Global Trade Issues & ROI calculation
The next big topic is around global trade issues and ROI calculation, and that’s a huge topic considering what’s happening with China, the US, and recently in the Suez Canal. Hats off to the Dutch salvage company that was able to move the ship along and get global trade flowing again—no pun intended.
Global trade can be used as a force for good. It can be used to modify behavior. As it relates to global trade issues, I’m going to talk specifically about what’s happening in commodities, but the lesson is not just applicable to commodities.
Many years ago, there was a time when Japan was considered to be such a major rising military, industrial and naval power—especially after the defeat of the Russian navy—that many Western powers thought the Japanese would eventually come west, or at least go far east and arrive at the US, which they eventually did. The Americans wanted to know in particular how they could contain Japan as a naval power. They realized that if you’re an island nation, you need a navy. A navy is built on steel, and the Japanese never really had steel. So, the Americans pulled back a special agreement they had in 1917, and they imposed a steel embargo on Japan. Obviously, Japan saw a steep decline in the amount of steel they could import, which led to a significant reduction in its ability to plan, launch and commission new naval ships.
In many ways, China is seen—whether rightly or wrongly, it’s not our place to judge—as a nation that’s going to challenge Western domination, for the first time ever, really, in recorded memory.
The question becomes, how do you modify Chinese behavior? First, you can cut them off from material they need. One thing they need a lot of is iron ore to produce steel. At the moment, China is highly dependent on Australia for its steel imports. Depending on the data you read, anywhere between 40-60% of Chinese iron ore comes from Australia.
It would be unusual if the Chinese military planners, industrial leaders and government were not thinking of the strategic weakness they have by being dependent on one source for iron ore. This has nothing to do with Australia. They’re wonderful people. I love Australian rugby. I love the Australian cricket team. I would probably cheer for them first, if New Zealand was not playing.
This is about strategic dependence on one source and not having diversification. This means that China is going to do everything in its power to diversify its iron ore supply. A big focus of this is looking at the country of Guinea where the Simandou fields are. For many years, especially when I was a senior partner advising CEOs, CFOs and COOs in the resources sector, we always looked at Guinea as a source for iron ore. But it is very difficult to develop the mines because they are on the side of a mountain and you need to build a 500 or 600-kilometer railroad to connect the iron ore mines to a port. You have to build a port, and you have to dredge the harbor.
For many companies, the economics didn’t make sense, but here is the deep insight. Oftentimes, when we do financial analysis, we make the assumption that return on investment for that development is the ultimate arbiter of success. For example, we say the return on investment of this facility is going to be very low because the cost of building the railway line, the port, dredging the port and so on is going to be so high that the ROI is just not worthwhile.
But when you consider ROI, you have to consider what you’re calculating the ROI for. If you’re calculating the ROI just for this port and development, it would probably be low. But if you calculate the ROI for the entire steel sector for China, and you factor in that any delay of iron ore supply will cause such a big hit to Chinese growth ambitions that they would rather bear this cost, then the ROI makes sense. If you calculate the ROI for the entire Chinese economy growing by not constricting iron ore supply, then the ROI makes sense.
There are two insights. First, when you’re calculating your ROI, pick the right boundary. If we just looked at the ROI for this one development, it wouldn’t make sense. But if we consider the ROI for the entire steel sector, it makes sense if we take into consideration what delays or constriction of the supply of raw material—the feedstock for steel—would do.
The second insight is that whenever you’re trying to get investors into a deal, whenever you’re convincing someone to work with you, you have to think about what is their strategic risk. You have to ask yourself how you can help them mitigate that strategic risk.
For example, if you were a group of developers who wanted to develop Simandou in Guinea, you could go to different investors or you could know strategically that the Chinese are interested in diversifying supply and locking up security of supply. You could go to them and say, “We know the costs are high. We know it’s risky, but if you do this, we guarantee you supply. In the short term, that may cost you more. But in the long term, once we get the volumes up, it will cost you less.”
Those are two important insights when you’re thinking through how to calculate return on investment figures from any large project, or any project for that matter.
This is an excerpt from Monday Morning 8 a.m. newsletter, issue #23. Many of you have found Monday Morning 8 a.m. so useful that you’ve asked us to release a book version of these newsletters. We’ve obliged and released a Kindle version, which you can find on Amazon under “Strategy Insights.” It contains the insights from previous Monday Morning 8 a.m. issues, edited into a bite-sized format that’s very easy to use. And you can learn about other FIRMSconsulting books here.
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