that doesn’t mean you have 18 months of buffer stock. You have to manage your inventories appropriately but not in excess, especially when the financial pressures are going to make it harder and harder to justify doing that.”
Supply chains face higher fuel costs
AMERICAN SHIPPER: There’s another big cost factor as well: fuel. There is underinvestment in new production. There is extreme underinvestment in tanker capacity, which will probably be very profitable for tanker owners in the coming years and very painful for shippers. There’s a shift to more environmentally friendly fuels that are much more expensive. There are geopolitical risks to producers. Look at what’s going on in Russia. It’s hard to imagine how the price of fuel will go down over the long term. What does that mean for importers?
BINGHAM: “This is an incredibly important point. The energy transition continues, but it’s a decades-long process, and you’ve got some unrealistic expectations on the part of policymakers. There are so many bottleneck points that make you think this vision that’s been painted is not going to be as seamless and easy to get through as many have posited. There’s an unreality that exists on the policy side that if you put financial incentives in place, the market will magically solve the problem with magical technologies that don’t exist yet.
“An economist would say this all translates into higher energy costs. It’s going to cost you more, whether you’re paying to move to an alternative fuel or sticking with conventional sources. So, it looks like you’d better learn to live with higher energy costs. You’re not going to get back to some of the periods of very low energy costs we experienced in the past.”
“[For importers] it’s not just about paying for the goods themselves. It’s also the energy that’s embedded in the transportation services. You’re facing higher fuel surcharges. Energy is also part of the production equation in the utility bill of the facility operations. If you’ve got a high component of plastics in what you’re producing, you’ve also got higher costs from the underlying plastic element from petrochemicals. Energy is more pervasive than many people understand. It all boils down to planning for a higher energy cost component in your supply chains.”
Inflation and uncertainty ahead
AMERICAN SHIPPER: Putting it all together, we’ve got higher costs from the need to diversify supply chains and insure against geopolitical risks. That China risk reminds me of the very low-probability, high-impact risk you talked about in the lesson learned from the pandemic. We’ve also got potentially less efficient supply chains due to Balkanization of world trade. Then there’s the need to hold more inventory and thus pay more inventory costs to protect against disruptions. And then there’s the higher fuel cost component. This all sound like sources of systemic inflation. How do decision-makers at U.S. import companies deal with this?
BINGHAM: “I think there’s a gap in executive management experience because for most of their careers they have never dealt with even the [high] single-digit rates of inflation we have today. The generation of managers that dealt with double-digit inflation in the 1970s and 1980s are almost all retired by now.
“This is a management challenge. You’re not going to solve inflation. You have to manage it. And there’s a different management philosophy when prices aren’t constant and you have an escalating price issue. There is a requirement for managers to deal with inflation as an ongoing factor. You need accelerator clauses in your supply contracts and you need to manage your fuel surcharges. You have to look at whether your own customers will be able to pay for the inflating prices. And you have to look at the timing of the increases and the duration of the increases [in relation to] how long your contracts are.
“This is compounded for global traders by exchange-rate factors, which can amplify or dampen inflation. It becomes incumbent on managers to understand all of this because it can have as much of an effect on your profitability as managing your inventory well or achieving certain sales targets.”
AMERICAN SHIPPER: An even bigger management challenge may be the incredible degree of uncertainty regarding all of these factors. No one knows what’s going to happen next with geopolitics, globalization, energy or inflation. When it comes to the supply chain, we’re down from peak congestion, but a new West Coast port labor contract has yet to be negotiated and the rail labor contract still needs approval. Obviously, the last two years had all the unknowns related to COVID, but for managers looking to 2023, the level of uncertainty seems historically high.
BINGHAM: “I would argue that most managers are now living in the greatest period of uncertainty in their entire careers. There’s nothing that they can do to reduce that uncertainty. They have a harder job. That’s just what it boils down to. This is the reality they’re faced with. They’re going to have to step up and do whatever they can to manage the risk. They can’t just jump to another company that’s going to have a smoothly performing supply chain with no risk. There’s no escape.”