Raw (Materials) Deal
(Akron/Tire Review) The volatility of the world’s political climate, the unpredictable weather in North America and El NiÑo in the Pacific Ocean are having very expected outcomes in terms of the cost of raw materials for the tyre industry.
Oh yes, and then there’s China. The economy of the world’s most-populous country continues to grow faster than kudzu in the South. By any western measurement, China growth curve and ravenous industrial appetite throws another concern into the long-term raw materials picture: seemingly endless increases in demand.
And, through all of this, the mission for tyre manufacturers remains as it has for many years: long-term flexibility and the ability to trim rising production costs.
But, today, the tides of the raw-material-cost ocean appear to be ebbing. Providing that world politics don’t worsen or there are several devastating weather events, tyre manufacturers believe that, despite current volatility in rubber prices, raw material costs will remain relatively stable in the short term.
For the long term, though, they see raw material costs continuing to rise.
Fueling that belief, in part, is the commodity that has been the historical gauge of tyre raw material pricing fluctuations – oil.
Nearly 200 raw materials are used in making tyres. The main components are, of course, rubber (natural and synthetic), metal and textile reinforcements and a variety of chemical additives and fillers.
Even then, oil or petroleum-based components comprise a majority of a tyre’s makeup.
According to the Rubber Manufacturers Association, it takes approximately seven gallons of oil to make the average passenger car tyre. Five gallons are used as feedstock (from which synthetic rubber and other compounds are derived), while two gallons supply the energy necessary for the manufacturing process.
“We are at the mercy of crude oil prices,” bluntly states Steve Carpino, vice president of research and development for Pirelli Tire North America. “The price of petroleum is a good indicator of our costs. Many of the materials we use, whether synthetic polymers or carbon black, etc., are tied to crude oil prices. While they may not be linked penny for penny, they are still closely tied to it.”
Gary Miller, Goodyear’s vice president and chief procurement officer, says, “While synthetic rubber prices are not directly or immediately impacted by oil prices, there is a relationship, since synthetic rubber’s feedstock is derived from oil. That price relationship will appear, in time, as a lower oil price will, in the longer term, mean a lower synthetic rubber price.
“If natural rubber prices do not stay in tandem with lower oil price movement, tyremakers could switch to using more synthetic rubber to be competitive in the marketplace,” he adds.
At the same time, he says, “the sharp fluctuation in natural rubber prices due to speculative market influences could, in time, drive tyre and rubber product manufacturers to seek more stably priced raw material alternatives.”
The reaction is similar from Bridgestone/Firestone.
“It’s basically a supply-demand relationship,” says Ken Weaver, vice president of finance at Bridgestone/Firestone North American Tire (BFNAT). “Tyre materials are not unlike any of the commodities we consume at home. They are not unlike orange juice, corn, etc. The pricing is not fixed but is influenced by supply and demand. Our raw materials are commodities, too.”
Why should tyre manufacturers and dealers be concerned about raw materials? Because most experts estimate that raw materials account for more than one-third of their cost of goods sold, but their pricing changes impact around 80 per cent of wholesale and retail market prices.
The ebb and flow of oil prices was very evident in recent months. Warmer-than-expected temperatures in the U.S. this past December caused a short-term decrease in the price of a barrel of crude oil. Prices had fallen as low as $49.90 a barrel in January after an unseasonably warm start to winter.
That came on the heels of a drop of about 35 per cent since July 2006, when prices rose to a record of more than $77 a barrel.
But, in early February, crude oil prices increased on expectations of colder weather in major U.S. markets. That indeed did come to pass.
For now, it appears that oil prices will stay up. In mid-February, the level of West Texas Intermediate (WTI) was approaching $60 a barrel. And, major oil-producing nations have reduced production in a move to bolster oil prices.
Linda Rennels, vice president of purchasing for Cooper Tire & Rubber Co., says, “Crude oil prices have tripled in the past five years and, while they have come off their peak in the third quarter 2006, oil remains very volatile.”
According to a Bloomberg estimate for OPEC production released in mid-February, the production cuts will continue. Saudi Arabia, by far OPEC’s largest producer, released its monthly pricing for March delivery crude and prices were revised upward for all customers.
The Wall Street Journal reported that Saudi Arabia has advised of an impending 158,000-barrel-a-day output cut. The reduction is part of a December agreement by OPEC to cut output by 500,000 barrels a day on top of an earlier production cut of 1.2 million barrels a day.
Supporting the statement that oil prices will rise in the long term, the Energy Intelligence Agency (EIA) predicts that world oil demand will increase an average of 2 per cent per year between now and 2011.
If crude oil prices influence the price of synthetic rubber, what impacts the price of natural rubber – a commodity that was previously used to balance against past oil cost escalation? Ironically, the reasons are similar.
“Natural rubber prices have been on the upward trend for the past few years,” says Cooper’s Rennels. “Speculation, supply-demand and growth in China have all contributed to the rise in natural rubber prices.”
“Natural rubber [prices] peaked last summer and came down early in the third and fourth quarters,” says BFNAT’s Weaver. “Then, it increased 10 per cent in one month; I don’t think it’s the demand that has increased.”
In early February, natural rubber prices (the benchmark Ribbed Smoke Sheet 3 grade) rose to a five-month high of $2,800 per ton on the Shanghai Futures Exchange on concerns that a seasonal production decline might curb supply at a time of rising demand in China.
“We’re not able to predict what the price will be these days,” Weaver added. “It’s just like selling a car. You try to get the best price, but often have to settle for whatever price the market will accept.”
By several measures, there doesn’t appear to be an end in sight for escalating prices for synthetic or natural rubber. The International Rubber Study Group (IRSG), a recognised leader in monitoring the market and establishing statistical benchmarks for the rubber industry, says in its January/February 2007 Executive Summary:
“It is quite possible that the world economy is facing a cyclical slowdown in 2007. However, rubber has different cycles compared to the economy. After a relatively slow growth rate for two consecutive years, total world rubber consumption is forecast to pick up speed, increasing an average of 4.7 per cent during 2007 to 2009. Global synthetic rubber marketshare is predicted to decline to 57.2 per cent by 2009. Recent rising natural rubber stocks have had a negative influence on prices, and a slowdown in the growth of NR production during the forecasting period still shows an annual growth rate of 3.9 per cent.
“Growth rate of SR production is forecast to slow down, leaving the annual growth rate for the three-year period at 4.1 per cent. The excess supply in the NR sector is forecast to increase slightly before relatively stronger demand brings a global balance and reaches a deficit in 2009. For SR, a relatively similar growth rate of demand and supply means a small excess supply may be maintained for the next few years.”
Much as OPEC has a lot of say in global oil pricing, cartels in latex-producing countries – primarily in Southeast Asia – impact natural rubber production and subsequent pricing. In the past, when market demand remained relatively stable from one year to the next, a simple production cutback would push NR prices upward, making producers very happy.
The Beast in the East
In recent years, though, even the powerful cartels have been at the mercy of one undeniable force: China.
It is estimated that approximately 75 per cent of the world’s natural rubber is used in tyre manufacturing, and the Chinese tyre industry currently accounts for about 22 per cent of that consumption.
According to data from the Chinese General Administration of Customs, China imported 2.14 million tons of natural rubber in 2006, up from 1.68 million tons in 2005, while synthetic rubber imports rose more than 19 per cent to 1.3 million tons during the same period.
While China’s growth as a major tyre player has certainly impacted NR pricing, high global NR pricing may not be a direct result of China’s consumption. Goodyear’s Miller says, “Certainly demand for raw materials such as natural rubber has been high due to growth in China, but so, too, has been supply. Our data indicates that there is not a shortage of natural rubber.”
Indeed, one indicator supporting Miller’s statement is a report from the Jingyi Futures Co., one of China’s largest futures brokerage firms. Jingyi reports: “World rubber production will begin to surge later this year. After rubber prices first rose in 2001, Thailand increased its plantation area by about 16,500 acres a year, while Indonesia, another top producer, boosted output by about 10 per cent a year for the last two years.”
It is also known that China has been developing its own rubber plantations, which will reach maturity in the next five years. What is not known is if that additional supply will be enough to meet China’s burgeoning demand.
In 2006, China produced 283 million tyres, second only to the U.S., which turned out 306 million units last year. Though China’s domestic consumption of tyres remains far below that of western nations, it is still growing at a record pace. China produced 7.2 million vehicles last year, passing Japan to become the world’s second-largest vehicle producer.
Exports account for 10 per cent of China’s GDP, a high percentage for any country. And, its trade gap (for all goods) with the U.S. alone was $232.5 billion last year, fully 33 per cent of the U.S.’s total trade deficit.
Reports in the China Daily indicate that China’s trade surplus may surge to a record new high this year, despite government efforts to curb exports and encourage imports. If that projection comes true, China would overtake Saudi Arabia and Russia to have the world’s second-largest trade surplus after Germany.
One rarely mentioned tyre raw material is steel. Technically “wire,” approximately 14 per cent of the weight of an average passenger car tyre is metal reinforcing, primarily steel wire. Over the last decade, steel prices, driven by China’s construction boom, steadily grew. But things may be shifting for the better.
Jason Schenker, an economist for Wachovia Securities who follows the steel industry, says, “For most of 2006, steel prices struggled to resist downward pressures. Foreign imports continue to sell at a discount to domestic steel, and lower coal prices could also allow the domestic price of steel to fall.
“Although we are forecasting an economic soft landing, we have lowered our 2007 steel forecast from $475 to $450 per ton. Our 2008 forecast is for $425 a ton. Of the metals we forecast, steel has the greatest downside price risks because of the amount of spare capacity and availability of iron ore.”
Cooper’s Rennels adds, “While steel is trending down and stabilising, it is still above levels of five years ago.”
So what’s a tyre company to do? While it might appear that tyremakers are trying to put their arms around a puffy cloud, they believe there are a number of ways to combat the volatility of the raw materials market.
Tyre manufacturers indicate that they would like to increase interchangeability of synthetic or natural rubber to take advantage of the supply-demand curve and pricing variances. That option, they say, gives them greater flexibility in the event of supply interruptions and will cut costs if the price difference between the two widens.
But that is hard to do. To meet OEM and replacement performance demands, today’s tyres must use a high percentage of natural rubber. NR provides traction and wear characteristics that are hard to replicate in a lab. Still, research advancements are improving the performance of SR.
Pirelli’s Carpino also believes that timely usage of raw materials can help the battle. “Certainly, you ask yourself if you can you adjust compound ‘recipes’ to use alternate materials. In the past, that has worked, but it’s difficult to calculate when prices have been increasing on both ends.”
With the tyre industry’s average ability to interchange natural and synthetic rubber at about 8 per cent more than the usual ratio, Goodyear’s Miller says it is taking a similar approach.
“We have increased our ability to substitute synthetic rubber for national rubber to take advantage of cost differences between the two raw materials,” Miller says. “New proprietary polymers and rubber compounds we have developed allow us to freely replace more than 15 per cent of our natural rubber usage without impacting tyre performance.”
Miller adds that the ability to switch between the two rubbers doesn’t eliminate the company’s raw material cost concerns, but it does provide flexibility in the event of price fluctuations or supply disruptions. In some cases, Goodyear believes, that capability can be a decided competitive advantage.
Carpino adds that, while changing materials is an alternative to fighting rising raw material costs, in some instances “you are talking about redeveloping the tyre. That might be okay for the replacement market, but you don’t have that kind of flexibility with your OE customers.
“These [material switches] are long-term projects, too, with multiple sizes. In some limited cases, we’re doing it, primarily through transfer of production from one country to another. In those cases, it can be successful and work. When we look at production allocation, that’s one of the factors that can come into play.”
Another option is to calculate the right time to buy materials in advance of increases. However, industry analysts say any close correlation between the price of natural rubber and synthetic rubber will only be seen in the long term, and the current rally in rubber prices contradicts crude’s reversal, indicating synthetic rubber may not be much influenced by oil prices in the shorter term.
“We also investigate long-term buys by material to material, case by case. We like to use certain suppliers,” says Carpino. “Now, there are a new group of potential suppliers in China that weren’t available a few years ago. But, of course, you have to look at quality issues.”
BFNAT’s Weaver also admits that his company “will occasionally buy forward…maybe 60 to 90 days in advance, but we can’t do it that often. Forecasting isn’t a perfect science. Our number-one concern is safety and the quality of our products. We will not compromise our quality and safety.”
Cooper’s Rennels agrees with her counterparts, and adds, “We are managing these cost increases through specific cost-reduction initiatives and strategies. We substitute natural rubber with lower-priced synthetic rubber when it makes sense, and we have raised prices for our tyres to help offset rising costs.”
Rennels’ last statement reveals the most common tactic used in combating rising raw materials costs. Did someone say tyre price increase?
“We have increased tyre prices in all of our business units to help offset the increase in raw material costs,” says Goodyear’s Miller. “In the third quarter of 2006, our raw material costs were $249 million higher than in the prior-year period. We were successful in partially offsetting this with $225 million in improved price/mix.”
Weaver from BFNAT adds, “Primarily, we now just absorb some raw materials costs and ask the consumer to absorb a portion through price increases. We hate to, but if we have to, we will.”
There are other, more controllable options available to tyremakers, some that can be found within their own organisations. Michelin North America’s Chairman and CEO Jim Micali says his company is approaching the issue from a slightly different angle.
“I think a more intense discussion between the purchasing department, the user of the materials and the specifier of those materials – because, often, the user is not necessarily the specifier – needs to occur. You need to get those three corners of the triangle together in a room to find that sweet spot,” Micali told Tire Review in a December 2006 interview.
“We think there are a number of savings related to simplifying the specs so that there is no over-specing on something that doesn’t need to be over-speced. Or, perhaps, choosing just-as-good materials that might be a little bit easier on the production process than another. By doing just those kinds of things in a concerted fashion, maybe you can find 3 or 4 per cent. When you buy $9 billion worth of materials and services, that 3 to 4 per cent is some real money.”
End in Sight?
While those tactics help in the short term, what about the future of raw material costs?
“I think we can assume that anything tied to the price of petroleum is a long-term uptrend,” says Pirelli’s Carpino. “On the other hand, the rate of change in downtrends is a lot slower. We can try to mitigate that by developing closer relationships with our suppliers to put some stability in that pricing…like long term contracts…but do it carefully.”
The other variable, though, is political volatility, especially in the Middle East.
“World politics indeed impacts exchange rates and oil prices,” says Carpino.
But no tyre company can control political turmoil, just as none can control the weather or the economic growth of a major nation. They can only hope for the best.
BFNAT’s Weaver adds, “Our best projections show reasonable growth in commodity prices, but what we don’t know are which ones will be impacted by supply/demand spikes. We don’t see it going down soon, but we hope it will.
“It all depends on the strength of the world economy,” he continues. “China is a very important consideration, but it’s hard to measure the size of its impact when you throw that much additional demand out there.”