A highly flammable gas bubble for US manufacturing

The degree to which the US economy will benefit from the shale gas revolution will be determined in no small way by how well Washington can keep American wages and currency disadvantages to a minimum.

Wilson HTM senior research analyst Ivor Ries observed on ABC Television's Inside Business over the weekend that one of the reasons why the US economy is in such a much better state than Europe is it "drove down its manufacturing costs quickly” in the wake of the global financial crisis. The other reason, as Ries points out, is that the US restructured its banking sector. Europe did neither of these things.

Before the global financial crisis, American manufacturing wages were significantly higher than their northern neighbours in Canada. They are now slightly cheaper and they have to stay that way.

Thanks largely to the promise of unsuccessful Republican presidential challenger Mitt Romney to label China a ‘currency manipulator' on his first day in office, Americans are keenly aware that the yuan isn't all that it seems.

But with China's currency now hitting its highest levels since the launch of modern trading in the Red Kingdom in 1994, it's hoped that the appreciation trend will continue, to the benefit of American manufacturers. Some more Chinese wage inflation, also anticipated, won't hurt either.

PricewaterhouseCoopers has put out three reports on the American shale gas revolution over the last year or so and the US-China currency battle and wage controls are two of the biggest factors influencing the reach of shale.

"An appreciation of the yuan relative to the United States dollar seems likely to continue longer term as China's economy grows, which should be favourable for United States manufacturers,” read the A homecoming for US manufacturing report, released in September.

Of course every business chases cheap labour and energy, but it's particularly important for petrochemical manufacturers because the gas serves as a feedstock.

The challenge is to keep these manufacturing costs down – this means wages. This, combined with the ongoing jostling between Washington and Beijing over the trajectory of the yuan looms as a key challenge for the US to pump as much of that gas into a newly invigorated domestic manufacturing sector.

It's always fun – though sometimes slightly disconcerting – to discover how many products oil and gas derivatives end up in. From gas you can get ethane and ethylene, which ultimately end up in food packaging, bottles, window frames, pipes, carpets, anti-freeze, detergent, lenses, adhesives, coatings and tyres just to name a few.

Traditionally, petrochemical companies have followed the cheap energy. That means oil and the Middle East. But on the PricewaterhouseCoopers numbers, American ethylene is now 44 per cent cheaper than Saudi Arabia's.

While American gas prices are trading around $US3.30Mcf, levels, which are considered to be utterly unsustainable, this should give you an idea of just how big an opportunity this is for the US to pinch some business from China and the Middle East.

Of course, it should also be pointed out that petrochemical companies aren't exactly going to shut up shop in Beijing and Riyadh on the back of rig activity in Texas. But PwC estimates that there's $US11.5 billion worth of annual savings for US manufacturers exclusively attributable to shale gas.

There are some reports that indicate this revolution could benefit every American, all 315 million of them, to the tune of $US900 each. But let's not get ahead of ourselves.

What's particularly enticing about the prospect of cheap American gas for manufacturers is that it allows them to regionalise their supply chains, something that was touched on yesterday (BHP's new shale swagger, November 13).

This is being brought about by two factors. Firstly, transportation costs have been going up, meaning it makes less sense to make something in one place to sell it somewhere else – especially if the product, like heavy equipment or petrochemicals, are difficult to ship. Secondly, global climatic events like the Japanese earthquakes or Hurricane Sandy have highlighted how vulnerable the international shipping industry is.

This increasing focus on transport costs and supply chain risk are giving manufacturers greater incentive to build where they sell. Shale gas only enhances this equation.

Bobby Tudor, CEO of energy consulting firm Tudor Pickering Holt & Co, explains the higher the US gas price goes, which everyone agrees has to happen, the more the feedstock advantage to manufacturers will begin to shrink.

"It depends on the size of the feedstock cost advantage. But the auto companies are huge users of natural gas and plastic… it really changes the nature of their return,” says Tudor.
If you need any evidence of just how conscious manufacturers can be about gas prices, check out the latest comments from Incitec Pivot boss James Fazzino, whose Gibson Island fertiliser plant takes east coast gas as a feedstock. He's worried about the impact Australia's LNG boom, which brings with it hugely powerful Asian buyers, will have on domestic manufacturers. Speaking to The Australian after the release of the company's full-year results, Fazzino called for controls over east coast gas prices, saying that Asian energy inflation (something which could cause gas prices to double or triple) "is a crazy outcome for Australia... [it] makes the economics marginal".

His competitors in the US don't have this problem, nor a wages issue or a currency crisis.

Alexander Liddington-Cox is Business Spectator's North America Correspondent.