Core Category Detail

by Bob Zieger

Executive Observations
Soaring raw material costs continued to dominate the headlines in the second quarter of 2008, with crude oil attaining yet another sustained record high at over $130 per barrel. Overall, sourcing conditions for plastics, rubber, and raw materials have been as challenging as ever. Most chemicals continued their first quarter pricing momentum and even accelerated toward the end of the second quarter, which had an adverse impact on sourcing exercises. Savings rates in the second quarter for plastic and rubber components were down approximately four percent over the average savings rates identified in the first quarter of this year. Chemicals and core materials displayed similar reductions in savings. This is evidence that the entire supply chain has been significantly squeezed, and there is little room for cost absorption at any point.

Traditional sourcing project interest in these categories continued to be slower than usual, as buyers were pre-occupied with keeping plants running while fighting relentless increases. Ariba’s customers focused more on projects that sought to expand supply bases and enhance long-term options (supplier enrichments), along with various non-standard market analysis projects that provided a greater understanding of market drivers and commensurate best sourcing practices.

• Price movements last quarter were marked by double-digit percentage increases in many inorganic and organic chemicals, plastic resins, natural rubber, synthetic rubber, even specialty chemicals and core materials. Very few materials avoided cost increases over the last quarter, and this momentum is likely to carry forward into July and beyond for many commodities.
• Sluggish demand in North America (at less than two percent growth) kept injection molders and other plastics processors in a state of under-utilized capacity, which has maintained success in sourcing events for plastic and rubber parts despite the raw material chaos. Molded component markets continued to remain the most competitive, especially when utilizing a broad geographic base of market participants.
  
• Offshore low-cost country sourcing is still common in labor-intensive commodities and certain specialty chemicals, but LCCS cost advantages have significantly weakened for North American buyers due to “off-the-charts” logistics costs and a weak U.S. Dollar. Sourcing opportunities are increasingly shifting in favor of domestic and near-shoring suppliers when considering TCO (Total Cost of Ownership) models.

Second Quarter Trends
Plastics and rubber molded component events identified average savings levels at the low end of the historic range, as raw material apprehension was prevalent in suppliers’ business decisions. Supplier interest was still quite strong, particularly for those projects that were designed to be flexible with raw material-based price change allowances. However, sourcing events involving other processes that are more dependent on raw material costs, such as extruded and blow-molded parts, did not fare as well in terms of participation and savings in such hostile market conditions.

The injection molding industry in North America was somewhat steady in the second quarter, as slower domestic demand seemed to offset a reduction in Asian molded component imports due to the weak dollar, higher transportation costs, and stronger domestic demand within Asia. Western European molders continued to slowly lose ground to lower- cost Central and Eastern European (CEE) suppliers, but higher freight costs from CEE to Western European delivery locations tempered this trend a bit.

In the U.S., sustained high oil prices caused a further shift toward refining “lighter” petrochemical feedstocks, such as ethane and propane, instead of costly naphtha. As a result, fewer quantities of certain key by-products have been generated, most notably butadiene and propylene. The shortages caused butadiene prices to increase by almost 35 percent, and propylene to go up by about 30 percent, both in the second quarter alone. This had a significant ripple effect in rubber, plastic, and other downstream chemical markets.

The rubber markets were very active, as natural rubber prices spiked by about 20 percent for the quarter due to fears of a crop shortage in Thailand, the world’s leading exporter. This put additional pressure on synthetic rubber (specifically SBR) prices, which were already being plagued by higher butadiene feedstock costs. In addition, an explosion at a Goodyear plant in Texas tightened SBR supply. The result was a “perfect storm” for sourcing rubber and rubber-based commodities in the second quarter.

Commodity polyolefin resins (polypropylene and polyethylene) were each up about 10 percent in Europe and 20 percent in the U.S., as illustrated below. Polypropylene (PP), in particular, faces ongoing pressure from a worsening shortage of propylene monomer.

Other organic chemicals, particularly aromatics, also spiked last quarter. Benzene only rose about 10 percent, but downstream paraxylene, styrene, and toluene were still catching up from the previous quarter’s benzene spike. These intermediates saw increases in the 20 percent range for the quarter in both the U.S. and Europe.

Inorganic chemical markets were also hit hard by increases. Caustic soda suppliers declared force majeure in the U.S. (Dow) and Germany (Vinnolit), as global supply tightened considerably, forcing prices to new record highs in excess of $600 per ton. Spot prices increased between 30 and 50 percent during the quarter, a leading indication of further record contract hikes in the offing. Sulfuric acid also hit a new record high, exceeding $300 per ton in the U.S. as sulfur supply tightened and agricultural demand for fertilizer skyrocketed. These dynamics that drive high sulfuric prices are likely to continue for several more quarters, and this affects many downstream manufacturing industries, including metals and chemicals.

Third Quarter Outlook
The surging price of crude oil has been linked to the devaluation of the U.S. Dollar, and we discussed the effect of decreasing U.S. interest rates that have accelerated this dynamic in last quarter’s issue of Ariba SupplyWatch. Since the beginning of 2007, crude oil and dollar value declines have mirrored each other’s trend lines surprisingly well—that is, until the past few months (see the following chart). During the second quarter, the exchange rate with the Euro remained relatively stable as the Federal Reserve eased up on federal funds rate decreases. But crude oil has continued to surge in the absence of other significant fundamental market changes. So looking ahead, the price of oil could be due for a bit of a correction in the third quarter.

Many analysts at least foresee a light at the end of the tunnel by the end of 2008, but there is little evidence to suggest that things will turn around abruptly. As the third quarter begins, raw material and plastic buyers will have to contend with a relentless onslaught of surcharges and energy-related increase announcements that have pervaded the industry. July may be the pinnacle of frustration for buyers, who will have to work diligently to mitigate significant cost increases in a slew of resins and chemicals.

Higher propylene, ethylene, and paraxylene prices should continue to sharpen significant spikes in PP, PE, and polyethylene terephthalate (PET) prices in July. July could be a record monthly increase for PP, with as much as 18 cents per pound in announcements on the table. PE is faced with another seven cents per pound, and PET could see another nine cents per pound. These are just a few examples, as just about every type of plastic resin faces a buyer/supplier price increase discussion in the third quarter.

Futures prices for natural rubber in Asia seem to be calming down, but today’s historically high prices will be sustained in the near term. The SBR market is still faced with daunting increases and butadiene supply issues heading into the third quarter. Overall, rubber-based markets are not likely to improve significantly until the end of the year approaches.

Sulfuric acid and other inorganic chemical prices are expected to remain well above historical levels for quite some time, and this will serve to bolster the inflationary pressures that are already impacting consumers through higher oil, energy, and food prices.

We expect raw material sourcing activity to pick up once buyers catch their breath and look to recalibrate their market pricing, which may not occur until at least the fourth quarter. At some point over the next six months, crude oil and related commodities are likely to show signs of relief, since economic fundamentals do not seem to support sustaining the current premium. But for some materials, particularly those in the most dynamic markets (such as agriculture), the current bullish trend could be prolonged for several more quarters.

Industry Grapevine
In highly publicized fashion, many major chemical companies initiated abrupt and significant price hikes in the form of energy or raw material “surcharges”, some exceeding 20 percent. These across-the-board announcements by Dow, Rohm and Haas, Ciba, PolyOne, Huntsman, ISP, Lubrizol, and others should be evaluated carefully by buyers, since the intent is to incrementally raise prices over previous raw material cost recovery. Dow even announced another sweeping increase of 25 percent for July, which was in addition to a 20 percent increase announcement for June.

Ariba’s Take: While some portion of these increases may be justified, buyers are cautioned against opportunistic pricing behavior from their suppliers. Upon analysis, costs will not appear to align with increase announcements in most cases. It is critical for chemicals and plastics buyers to have options (alternative sources) that can be leveraged against these increases to mitigate organizational costs. While chemical companies will push the envelope of what they can capture, they do not want to lose good-volume business in these modest demand conditions. They will tend to capitulate, but only if a credible threat to their business exists.

Chemical safety was once again in the headlines last quarter, as new concerns were raised about bisphenol-A (BPA) used to make polycarbonate baby bottles. Some of the widespread media reports were somewhat misleading, exacerbating concerns and prompting major retailers like WalMart to pull polycarbonate baby bottles from shelves in Canada. While it can be readily argued that the science does not necessarily support the “big box” paranoia pertaining to BPA, phthalates, and PVC, perception of risk in any form becomes real risk to public reputation for large retailers. As a result, retailers will tend to implement decisions quickly and decisively to address any safety concern that gets media attention, regardless of scientific validity.

Ariba’s Take: These moves can have a significant impact on chemical supply networks, and can occur without much notice. This highlights the importance of category management practices that emphasize an understanding of raw material inputs to products that an organization purchases. Buyers of almost any chemical-based product should monitor these situations and proactively assess the potential impact on their own supply chain to mitigate risk.

Chemical pre-registration for the REACH program in Europe began on June 1, and the process has led to significant frustration among chemical manufacturers and traders, as the costs for compliance appear to be greater than most companies anticipated. With the announcement of higher fees and additional fees for confidentiality charged by the European Chemicals Agency (ECHA), European manufacturers are increasingly concerned about their ability to remain competitive. Consensus is mounting that the burdensome regulations may create a considerable cost disadvantage for European chemicals in the global marketplace. The deadline for initial registration is November 30. If a supplier has not pre-registered their chemical with the ECHA by December 1, they will be banned from manufacturing or importing that chemical until they undergo a more time-consuming registration process.

Ariba’s Take: Buyers in Europe will have fewer options as these regulations unfold. Suppliers that do not have an especially large stake in the European market or a particular product line may choose to avoid the hassle and cost of registering certain chemicals with the agency. Buyers should make certain they understand where their suppliers stand on REACH (particularly smaller producers and traders) in order to ensure continuity of supply and to understand any costs (direct or indirect) that can potentially be passed through to them.

Category Perspective:
Injection Molded Plastics - Automotive

by Bob Zieger

Industry Overview
The injection molding industry for automotive components is approximately a $40 billion market globally. Since 2004, flat to negative growth in North America has been offset by double-digit growth rates in parts of Asia, particularly China and India.

The supply base is fragmented, with thousands of injection molders spanning the globe. The Top 20 molders make up about 40 percent of the market in North America, and suppliers are less concentrated in other regions. Many of these molders (around 60 percent) support the automotive market. Suppliers certified to automotive quality standards range in size from less than $1 million to almost $1 billion in annual sales.

Most large, independent molders remain diverse in the industries that they support, which facilitates flexibility with their capacity and business growth objectives.

Supplier process capabilities vary widely according to press tonnage, secondary equipment, and ability to support specialty processes. Almost all molders support low tonnage, "shoot-and-ship" business, while higher tonnages and specialty secondary operations narrow the list of capable suppliers.

Market Trends
Injection molders' utilization rates remain favorable for buyers at under 70 percent. Supply bases in the U.S. and Western Europe are somewhat stagnant, while suppliers in Latin America, Central and Eastern Europe, and Asia have abundant emerging capacity.

The struggles of the automotive market in North America for the past several months have been well documented. Many molders are seeking to reduce their exposure to automotive business, as they have seen stalwart auto-molders such as Plastech and Blue Water Plastics file for bankruptcy.
Automakers have been forced to re-evaluate their supplier relationships with greater attention to financial stability. This has begun to create development opportunities for smaller, growing injection molders with diverse capabilities.

In today's inflationary environment, molders have been forced to increase press rates and pass along resin increases faster in order to maintain margins.

Category Assessment

Leverage: High business impact with a low supply risk (minimal obstacles to switching suppliers and a competitive supply base)

Successful Strategies: Standardization, LTA, cost reduction of overhead, part substitution, LCCS, and resourcing

Spend is usually quite significant for molded components, as plastic continues to displace metals and heavier materials in automotive designs. The automotive market represents the highest consumption of plastic molded parts by volume of any end-use market.

The vast, under-utilized supply base keeps supply risk relatively low, but switching costs for PPAP approvals can be significant, mitigating implementable savings. Supplier partnerships are increasingly important, but leveraging pricing proposals remains a critical tool to find and select the most cost-effective providers.

Cost Drivers
The primary cost drivers for injection molded components are raw material (resin), press rate, tooling, packaging, and shipping.

Most plastic resins have incurred significant increases in recent months due to the unprecedented spike in crude oil prices. As a result, raw material contribution to overall cost has increased to over 50 percent in many instances. This cost includes runner and scrap material that cannot be re-introduced as regrind back into the process.

Press rates, which represent direct labor, overhead, and manufacturing costs, vary according to machine press tonnage and required secondary operations. Common secondary operations include assembly, welding, painting, and printing.

Mold tooling is a significant cost, but is a capital expenditure usually not included in the direct part cost calculation. It can be amortized into the part cost, but is most often collected from suppliers and considered as a separately quoted item.

Packaging and shipping are typically applied as a percentage adder to the piece part costs.

Supply Management Best Practices
Ariba has identified the following best practices:

• Implementation needs to be a primary consideration, so parts are most often lotted (organized) by incumbent supplier, division or delivery location, or part size. Data completeness is critical.
  
• Involve a global supply base in sourcing events. LCCS from Asia is not a given solution for the lowest total cost of ownership (TCO) in today's market; near-shoring options should also be considered.
• LCCS suppliers should be required to quote on new tooling, since this is almost always more economical than transferring existing tools overseas.
  
• In RFP/RFQ language, it is important to declare how PPAP and startup costs will be shared, since these costs can be quite significant.
  
• Providing suppliers with source information for resins and non-plastic subcomponents allows for more accurate quotes.

Case Study
Current Situation: An automotive Tier 1 supplier was looking to expand its supply base for complex injection molded parts related to a particular sub-system product line. The goals were to identify savings opportunities, while reducing the company's supply risk imposed by its financially struggling U.S.-based incumbent suppliers.

Solution: Ariba was able to successfully align its global Centers of Excellence to identify qualified TS16949 automotive suppliers in Mexico, China, and India through a comprehensive Request for Information (RFI) phase. A Request for Proposal (RFP) quoting phase was then issued to the top 30 suppliers based on the RFI responses, using published drawings and part data.

Impact: The RFP "best and final" bid results yielded approximately 13 percent savings over historic costs of around $4 million, after considering TCO factors. Six suppliers representing all three regions provided pricing with greater than eight percent savings on this basis, providing the customer with multiple supply options to meet its objectives.

The customer wanted to implement an escalator-de-escalator clause with semi-annual reviews in the RFP for the first time in sourcing this category. The project resulted in 12 percent savings, which is above the average savings seen in this category over the past few years.

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