Middle market businesses in the United States and the rest of the world have come to rely heavily on China, which exports more intermediate manufactured goods than any other country. The risk of economic disruption to this system increases the longer the coronavirus pandemic persists.
Since the first confirmed case of the coronavirus disease in Wuhan, China, in late 2019, the virus has spread to manufacturing hubs including Shanghai, Zhejiang, Jiangsu, Guangdong and Chongqing, according to data released by Chinese officials. These centers are the heart of an increasingly interdependent, global manufacturing network. Even as companies in these districts gradually resume operations following a shutdown, the number of coronavirus cases around the world continues to grow as of this writing and the potential for more widespread ripple effects across the world and to the middle market is enormous.
About 20% of global imports of intermediate manufactured goods – the amount that comes from Chinese factories, according to figures from Bloomberg Intelligence and trade data from the Organisation for Economic Co-operation and Development – are exposed to risk because of this disruption. American factories are also at risk, with approximately 30% of all imported manufacturing inputs coming from China in 2015, according to Bloomberg and OECD. Those figures have only increased since then.
In any industry where China is the leading provider, it will be difficult for manufacturers to find alternative sources, especially in the short term. These industries include textiles, computer equipment, electronics and non-metallic mineral products, all of which relied on China for at least a third of their imports in 2015.
The pandemic has upended broad segments of the global economy including oil markets, which are hurting. The price of the benchmark Brent crude hit $24.88 per barrel on March 18, marking its lowest price since December 1998 when it was $10.53 per barrel. This is well below the average U.S. breakeven oil price of $48 to $54 per barrel, according to the Dallas Federal Energy Survey. If prices remain below $40 per barrel for a sustained period of time, it will be difficult for the industry to withstand.
This price decline is in part because of weakened demand from China, one of the world’s largest importers of commodities, including oil. Another contributing factor was Saudi Arabia’s price cuts in response to Russia’s unwillingness to agree to reduce production at their March OPEC meeting, which has also put downward pressure on prices. We anticipate this will keep oil prices low in the short term, as Saudi Arabia, with some of the lowest production costs, looks positioned to regain market share. It will be difficult for other oil exporters to endure these price shocks for long.
It is unclear what the expiration of production cuts on April 1 will bring as countries regain the freedom to pump supply into the market. Excess supply will only bring prices lower and could create further challenges the longer it persists. The price of U.S. shale oil in February reached its highest point since Jan. 1, 2014, showing producers had initially hedged their output. Producers are vulnerable if prices remain low and production volume drops below breakeven. Cash flows for this capital intensive and highly leveraged industry could become a concern as production slows and threatens sustainability.
Already weak metrics for the aerospace sector will get worse with travel bans, travel restrictions and cancelled flights resulting from the spread of the coronavirus. Demand for air transport – measured in global revenue per kilometer – declined 23.6% from December to January for top carriers worldwide, according to Bloomberg Intelligence.
Airlines are cutting schedules, grounding planes and trying to manage labor costs to respond to the decreased travel demand. While fuel costs will be drastically lower with the increased supply, the savings will not make up for the weak demand. The economy and national security are dependent on the airline service in times of war and national emergencies. Airlines may get $50 billion in aid from the massive stimulus plan federal lawmakers aimed to vote on Wednesday. That assistance would supplement operations with about a quarter of a year’s total revenue.
Due to the coronavirus pandemic, manufacturers can expect an impact on the first quarter at least. Supply chains that are integrated with China will take the biggest hit. Chemicals used in products with the shortest supply chains to the customer – coatings and packaging – will feel the effects the quickest. Others, such as industrial gas, will face more risk with time. Specialty chemicals with limited production may experience supply disruptions sooner, which will likely result in price increases.
As investors respond to concerns over the virus and decreased demand for products, a shift in investments will likely occur from the most sensitive to the most resilient. Therefore, the spread between a sensitive chemical like titanium dioxide and industrial gas widens as investor confidence wanes. The spread is well beyond a peak reached at the end of 2019.
Chemical manufacturers are feeling the effects of uncertain demand in their financial performance. German chemical company BASF said in a statement that they anticipate the result could be the worst growth for the sector since the Great Recession in 2008.
The interconnected supply chain
Today’s global manufacturing ecosystem is highly interconnected. Evolutions in the way goods are made inherently increase the risk of disruption from events like the coronavirus outbreak. Characteristics of modern supply chains include:
- Just-in-time manufacturing: A production model where items are created at the time of order based on customer demand, not in advance or held on hand. Businesses engaged in these processes could face challenges in operations from sourcing through delivery.
- Concentrated partnerships: Manufactures engage in strategic partnerships often times for specialized and proprietary manufacturing to improve processes or make new products. These arrangements require major upfront investment and coordination and are therefore vulnerable to interruption.
- Contracted sourcing: Procurement teams generally formalize the sourcing of products or services with vendors through contract terms. Manufacturing limitations or service-level agreements often come with penalties for temporary service disruptions.
It is crucial for manufacturers of any kind to assess their supply chain and business exposure to the coronavirus outbreak.
“While organizations typically prepare business continuity plans focused on isolated disruptions, pandemics and emerging diseases require consideration of broader situations that could have impacts on a regional or even global scale,” said Troy Harris, senior director of RSM’s business continuity planning practice.
What’s a manufacturer to do?
Here are some effective measures a company can take to increase resilience. Along with the current coronavirus outbreak, these can also apply to future emergencies:
- Develop preventative and containment strategies for internal and third-party sites
- Monitor updates from health departments and other appropriate agencies during a crisis
- Diversify supply chain and identify substitute suppliers
- Develop comprehensive incident and crisis management plans