Raw material: A key to understand price alterations
With the onset of this new year, certain car brands are set to become expensive due to price hikes. Yamaha increased prices of its motorcycles R15 V5 and FZ-X models by Rs.2000. Also, the prices of the scooters Fascino has been hiked by Rs. 800 and Aerox 155 by Rs. 2000. The price hikes for Volvo cars will vary between Rs. 1 lakh and Rs. 3 lakh depending on the car model. Maruti has also informed prices hikes of its vehicles effective from Jan 2022. Even the prices of essential commodities are rising and there is little understanding of how exactly it’s happening. What one sees is the percentage or a figure of rise or fall? But does one have a bird’s eye view of various situations that parallely occurred and led to price alteration? May or may not. For those who don’t have, having a capability to understand and take a bird’s eye view can help to be prepared for future volatility as well as mitigate during a volatility scenario. What does it take to gain such capabilities?
To gain such capabilities, one needs to understand the raw material supply chain and the pricing dynamics of raw material because the price hikes mostly occur due to increase in input cost i.e. raw material cost. This blog provides a visual tool that can help anyone in easily developing a bird’s eye view of pricing dynamics of raw material. This blog is a beginner series for understanding pricing dynamics of any product that is present around us. Before starting with the pricing dynamics, let us first understand the definition of a raw material.
What is raw material?
Raw material is an input good or a resource that can be converted by manufacturing, processing, or combination into a new or finished product. Raw material is an input good used by a company to manufacture its products. Also, a finished product which is the final product of a company can be a raw material for another company. More understanding can be developed from the example of the mining supply chain given below.
In this supply chain, the input goods are primary metals or secondary metals. The primary metals are the metals that are extracted from the ores while secondary metals are obtained from waste or scrap. These metals are smelted and refined and then converted into various shapes like sheet, plate, bar and rod. These products are finished products of a mining supply chain. The finished products include steel, stainless steel, aluminium, etc. These products then become raw material or stock pieces for other industries. An example: steel and aluminium becomes a raw material for the automobile industry. Similarly edible oils, palm oils and coconut oils are raw materials for FMCG industries.
From the definition of the raw material, one can conclude that to understand the raw material price dynamics any supply chain can be picked up. For this blog, the dynamics of the mining supply chain was chosen for ease of understanding.
Raw Material Price Dynamics
The raw material price dynamics will be explained by creating a Causal Loop Diagram. Check the basics of causal loop diagram construction.
Look at the image above. Let us think that the world population is increasing as well as the global GDP is increasing. Thus the needs as well as the purchasing power of people has increased. Due to this new markets like EV, home automation, air taxi, etc have increased. This creates a demand for products and thus demand for raw materials.
Let’s think that a company with deep pockets is keeping a track of these developments and finds that the raw material demand is 100 units per month. Thus, the company decides to invest to create a mine and provide a raw material supply of 100 units per month. The raw material is priced at $5 per unit.
Now, both demand and supply is present. Both are in the same quantity i.e 100 units. If quantity at either demand or supply side changes, there will be a fluctuation in price. Look at the image below.
Generally, if the demand and supply is equal, there will be no change in price. What if there is a disruption in the supply chain? The demand and supply will be unequal and there will be either a shortage or a surplus in supply. As a consequence there will be price fluctuations and the fluctuation in turn will affect demand and supply. Let’s do some disruptions and check what happens to the supply chain.
Let’s imagine that the world population and the global GDP increased by some numbers. Thus demand will increase. Let’s take current demand to be 150 units per month. But the mining company was built to cater a demand of 100 units per month. Thus, there is a shortage of supply. Customers will meet their demands anyhow and at any cost. Hence, the sellers will increase the price. Thus, there is an alteration in price. Let’s say that the current price is $10.
The increase in price will in turn affect both the demand and supply sides. Let’s focus on the demand side first. Since, the prices are rising and there is no other option rather than buying, the customers will start finding out the alternative for the current raw material. The customers will have to perform some R&D and it will take some time till they find the substitute. Once they find the substitute, the demand for the current raw material will decrease. Thus, increase in price will lead to decrease in demand in future. Let’s say the demand is reduced to 125 units per month. See below figure.
Let’s come to the supply side. Since the sellers have earned profit in excess, they would like to increase their mining capacity to meet the demands. They would also like to do recycling to get back the raw material. Thus, the supply will increase. Let's say the supply is increased to 125 units per month.
Thus, both demand and supply sides are trying to reach a new equilibrium so as to tackle disruption. Once a new equilibrium is reached, the sellers will stop increasing their mining capacity.
Another perspective can be taken i.e the effects of mining. Let’s say that excessive mining is increasing environmental risk in the region. In response, the government decides to increase restrictions and later shut down the mining activity. Thus, there will be shortage of supply, prices will increase and again same activities will follow on the demand side. In the supply side, the seller will do a new mining project in another region and thus increase the supply to reach a new equilibrium. See the figure below.
From above two disruptions one can observe that a disruption in one part of the supply chain affects the entire supply chain. Many more disruptions can be done to see its effect on the supply chain. A more precise diagram of the raw material dynamics is shown below.
The above example was a theoretical way to understand how raw material prices are affected by disruptions. Below are three real examples of disruptions that led to increase in the prices of raw materials.
Example 1 : Russia Ukraine War
On 24th February 2022, Russia attacked Ukraine. The efforts to stop the war through dialogue and diplomacy failed. In response, the western countries, EU, and other countries imposed sanctions on Russia. EU sources nearly half of its gas from Russia. According to a BBC report, Putin might reduce the supplies of gas to Europe in response to the sanctions. This would lead to shortages in supply of gas and it will cost more to heat the homes.
According to a CNBC report, Germany derives most of its energy needs for manufacturing and electricity from the natural gas supplied by Russia. The sanctions will cause an increase in disruptions which will hold back manufacturing in Germany. Top exports from Germany include autos and auto parts, other transport equipment, electronics, metals and plastics. A curtail in production will affect manufacturing in other countries.
Example 2: Geopolitical impact on raw material prices
A geopolitical tension between Saudi Arabia and Yemen caused a surge in oil prices on 14th september, 2019. On this date, Saudi Arabia’s two oil fields Abqaiq oil field and Khurais oil field were attacked by drones and cruise missiles. The attacks forced the shutdown of the facilities which resulted in loss of 5.7 million barrels of oil per day. Due to these attacks, the prices of Brent crude oil soared by 20% and prices for West Texas Intermediate (WTI) soared by 15%.
Example 3: Logistics impact on raw material prices
In March 2021, Suez Canal was blocked for six days after grounding of a 400 m long vessel ‘Evergreen’. It took seven days to dislodge the ship. In the meantime, traffic around the canal multiplied several times. Over 400 got stuck by the time the authorities were able to resume traffic through the Suez Canal. According to the reports, some ships were carrying Robusta coffee. The coffee beans from Asia and East Africa come to Europe from Suez. Vietnam is the biggest producer of Robusta coffee in the globe. The delay due to Suez Canal blockage and shortage of shipping containers increased the price of Robusta coffee by 2.8%.
What does it require to develop an in-depth understanding of the pricing dynamics?
The blog has provided a visual tool to understand the pricing dynamics of raw material in an easy way by looking at one disruption at a time. But in reality, disruptions take place parallely and the pricing dynamics becomes complex to understand. This blog is a starting point and to develop better and in-depth understanding of the pricing dynamics, one needs to move beyond this blog. One needs to keep a watch on what’s happening in the market and also build a strong informal network to know the news in advance so as to figure out the possible effects of disruptions and make better decisions.