There is a fundamental change occurring in the global production of basic materials. The Asian economies, hungry for growth, are combining access to cheap labour and cheap energy on a massive scale. The result? An oversupply of materials, which is destabilising the Australian market.
The production of basic materials, such as petrol and cement, is a capital-intensive exercise. Historically, these materials would be supplied by a handful of local companies that would build the infrastructure at great cost, and in return, enjoy monopolistic pricing power. As a result, the producers of basic materials in Australia have been relatively sheltered from the rising powers in Asia due to distance.
Australian producers uncompetitive
But with global shipping rates decreasing and the Australian currency remaining relatively strong, Australian production has become uncompetitive. The giants of Australian industry, which enjoyed favourable market dynamics for decades, are faced with the reality that their business models must fundamentally change – and fast.
Let’s first look at the impact on the Australian fuel market, which was traditionally dominated by BP, Shell, Mobil and Caltex. The companies would import crude oil from Africa or Singapore to produce petrol or diesel in their onshore refineries.
Singapore was traditionally the only refiner to export to Australia in volume, but in the past five years there has been considerable investment in the region. Because fuel is refined in accordance to universal standards, a wide range of commoditised products can now be sourced from anywhere in the region – Japan, Taiwan, China, Korea, India.
For Australian refiners, it is now more economical to convert existing refineries into import terminals. Not only does this outsource the risk of production (which can be very volatile), but the lead time is reduced from months to weeks.
Caltex made the decision in 2012 to restructure its supply chain and focus on distribution. It is likely that it will import all of its product within ten years. Due to its global reach, Shell has chosen to direct its resources to exploration. It has since sold its Australian petrol stations and refineries, but will retain ownership of its aviation fuel business and grease plants in Brisbane. There are reports that BP is also considering the sale of its refineries in Queensland and Western Australia.
The same shifts are occurring in the region’s cement industry. The main producers in Australia are Adelaide Brighton, Boral and Cement Australia. In the early days, each player had invested in a particular state due to the natural monopoly afforded to capital-intensive cement production. This limited competition skewed the bargaining power in favour of the resident-producer, and so competitors would be forced to accept the terms of their interstate counterparts when supplying product outside of their primary markets.
But in the past decade, there has been a dramatic shift in the global cement market, which is described by Boral in its 2013 Review. Ten years ago, 95% of cement was produced in Australia, while 5% was imported. In 2013, 70% of cement was produced in Australia, and 30% was imported. This trend is likely to continue, as Australia’s demand for cement is 10 million tonnes a year, while China is producing 2.15 billion tonnes a year.
This has dramatically changed the economics for the local incumbents. Like the fuel refiners, the incumbents are focused on shifting their value chain to the distribution of building materials, rather than production. Boral has converted its production facility in Victoria to an import facility. Adelaide Brighton has invested in Malaysia to source product from overseas. Cement Australia also has plans to build import facilities, and has recently terminated a major contract with Adelaide Brighton in South Australia as a result.
So where will the value lie as these major players transition from production to distribution? Does this create investment opportunities?
Pricing power
Typically, distributors aren’t compelling value propositions because they don’t control the product, which means it is difficult to exercise pricing power. But this dynamic may in fact be favourable to the incumbents, as they change from a volatile, capital-intensive business, to a model that is characterised by steadier cash flows.
Sustainable value will be dependent upon the companies’ bargaining power with suppliers. In the case of Caltex, the company has favourable bargaining power with suppliers given the number of mega refineries in the region. If Caltex can build an efficient operating model, this may provide enough protection to withstand the Asian advances in the medium term. But given how rapidly the global market is changing, the landscape may be very different in another ten years.
Roger Montgomery is the founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able’