Is low-cost country sourcing set to become a victim of the rising costs of oil?

A new article from Purchasing.com reports on an Economics and Strategy Report from CIBC World Markets in Toronto, whose chief economist believes that the rapidly rising costs of transportation may be reversing globalization as businesses are forced to look closer to home for suppliers. Claiming that rising costs will once again make the world rounder, the article notes that the combination of global raw material costs and high energy costs in China have led to receding Chinese exports of such products as steel, furniture, footwear, metal goods and industrial materials. Interpreting the CIBC World Markets Report as a sign that transport costs are erasing China's labour savings edge, the Montreal Gazette cites from the report that it currently costs $8,000 to ship a standard 40-foot container from Shanghai to the North American east coast, up from just $3,000 in 2000, and at $200 per barrel of oil, the cost to ship the same container is likely to reach $15,000, making the cost of moving goods the largest barrier to global trade today.

While the greatest impact of rising oil prices is on poor, oil importing countries, record prices even have energy producers concerned. During talks between energy producers and consumers held in Rome in late April, OPEC oil ministers insisted the problem has nothing to do with short-term supply but is rather the result of a weak U.S. dollar. Yet in October last year China Dialogue analyzed the findings of a German energy study produced by the Energy Watch Group (EWG) which found that petroleum output peaked in 2006 and henceforth would drop annually. Expecting world oil production to fall by as much as half by 2030, the study envisioned apocalyptic consequences when extreme shortages of fossil fuels and rising demand lead to economic restructuring and social breakdown. In China, the rising price of oil is particularly daunting, as Donald Straszheim comments at Forbes.com, because while its strong economy has been a key driver inflating prices, China has a burgeoning appetite for oil with demand growing 65% faster than the U.S. and four times faster than India, complicated by China having to import over half of its oil while controlling retail prices with inflation in excess of 8%. 

Cargonews reported this week that, in response to the dizzying rise of bunker fuel prices, shipping lines have shredded almost all of last year's customer contracts, in contrast to previous years when contracts were usually extended for another year. As fuel prices are making it hard for lines to make a profit, oil price shock has replaced the traditional arm wrestling at the negotiating table over the rates for the peak season from July through October. Hence more emphasis is being placed on volume discounts, guaranteed sailing dates and shipments, and long-term pledges by shippers.

Dan Gilmore at Supply Chain Digest recently analyzed the cost impacts of rising oil prices on supply chain network design. Incorporating the analysis of MIT professor and supply chain thought leader Dr. David Simchi-Levi, who used data from a real consumer goods company, it was found that every $10 per barrel price increase of crude oil amounts to a 4-cent per mile increase in transportation costs in the U.S., yet when the price of crude oil surpasses $150, things really start to change:

At that point, rising transportation costs start to significantly impact both where products are made and what the distribution network looks like...Rising oil prices would have the effect of changing the way we think about outsourcing and offshoring, after 10 years of a mad rush to China and other Asian locations.

Yet if $150 is an ominous benchmark, Gilmore expects that we will blow past $200 in a heartbeat, so with some fitting hyperbole of the doom that awaits us, Gilmore likens the impact of rising fuel costs to an unwitting frog in a pot of water being slowly heated:

We're being boiled alive, but may not realize it until its too late. The US economy and our supply chains can be very resilient, but at some point in both, something has to give. 

In what could have been a regrettable case of unintended double meaning, or 双关 (shuang guan), Chinese officials last week delivered news of how suspicious, inflammable liquids in an aircraft toilet nearly facilitated a terrorist attack. I would not be so presumptuous to assume that the toilets on China Southern Airlines are unusually unpleasant places (see for instance Mutant Palm's expose of the airline, blocked on mainland), but in my experience toilets on public transport in China are generally places to enter with extreme caution (except perhaps on the all-new 300 k/m per hour bullet train between Tianjin and Beijing. As a resident of Tianjin, kudos to the Ministry of Railways for making my journey to Beijing soon only 30 minutes, short enough likely not to need to go).

The suspicious liquid on the China Southern Airlines flight from Urumqi to Beijing, however, turned out to be gasoline (a particularly suspicious liquid indeed), which, the story goes, someone had been carrying around with ulterior motives. Yet one would think China Southern Airlines were happy in the end to pocket two cans of gas, as the consumption tax on imported fuel was raised by more than four fold on March 5 as part of efforts to limit energy use.

This is not the first incident involving suspicious liquids (especially the flammable types). When a British Airways Boeing jet crash-landed in London in January this year, and it turned out it had departed from China, quality fade expert Paul Midler smelled a rat. With suspicions of contaminated fuel and the possible presence of water in the tanks raised by the crash investigators, Midler thought somebody on the ground could easily have replaced 1% fuel with water, which could be a tidy saving of $2,000. So that's quality fade applied to gasoline: a very suspicious liquid.

With its commercial aviation market booming, China doesn't need a lot of water-tinged gasoline. The country's leading manufacturer of helicopters declared early this year it will be focusing more on developing civilian aircraft to cash in on growing demand, and China is also developing its first passenger jet, the ARJ-21, produced by the country's biggest plane maker, the China Aviation Industry Corporation I. Attempting to break into a very competitive aviation market (forecast to need as many as 3,400 new planes globally in the next 20 years) the 70-90-seater aircraft was showcased in December and delivery to the first customer is expected later in 2009. (The plane's chief designer, Wu Guanghui, sounded a hopeful note in the People's Daily last week, saying a total of 171 ARJ-21 jets had received internal orders, and talks were underway with foreign customers).

Its uncertain, however, whether ARJ-21 is going to keep pace with Great Wall Motor Company, the largest producer of pick-up trucks in China. Great Wall is clearly extending its boundaries and told People's Daily on Wednesday it expects to sell 55.7% more pick-up trucks abroad this year, especially in North America and Europe, exporting a total of about 80,000 units. In December it was reported that China's motorcycle exports reached 7.27 million in the first eleven months of 2007, up 22% over the same period in 2006.

Some of these have really rocked the world of a few villagers in Laos, where (the New York Times reported in December) fruit farmers in the steep hills above the Mekong Delta have been able to purchase cheap Chinese models to transport their produce to the market at the local city of Luang Prabang. And where before improvised bamboo stretchers were the quickest way to get to hospital, the Chinese motorcycle has literally meant the difference between life and death for some. Until, that is, your Chinese bike starts developing maintenance problems, which (as the article put it) was a commonly heard complaint affecting the enthusiasm for Chinese goods. People with money, one local mechanic explained, buy Japanese motorcycles, but at least the influx of Chinese motorcycles (which usually need an overhaul within three to four years) has been good for mechanic shops in Luang Prabang, increasing from only a few a decade ago to more than 20 today.

The motorcycle mechanics in Bangladesh, where Chinese motorcycles are set to enter the market from this month, must be looking forward to the prospect.          

From a China Daily report on Thursday, China's auto production and sales are both likely to hit a record 10 million units in 2008. In 2006 China surpassed Japan to become the world's second largest car market, trailing only the U.S., and is currently the world's third largest vehicle producer after Japan and the United States. Set to play an integral role in China's burgeoning consumer spending, vehicle sales jumped to 7.95 million units in the first 11 months of 2007, a 23.3% year-on-year increase. (Even in the Tibet Autonomous region, where according to a Xinhua report 1 in 20 people now own an automobile, due to soaring car ownership vehicle tax has been introduced for the first time.) Reflecting China's expanding industrial prowess in the automotive sector, these developments are part of China's high-tech industry growth which, according to Wu Zhongze, vice-minister of science and technology, has averaged 27% each year for the last five years. While allowing domestic products to substitute imports, innovative homegrown technologies have given domestic car makers a 17% share of China's total auto sales in 2007.

According to a Deloitte Special Report entitled Future Drivers of the China automotive industry, in 2005 the total value of automotive products and export volume of vehicles from China for the first time surpassed the corresponding imports into China. International demand for Chinese vehicles have been steadily increasing, especially for light weight trucks, and a few ambitious Chinese automotive companies are planning to export to mainstream markets in Europe and North America. Yet despite a savings potential of 10-40% or more on landed cost for simple components with high labour content, sourcing from low cost automotive suppliers in China is a risky undertaking complicated by immature suppliers lacking reliable information and compliance controls and who are often unable to meet the demands of international procurement.    

An IBM Business Consulting Services report on 'how the Chinese view their automotive future' found evidence of 'euphoria' about the development of China's automotive industry, yet also 'uncertainty' about the 'significant gaps and challenges for both domestic and foreign companies relating to a host of issues including poor quality, unknown/uncertain supply, lack of a clear export strategy and intellectual property concerns limiting the introduction of new technology.

Our study results pinpoint a number of serious challenges...including defaults on auto loans, uncertain relationships with joint venture partners, higher demand for oil, higher pollution levels, and severe traffic problems in the cities. (Yet) Chinese manufacturers and suppliers realize the need for research and development capability and are taking steps to close the gap between themselves and their world-class competitors.

Ultimately, as the Deloitte report concluded, automotive sourcing from China 

is a strategy, not a tactic. Give it the commitment and attention it deserves and you will gain both short-term wins and long-term sustainable improvements.

All Roads Lead to China recently emphasized the importance of logistical frameworks in facilitating trade and investment in China, citing as citing as further proof a World Bank report of early November (based on a world survey of international freight forwarders and express carriers) stating that trade logistics (the capacity to connect to international markets to ship goods) is critical for developing countries to improve their competitiveness in 'an increasingly integrated world'. In China, the posting concluded,

the logistics industry that has been set up for the export market is in many ways the most efficient system in place... Domestically though, China is still in a mess in many ways... but is improving.  

DHL Worldwide Express Inc. announced plans last week to invest $175 million on a new North Asia cargo hub at Shanghai's Pudong International Airport, and the CEO of DHL for Asia-Pacific was quoted as saying 'China remains the most important player in the global logistics chain in North Asia.' News reports last week (see China Daily's) also had China joining the 'world elite' in shipping, with the number of container units handled by mainland ports this year hitting the 100 million mark. Yet the China Daily article also quoted comments by Song Dexing, Director of the Chinese government's Water Transport Department, who claimed that China

is still a long way from meeting the growing demand of its rapidly expanding economy. The container industry must move away from traditional transportation and toward comprehensive logistics and service industries.

In fact, Logistics Management magazine identified China's underdeveloped transport infrastructure and immature logistics industry as a crucial challenge to the government's pursuit of a 'harmonious society.' Fragmented distribution systems, limited use of technology in the distribution and logistics sector, dearth of logistics talent, regulatory restrictions and local protectionism are all factors inhibiting the efficient distribution of domestic and imported products. Despite China's reputation as a low-cost country for business, selling in China remains expensive. Logistical costs are 40-50% higher in China than in the U.S., and by 2010 China will need an estimated 400,000 logistics professionals, while local universities struggle to produce even 10,000 logistics graduates a year. The logistics industry has at least begun to consolidate, which is gradually stiffening competition and lifting service standards. There are still over 18,000 registered logistics providers in China, however, and no single company commands more than 2% of the market. 

In the latest of the sustained upgrading of China's transport infrastructure, the People's Daily on Saturday reported the commencement of construction of two new railway lines to link Fujian on the southeastern coast with inland areas. One of the lines is to start in Xiamen, a port city facing Taiwain, and will continue for over 500km along the coast to Shenzhen. Upon completion in 2011, travel time between the two cities will require less than three hours (compared to the current eleven hours). The second project will be a 600km railway linking Nanchang in Jiangxi with Fujian province.

With plans 'on track' to drastically reduce travel times, the China Sourcing Report today reported that over 80 million digital still cameras will be produced in China and Taiwan this year, up 27% year-on-year. Greater China accounted for more than 73% of global shipments of this product in 2006, and is forecasted to take an even greater share in 2007. Chinese manufacturers are aware of the highly competitive nature of the global digital still camera market, and hence are increasingly targeting mid- to higher-end markets with advanced products and competitive pricing, ultimately leaving a more robust manufacturing base. In addition, more than 65% of Greater China's manufacturers are preparing for an increase in output in the next 12 months by expanding production capacity.

And with Chinese Vice-Premier Wu Yi assuring American companies in a keynote address in Beijing on Friday that China's door will remain open 'forever' and the country receptive to foreign investment, current trends are not likely to change direction soon. More than 70% of all U.S. firms investing in China made a profit in 2006, Wu said, and she assured her audience that China's position to value foreign capital will not be changed.

All just more sings that the future of sourcing in and from China will likely be faster, better and more....