S6C7: Commodities & Manufacturing

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a) Mapping hydrocarbon production and refining

Time to start linking up some of the threads weaved at various times across the previous chapters of this Knowledge Series. In S6 Section 1.c we covered the principles and techniques of oil & gas exploration and production but did not learn much in terms of geographic bases for this. The largest global producer is the United States with most of its fields located offshore in the Permian basin and Eagle Ford formation in Texas, the Gulf of Mexico, the Bakken across North Dakota and Montana, and in Alaska. Among these, an increasing share comes from oil shales with production techniques involving horizontal drilling and hydraulic fracturing, also-known as fracking. I include a link to the Wikipedia entry for fracking in the last section if you wish to understand this technology better. Likewise, Canada who is 4^th on the list of oil producers, heavily relies on unconventional oil sands in the provinces of Alberta and neighbouring Saskatchewan. Russia is roughly tied for second place with Saudi Arabia and next come China and several of the Middle Eastern members of the OPEC cartel (Organization of the Petroleum Exporting Countries) such as Iraq, the UAE (mostly Abu Dhabi), Iran and Kuwait. The purpose of OPEC is to try to influence the price of crude oil by reducing or increasing a volumetric crude oil output quota shared among its members. It doesn’t always work that well though, as game theory would have predicted, because there is a strong incentive to cheat and produce more than the quota and, because it doesn’t exist in the vacuum: if prices rise beyond certain levels then other fields elsewhere in the world become economical and will be restarted or increase their production rate, thus taking market share away from the cartel members.

The crude oil makes its way in tankers (refer to S5 Section 4.b) to refineries, strategically located either close to production centres, key maritime routes, or harbours close to major consumption centres. We looked at oil refining in S6 Section 1.d and the various petroleum products it yields but did not mention any countries then, hence we will do so now. The largest installed capacity can be found in the USA and China, the two largest economies in the world, then comes Russia, a large producer of crude, followed by India, a large importer with a massive population and ongoing industrialization. The next three in the list consist of South Korea and Japan, two countries with large industrial bases, and the large exporter that is Saudi Arabia. When drawing the major flows on a world map, linking producers to refineries to consuming centres, then we realize some of this maritime routes are subject to several choke points, a topic covered in S5 Section 4.d. In relation with oil, the main flashpoints are the Straits of Hormuz, the Straits of Malacca, the Suez Canal and before that the nearby area between Yemen and Djibouti called Bab-el-Mandeb.

The exports of natural gas coming out of the Middle East, Qatar being by far the largest contributor, are exposed to the same geostrategic chokepoints. Not so for the LNG exported out of the USA or Australia. The other major gas exporters, and this is by pipeline rather than by ships, are Russia and Norway – we looked at pipeline technology in S5 Section 1.e and in S5 Section 1.f we devoted some time to the related geopolitical flows. Besides those aforementioned countries, the list of the largest producers of natural gas globally also includes Iran, China, Canada, and Saudi Arabia.

If you happen to live in a country with a high GDP per capital, you would be forgiven for thinking coal in on the decline. However, it is still the main fuel used in electricity generation, with coal-fired thermal power plants supplying around 35% of the total electricity generation worldwide. This is because in some countries like China and India its share is in excess of 60% and 70% respectively, and unsurprisingly, because the power plants are located close to cities, it explains why some of the worst urban air quality in the world can be found in those countries – you may want to check S5 Section 9.g on air quality index if this concept is unfamiliar to you.

Besides the aforementioned two countries that top the list, the other main coal-producing countries in the world are Indonesia, the USA, Russia, Australia and South Africa, in this order. If we remove the three countries with very large economies, then we are left with the four largest exporters: Indonesia, Russia, Australia and South Africa. The main trade flows of this commodity are directed towards North Asia, whether it is for electricity production or steelmaking.

b) Moving and smelting ore

The coal required in steel manufacturing is not the same as the thermal coal used in power plants, it is called coking coal and is bituminous with a low ash, sulphur and phosphorous content – these parameters were mentioned in S6 Section 1.a, the first section of this series. Steel is an alloy of iron and carbon, so coking coal is one of the key raw materials alongside iron ore. It is baked at high temperatures, in excess of 1,000°C without oxygen, to produce coke and then carbon monoxide (CO) by combustion in a blast furnace where it reduces iron oxide (Fe₂O₃) to yield iron (Fe) and carbon dioxide (CO₂). This energy intensity explains why the steel industry is estimated to account for about 10% of the total CO₂ emissions globally.

Steel falls under the heading of commodity but one doesn’t buy steel, one buys a certain type of steel; it can be rebar for construction, cold rolled coil (CRC) or hot rolled coil (HRC. Moreover, standard steel can be further alloyed with other materials to improve its mechanical properties and other characteristics. For example stainless steel includes nearly 20% of chromium and exhibits resistance to corrosion and oxidation.

Copper is arguably the second most important metal to be manufactured and traded. The largest producing countries are Chile, the DR Congo, Peru and China with about three times as much coming from Chilean mines compared to Chinese ones and the two largest mines in the world are located in the high Andean plateaux of Northern Chile. With a mine head-grade of below 1%, in fact the average is closer to 0.5-0.6%, it would be prohibitively expensive to transport ore over long distances so smelters would have to be located in proximity, which for logistics reasons, including the availability of electricity or lack thereof, would be somewhat challenging. Instead, the ore undergoes a beneficiation process involving reagents and flotation so that the concentration of copper can reach nearly 30%.

This concentrate is then shipped to smelters, and for nearly 50% of the volume, this means to China. Smelters first transform the concentrate into copper matte then blister, a process during which unwanted materials such as iron and sulphur get separated to form slag. The blister copper has a purity level approaching 98% by that stage and it is refined into an anode furnace via electrolysis in a solution containing copper sulphate (CuSO₄) and sulphuric acid (H₂SO₄). The final product that is marketed is thus copper cathode and the A-grade version reaches 99.99% purity.

The last of the big-three in the space of metal production and refining is aluminium. And it also uses electrolysis as part of the manufacturing process. We are talking in excess of 20MWh per ton here, this is the reason aluminium smelters tend to be located near hydropower facilities or, alternatively, near major ports with a local power generation facility. The raw material for aluminium is called bauxite (it was named thus because it was discovered near the village of Les Beaux in the early 19^th century) and the three largest producers globally are Guinea, Australia and China though Indonesia and Brazil also have large reserves.

This ore is first refined to produce aluminium oxide (Al₂O₃), also known as alumina and the favoured method is called the Bayer process for which I include a link to the relevant Wikipedia entry at the end of this chapter. The electrolytic process requires three electrons to produce each aluminium atom; it involves a carbon anode and the carbon gets oxidized by the oxygen present in the aluminium oxide to form a mixture of carbon monoxide and carbon dioxide, leaving individual aluminium atoms. At the time of this writing, nearly 60% of the world’s aluminium smelting capacity is located in China.

c) Supply Chain dynamics

More so than for agriculture which sees comparatively less energy-intensive transformation processes, the manufacturing supply chains from the mining of ores or extraction of hydrocarbons all the way to the production of finished goods has undergone systemic shifts since the 1970s.

With the rising level of prosperity in post-WW2 United States and Western Europe came an increase in productivity on the back of relentless automation but also a rise in the average salaries of workers in the secondary sector, dubbed the blue collars. This also coincided with a strengthening of shareholder capitalism whose sole objective was to maximize shareholders returns and therefore profitability, as opposed to the sharing of the added value among all stakeholders, including employees, the state and national governments via taxes and the surrounding communities thanks to increased employment levels, whether directly or indirectly.

This has pushed large conglomerates to evaluate their cost base and realize that, from a pure financial standpoint, closing factories in high-cost countries and moving production to factories in developing countries, in particular the Tiger Economies of Asia (South Korea, Hong Kong, Taiwan and Singapore) then China and the rest of Southeast Asia over the next decades, was a very obvious manner to significantly improve profitability. This led to the surge in the internationalisation of supply chains, first with factories owned by the designers and sellers of the end-products in OECD markets (Organisation for Economic Co-operation and Development comprising high-income countries) and then increasingly to contractors originating from those exporting countries. Thus, it became possible to switch from one contractor to the other, always seeking to lower costs as long as quality did not deteriorate too much, creating in the process a strong pressure in the salary level for the local workforce often working long hours in sub-par conditions.

As the saying goes, there is no free lunch. Hence, this system has precipitated the decline in the manufacturing base of the high-income countries and generated unemployment there, but it has also left companies exposed to both logistics and geopolitical risks. The threat of tariffs on imports and the restriction on selling sensitive technologies in particular countries perceived by other countries as military or economic competitors has recently risen to the level of consciousness among corporate executives. This has been compounded by the massive physical disruptions affecting international freight brought about by the Covid pandemic and the restrictions attached to its attempted smothering. Altogether, this has forced a rethink of the optimum supply chain strategies with three main options on the cards and the possibility to mix them according to the inherent risks of each industry:

The first option is to hedge bets and avoid concentrating the sourcing of semi-finished or finished products from only one or two countries. This remains outsourcing, just a diversified version.
The second option is a middle-ground one and is called near-shoring. It consists in outsourcing manufacturing to countries that may not have the cheapest cost but may provide either better quality or much less logistical risk, or both. This would be the case for Western European companies opening factories in Eastern Europe or American companies doing the same in Mexico for instance.
The third option is called reshoring, which means bringing back production onshore, at home. This is the option politicians are pushing for but short-term tax breaks may not be sufficient to tilt the financial balance sufficiently, in part because they may only last a few years whereas factories are expected to operate for more than two decades.

d) The auto industry case study

Even though the first automobile was invented in 1769, as we learned in S5 Section 2.a, its manufacturing at even a small scale did not start until the mid-1880s, courtesy of Mr Benz. Until then it was the prerogative of inventors and very much a garage industry, so to speak, and it would take better technology, performance and safety for the vehicle to become sought-after. Once the product reached an adequate technological and comfort level, the next challenge for adoption was affordability so the accelerating factor was the birth of the assembly line at the turn of the 20^th century, a process allowing for a specialization of workers and workstations, which enabled a crucial lowering of the marginal cost of production. However, this required selling into a mass market and therefore a lowering of the selling price despite the significant upfront investments required. Ford was the first to do so and mass production soon took off in the USA with the trio of General Motors, Ford and Chrysler becoming the largest manufacturers in the world. In the meanwhile, production in Europe was dominated by the likes of Volkswagen, Mercedes-Benz, Renault, Peugeot, Citroen, and Fiat.

The rise of the Asian manufacturers post-WW2 was not a matter of offshoring but rather of technological transfer to ensure countries like Japan remained on the capitalist side and their dedication to product quality and incremental enhancements rather than innovation saw them steadily climb the ladder, all the way to the top in the case of Toyota for several years. In the meanwhile, the shift that is of most interest to us here, offshoring, occurred starting from the 1980s and has never really stopped since then. It saw the American companies build new plants in Mexico and then close some in regions with high manufacturing costs, laying economic waste to the Great Lakes regions in particular since the Big Three were all headquartered in and around Detroit and there was a significant steel manufacturing base in this and the nearby Mid-Atlantic regions. In Europe, production was delocalized to Spain, Portugal and later on, after the fall of the iron curtain in 1989-90, to Eastern Europe with countries such as Slovakia attracting a lot of investments.

This trend eventually made its way to now prosperous Japan then South Korea but mostly in another form: building plants in or near to countries where they market their product. Shipping a car across the oceans is not cheap and there are significant tax incentives to attract automobile assembly plants plus there can be tariffs or other types of taxes on added value so that it is often more economical to internationalize production to sell into overseas markets. And so the likes of Toyota, Nissan, Honda or Hyundai slowly became an integral part of the automobile park in the USA, many emerging markets around the world and, eventually, Europe as well.

Now, this is only part of the offshoring story and the reality is that the hyper-specialization has led to a fragmentation of the number of part providers with contractors not only concentrating on a few pieces of equipment but often sub-contracting some of the lower-level parts. Not completely surprising when one realizes there are generally more than 10,000 parts in a car. This means that a well-known brand can do the last assembly job and yet not have manufactured many of the parts – typically the engine would be a special case given the intellectual property involved and the difference it makes to the overall performance and therefore to the brand perception. This dramatically facilitates offshoring without attracting too much backlash from the public opinion and, as a result, on a look-through basis, the dynamic has been much more extreme than appears at first glance.

A few things have been changing recently though, not so much the political pressure applied by politicians on companies to keep jobs within the country – this has always been there and comes and goes like the tides – rather it has to do with the re-evaluation of the logistic risks associated with stretched just-in time supply chains, the increasing share of electrical vehicles (EV) in the market and the development of autonomous vehicles, an aspect we covered in S5 Section 2.e titled “the autonomous paradigm shift”. We already covered the first aspect in the previous section but the reality is often one of scattered contractors and subcontractors so re-onshoring is not a silver-bullet and, instead, the easiest mitigation is to increase the storage of specific parts and to diversify the sourcing of parts.

Regarding EVs, this is a partial game-changer because of the overriding importance of electrical batteries in the performance of the vehicle, not just capacity but also charging time, weight and price, coupled with the concentration of the production of said batteries in one country: China, with a market share of over 60% for Li-ion batteries (refer to S6 Section 5.a for more info on this technology). When we overlay this with the centralized political system imposed in the country and the long-term strategic thinking it has exhibited in many instances in the past, it seems this technological and manufacturing EV supremacy could spread well beyond Chinese borders and, unlike the pure profit-driven companies headquartered in more democratic countries, it is not obvious they will be offshoring much of their production.

China’s government-directed ability to concentrate investment at scale in sectors deemed strategic is also now bearing fruits in the development of autonomous vehicles and is made possible by their leading or near-leading positions on computer vision and artificial intelligence – and this domain is much broader than the much-hyped large language models. Consequently, we can expect the compounding of all these factors to reshape the world map of auto manufacturing in the next 10 to 15 years.

e) Understanding capital and profitability

Since the term profitability has been mentioned a few times in this chapter, it is worth clarifying what is meant by it. The first interpretation could be described as the difference between the selling and the purchasing prices of an item being traded; this is a cash flows driven view: the money you receive less the money you spent acquiring a specific good. Transactions are seldom so straightforward, or at least the evaluation of their profitability, because in most cases they involve some kind of processing or there are costs associated with distribution such as the rental of a brick-and-mortar shop.

In the case of retailing for example, you may need to pay to set up a market stall or to lease a space by the month. Accordingly, when evaluating profitability, you should allocate part of this rental cost to every product you sell, or at the very least to every product you expect to sell when assessing the actual or potential profitability. Furthermore, you may have to do some works inside the shop, or buy a van to transport your stall and products to the market so this cost should also be allocated and the way to do this would be to spread it over the expected life of the investment, which depends on the nature and quality of the equipment involved.

Likewise in manufacturing or for the agriculture sector as well, the evaluation of the profitability of any sale transaction needs to incorporate a calculation not merely of the direct costs. Instead, the investment in a tractor or a full-blown automobile manufacturing plant with all the robots in there as well as all the labour costs, the energy consumption, etc., all these are part of the equation. The assets are recorded on the asset-side of the balance sheet and their prorated cost over their expected useful lifetime is allocated, the term is depreciation, into the income statement below the revenue and direct cost of goods sold lines. After this comes the administrative and financing costs, exceptional items (if any), and taxes with net income being the bottom line, literally. Apologies for accountants and financial controllers out there if this is somewhat oversimplified, I think this is a good enough approximation for our purpose here.

Large investments are made possible by one tool called capital, which is the accumulation of savings or profits over time. Capital can be invested, as a lump sum, to finance the upfront purchase of the materials and equipment required as part of the manufacturing and distribution processes of a business, whether it is a one-person affair or a large corporate. This lump sum aspect generally entails the use of money, a concept we will cover in the upcoming Chapter 8. As a rule of thumb, the more scale is involved in a business, the more capital is required, with the notable exception of digital platforms although these may require large upfront advertising budgets in lieu of fixed assets.

Putting all the above together, decision makers need to assess the return on investment after considering the size and timing of the capital investment required as well as the cost of goods sold, being those cost that vary almost linearly with the volume of sales. This would be computed as a percentage return per year, expected or actual, and comparing these numbers across different options is key in taking decisions such as whether to shut down a plant and open a new one in a location with a cheaper operating base.

This may sound standard to many and yet, there is no reason why it should be so because returns are computed solely on the basis of capital rather than across various stakeholders such as employees and the region or country. Nor does this consider the impact on the environment, an integral part of the concept of society in my personal opinion. This is what we call shareholders capitalism and this system drives short-sighted decisions that seldom align with the greater good, regardless of what believers in the magic of “the market”, a complete illusion, may think.

f) Trivia – The Industrial Revolutions

We love to detect trends with the benefit of hindsight and the various industrial revolutions neatly fit this observation. They did not happen evenly, in one place, at one time, so the term revolution is not adequate to describe the instantaneous experience of someone living during one, however they provide a useful framework for thinking about technological and societal shifts.

The First Industrial Revolution owed much to the invention of the steam engine in the second part of the 18^th century and took several decades to spread from Great Britain, through Continental Europe and then across the Atlantic to the United States. It started with textile and cotton making its way to the mechanized looms in factories and was followed by the use of steam engines in blast furnaces to make iron-based products.

The consensus regarding the Second Industrial Revolution has it spanning from the 1870s all the way to the First World War and being the result of various developments which we can categorize in two buckets. On one hand, an improvement of the scientific process of enquiry leading to several key scientific discoveries and product innovation, having to do with electricity, the combustion engine and steel making. On the other, the increasing industrialization of the economy together with the standardization of materials and the specialization of work enabling the process of mass production.

The Third Industrial Revolution is colloquially termed the Information Age, it started after the Second World War, fostered inter alia by the invention of the transistor and computers, and it has not really ended. This era is marked by telecommunications, computing and the digitalization of data and services.

In parallel, the Fourth Industrial Revolution could be in the process of taking off. It is witnessing the rise of biotechnologies, artificial intelligence and robotics all replicating, improving on, and soon displacing the natural human biological capabilities. If the topic is of interest, you may want to read the related paper titled AI Risks & Mitigation posted on the Syllab website.