Inflation in key raw materials is on an unprecedented rise over the past two years, adversely impacting the industry and supply chain. Both owners and contractors are today facing a piquant situation with respect to executing fixed-price contracts. As a practical solution to this dilemma, apex industry body IEEMA recommends a variable contract between contracting parties, in this article by IEEMA Research Group.
The cost of raw materials had been on the rise since the onset of COVID-19 about two years back. Though the pandemic has subdued, there is now the Russia-Ukraine war, which has affected almost the entire world thanks to interconnected global economies.
Sanctions imposed on Russia have sent the prices of petroleum products skyrocketing, with Brent Crude hovering consistently above $100 per barrel, sometimes even touching $130 per barrel.
India is facing an adverse impact as it meets 80 per cent of its crude oil requirement through imports. From Russia alone, India imported $2.05 billion of crude oil, $832 million of precious stones and $609 million worth of fertilizers, in 2020. An increase in prices of such commodities may lead to considerable inflation in the country. India buys palm oil mainly from Indonesia and Malaysia, with soy oil mostly imported from Argentina and Brazil, and sunflower oil from Russia and Ukraine. Supply of edible oil has been severely impacted.
Ukraine on the other hand is among the largest exporters of food grain. The war and resultant closure of maritime route has severely impacted the supply side, with food grains experiencing acute price increases. The economies around the world that were just recovering from the aftermath of COVID19 were ill equipped to handle another shock.
Industries around the world are facing difficult times due to the repercussions of global events. Prices of diesel and petrol are already on its peak. Commodities in India are highly influenced by petrol and diesel prices. Transportation and logistics cost shoots up with the rise in fuel price, leading to increase in the fare of international and domestic commodities. Indian industries including the electrical and power sector are facing the same heat due to supply-side challenges in availability, cost, and logistics.
Impact on power transformers
Neeraj Goyal, General Manager – Design & Technology, CG Power & Industrial Systems Ltd and Chairman IEEMA Power Transformer Division, articulated, “As we are aware the prices of key materials such as CRGO, oil etc have seen an acute price rise as well as scarcity in the past two years caused due to capacity diversion to other sectors, operational impact caused due to COVID, capacity reduction, increase in logistics cost and increased local demand in other countries/regions.
Rising prices of key raw materials has been a key issue for power transformer industry. Copper and CRGO which constitute for about 55 per cent of total material content in power transformers, have seen a never-seen-before kind of price escalation. In past two years post COVID, the copper prices have seen an average rise of about 65 per cent whereas CRGO on an average has witnessed a staggering 110 per cent rise.”
“Steel and oil prices have seen constant rise with naphthenic base oil availability being an issue since it is imported with few sources. All these price escalations have caused the material costs of transformers to rise anywhere from 40 per cent to 50 per cent. In addition to that rupee devaluation against USD by more than 20 per cent has made things worse as more than 50 per cent material is having imported base. Since a lot of contracts had FIRM pricing clause, manufacturers executed such orders at negative margins with material cost going significantly beyond the sales price. To make matters worse, CRGO has seen not only price escalation but also severe scarcity which resulted in dual hit for the manufacturers in terms of negative margins and also LD due to delayed delivery caused by scarcity of materials,” Goyal adds.
In view of the volatile trend of prices for input materials, it is important that all contracts have price variation clauses which are to full extent accepted by customers.
Fast-moving consumer goods (FMCG), consumer durables, cars, two-wheelers, fuel, fertilizers, steel, nickel, semi-conductors and many other finished products, as well as raw materials, have witnessed a steep price hike in the last few months. Inflation is really hurting the businesses. It has impacted the discretionary buying capacity of the consumers.
These supply-side dynamics including the extraordinary price rise is beyond the control of the supplier and buyer. The risk associated with such extreme price volatility cannot be borne by the industry that is already witnessing extreme pressure on its metal (purchase) commitments.
Raw material shortage
In the opinion of Supushpa Kaushal, Head – Business Development (North), Larsen & Toubro, “ In FY2021-22, we saw huge surge in raw material prices, especially talking about our T&D Industry, the main components like steel, copper, aluminum and zinc witnessed around 35 per cent increase in prices also there were shortage of raw materials which had huge impacts on projects. Starting FY2021-22 the situation is seen to be improving, still there is 10-15 per cent impact of the industry but we are sure that it will further improve in near future.
Energy demand in H1FY2022 remained higher by 2.9 per cent against the same in H1FY2020 (pre-COVID), led by relatively sharper recovery in the energy demand as reflected by 8.4 per cent growth in Q2FY2022 against Q2FY2020.”
Also read: CG Reports 22 Per Cent Growth In Power Systems Order Intake
The scope for variable contracts
Given the unprecedented scenario of volatility and price increases, it has become difficult to execute the contracts with fixed price or having restriction variation (price variation clause) since the cost hikes may not be adequately covered by the profit margins.
Hence, IEEMA recommends a constructive dialogue between the contracting parties where a shift (albeit temporary), may be made in favour of a variable contract where the cost escalation may be allowed to be passed over to the buyer. The variable contracts may be able to create a win-win situation in the current scenario:
- It reduces the risk of default or project slowing down due to resource constraints
- In case of price reductions of raw materials in future, the same will be passed on to the buyers
- Contractors will be able to offer a lower bid value since they may not be required to build-in future cost escalations
- Contractors/suppliers will be able to focus on project execution rather than channelizing their energies on timing the raw material purchases to gain from market movements
The price hikes could potentially squeeze margins. However, a big theme this year, common to all the players in the industry, is: how much cost burden would we be able to convince buyers to share with contractors.
Featured photograph is an illustrative image of CRGO steel, an important raw material for power transformers, which has seen significant price rise in recent years.
