For Indian policy makers, the war in Ukraine has prepped up the battleground in India for a different struggle — against a looming commodity crisis that threatens to drag the country’s 1.3 billion people into a quagmire of ‘stagflation’.
In stagflation, prices rise to such a level that they start strangling demand, slowing down the economy, resulting in lower purchasing power and widespread job losses. From there on, it is a vicious cycle of low demand fuelling low production fuelling high prices fuelling lower demand.
Even though Russia is a marginal trade partner for India, accounting for just 1.4% of our imports and 0.9% of exports, Moscow still holds the key to India’s economic well-being due to its dominant role in supply of natural resources which have already been badly disrupted.
Boardroom honchos faced with supply disruptions, soaring prices and artificial shortage of commodities are responding with value added products, lower inventory and re-jigging fuel mix — besides the inevitable price hike in finished products.
Russia’s Commodity Spiral
Though Russia accounts for just 1.77% of global GDP, the world relies heavily on its natural resources. In 2021, it supplied 42% of global ammonium nitrate (key raw material for fertilisers), 21% of global wheat, 43% of palladium, 14% of platinum, 11% of nickel and 6% of aluminium. Coupled with Ukraine, it accounts for 40-50% of global neon production, says a report by Switzerland-based LGT Private Bank.
In 2021, Russia was the largest natural gas exporter, second-largest crude oil and condensate exporting country after Saudi Arabia and third-largest coal exporter after Indonesia and Australia. Russia is also the second-largest aluminium exporter. Around 11% of seaborne global steel exports come from Ukraine and Russia. It earned $235 billion from energy exports in 2021, half of its export revenue, according to the Institute of International Finance.
Supply disruptions and surge in prices of these commodities have delivered another blow to the global economy that was already reeling from the impact of Covid-19 and rising inflation, forcing companies to adopt varied strategies to manage the situation.
Impact On Corporates
India’s commodity imports face two challenges. First, most commodities are quoted and traded in U.S. dollar, which causes a strain due to exchange rate fluctuations and depletion of forex reserves. Second, though India is a big commodity consumer, on pricing, it is at the mercy of global trading houses which set prices on exchanges. Prices are discovered on global commodity exchanges like London Metal Exchange (LME) and Chicago Mercantile Exchange. Between April and January 2022, India imported petroleum products worth $114 billion, twice of last year’s imports.
Some of the commodities that have seen a sharp price surge are important inputs in many industries. Besides petrol and diesel, crude oil is crucial for manufacturing plastic, paints, lubricants, chemicals and personal care products. A rise in plastic prices impacts almost all consumer-facing companies.
On the other hand, coal is crucial for industries like steel, cement, power and aluminium, among others. In FY21, India imported 215 million tonnes (MT) of coal. In the first nine months of the current fiscal, the number was 161 MT.
More than 90% of sunflower oil imported by India is from Ukraine and Russia. Around 60% of NPK (Nitrogen, Phosphorus and Potassium) fertiliser and 17% of MOP (Muriate of Potash) fertiliser are also sourced from Russia. India provides fertiliser at a subsidised rate to farmers. Although the country’s dependence on Russia for mineral fuels (crude and coal) is only about 2.8%, its indirect exposure as a net commodity importer is very high.
The global upsurge in prices has led to demand destruction in many cases. A research report by Coal Trader International dated March 10 says Australian coal cargoes that were initially meant for India were redirected to Europe as Indian buyers were unwilling to pay high prices.
Steel, Cement, Auto Dilemma
Businesses are experiencing short-term margin squeeze and are passing on costs to consumers, though in a staggered manner.
For instance, major steel companies have increased prices by 10-15% in the last two months. Tata Steel, which buys up to 15% of its coal requirement from Russia, is now planning to buy more from North America for its European operations and from Australia for its Indian operations. Coking coal, which accounts for 40% of steel making cost, has seen its prices double to over $650 per tonne, the company said in an email response to Fortune India. And with steel prices going up by around `10,000 per tonne since February, the company’s margins may expand for a few months before cost pressure catches up and hits the steel industry over the next quarter, it added.
Steel is primarily made either by using a blast furnace, preferred in India, or an electric arc furnace, prevalent in Europe. Blast furnaces need imported coking coal, which accounts for 50-60% of the production cost. On the other hand, electric arc furnaces run on natural gas, which has seen prices increase manifold in just the last one month alone. Hence, a company such as JSPL, which owns captive coking coal mines in Australia and Mozambique, is better placed to curtail production cost, says Sahil Sanghvi, research analyst, Monarch Networth Capital.
Forced to find solutions, steel companies are now focusing more on producing ‘value added’ and ‘specialty products’ such as alloy steel where margins are high. Currently, such products contribute 61% to JSW Steel’s revenue, the highest among its peers. Others, including Tata Steel and Jindal Steel, derive 45-50% of their revenue from special products.
But even in the crisis there is an opportunity. A 45-million-tonne supply vacuum left by Russia and Ukraine has opened up export opportunities for domestic steel producers as well.
Cement is another sector that has been badly hit by commodity disruption. Fuel, which accounted for 33% of cement production cost before the war, has risen to 40% since. Energy and logistics costs together comprise around 60% of the overall cost of cement firms.
Indian cement makers import 70-80% of their thermal coal requirement. Petroleum (pet) coke is a cheaper substitute to thermal coal but has environmental implications since its sulphur content is 10x more. Sulphur emission is contained through back filters, which carry a huge installation cost. Hence, only one-third of cement manufacturing units, usually owned by big companies, are legally permitted to use pet coke as fuel. These companies have started blending more pet coke with thermal coal to keep their fuel costs in check.
“Due to the steep rise in fuel cost, EBITDA of cement companies may come down by 20-25%,” says Mahendra Singhi, MD and CEO, Dalmia Cement (Bharat) Ltd. Dalmia Cement manufactures 35 million tonnes per annum. The impact on the sector was visible even before the war. In Q3FY21, energy costs of Ambuja, UltraTech and ACC shot up by 58%, 39% and 26%, respectively, year on year.
Cement companies have fine-tuned their plants in such a way that either pet coke or thermal coal or their blend can be used efficiently, says Singhi. The industry is also procuring cheap coal from Australia, South Africa and Indonesia, he adds.
The domestic automobile industry is also expected to bear the brunt of lower supplies of components triggered by the war. Both Russia and Ukraine produce raw materials which are used in components that are key to producing automobiles such as semiconductors. Among auto majors, Toyota Kirloskar Motor, for instance, announced up to 4% price hike across models due to rising input costs.
The Inevitable Price Hike
For companies, the immediate strategy to deal with soaring raw material prices is to pass on the additional cost to consumers. Luggage behemoth VIP Industries, a plastics consumer, recently increased prices. FMCG giant Hindustan Unilever has been increasing prices of its personal and home-care products at a steady rate since Covid-19 lockdown and will continue to do so.
Companies in other sectors are also hiking prices based on peculiarities of their markets and demand season. Fertiliser, power, tile and textile companies, among others, are set to announce price hikes. Amit Agarwal, group CFO, Raymond Ltd., says the company is raising prices to mitigate impact on margins. “In the suiting business, we have been able to pass on the increase in cost, while in cotton fabric, the increase in cotton prices is very high and we have been able to pass it on to consumers with a lag.”
But price hike is not easy in sectors that are not able to pass on the burden immediately to consumers. That is why gross margins of companies like Havells, Crompton Greaves and Blue Star are under pressure due to high input costs, says Nirav Vasa, senior analyst of brokerage firm Anand Rathi. Copper accounts for 15% of their cost. “Price rise in copper, metals and plastics has left AC manufacturers no option but to pass on cost pressure to end consumers,” he adds. Since the Ukraine war, copper prices have risen 10% to $4.9 per pound. Margins of all consumer durables companies are expected to be under severe pressure for the next two quarters. A 10-20% EBITDA contraction is expected in Q4FY22 and Q1FY23, say industry sources.
Inventory Light Models
Since a price rise leads to destruction of demand, some companies are lowering inventory to save costs instead. Prior to the war, most consumer durable companies such as LG, Electrolux, Samsung, Voltas and Whirlpool kept 45 days of finished goods and raw material. But industry insiders say firms are eager to liquidate finished goods and have brought down raw material stocking to 30-35 days. Agarwal of Raymond says the firm has brought down inventory from 40 days prior to the war to 30 days now.
Amol Rao, an independent analyst, says most firms are keeping low inventories of both raw material and finished goods. Another reason for this is Backwardation that has started in crude oil, where prices for future months are lower than current/spot prices. Backwardation in crude oil is a precursor to a similar trend in other commodities.
Opportunity For Policymakers
Every crisis presents an opportunity. India’s energy needs are primarily fulfilled by import of crude, petroleum products, and coal. Oil provides for 27.63% of its energy requirement, while coal contributes 55.27%, according to the Petroleum Planning and Analysis Cell, the research arm of the petroleum ministry.
As the world deals with commodity disruption and climate change and plastic menace that primarily originate from consumption of crude, coal and plastic, eco-friendly manufacturing, transportation and packaging could emerge as viable alternatives. “Within two years, the cost of EVs will come down on a par with their petrol variants,” transport minister Nitin Gadkari had said in March.
Likewise, promotion of eco-friendly substitutes in packaging, FMCG manufacturing and agriculture will reduce the current commodity consumption in multiple sectors, thereby freeing up resources to be used in sectors where eco-friendly technology is unavailable or inaccessible.
Government research institutions are working on solutions such as bio-diesel, starch-based packaging polymers, solar-powered gadgets, and are looking for industry partnerships. The current crisis presents an opportunity for India to lead the sustainable world order.
The End Game
The increase in commodity prices translates into price hikes of finished goods because businesses pass on increased costs to consumers. In specific sectors, the government steps in to mitigate the impact. For instance, the government has absorbed the escalated cost of raw material used in fertiliser production by providing a subsidy worth `1.4 lakh crore in FY21. As the crisis escalates, the Centre may look at increasing the amount, which could lead to a rise in both direct and indirect taxes.
Hence, while it is vital to tackle the imminent commodity crisis in the short term, developing a self-reliant industrial model with sustainability at its core is the best-possible option for India in the long term.