Monday, September 24, 2018

A Short(age) Tale


Trevor Needs Some Water

Once there was a man named Trevor living in a rural area who bought his drinking water for his water cooler from a local supplier. His requirements averaged four jugs (5/gal each) a month. In the summer he would use a little more, and in the winter a little less, but for the year it always averaged out to four jugs a month. So, every month Trevor would place an order for four jugs (20 gallons), to be delivered the following month.

But then an environmental event occurred at the spring where the water company is sourcing its supply. The company delivers two jugs to Trevor the next month, instead of four. The company explains the situation. It says he will get his other two jugs in about three weeks, because they have all their customers on allocation due to the shortage. They are unsure how much water they will deliver next month and don’t know how soon the situation will be rectified.

Now it is time for Trevor to place his next order. Let’s assume he can place monthly orders, twelve months out (so 12 monthly orders), and he can change the quantity he previously ordered, one month before delivery without any penalty.

How many jugs would you order under these circumstances? Let’s say Trevor orders eight jugs a month for the next 12 months. His logic being that if he is on a 50% allocation, he can still get his four jugs every month. When he is sure supply is normalized, he will cut the remaining orders in half. He also plans to put four additional jugs in safety-stock inventory, just in case supply is disrupted again.
How many do you order?

In addition, there is another water supplier. Unfortunately, this company draws water from the same spring and also has a shortage. However, Trevor thinks there is a chance this supplier could get more water sooner than his main supplier, so he orders 16 jugs spread out over the next four months from this company.

The typical monthly order is four jugs, but due to a supply shortage, Trevor has just ordered 112 jugs of water. And let’s say all his neighbors respond the same way. The water suppliers are ---- flooded with orders! They have never had so many orders in the history of the business. They don’t have to worry about filling all these orders in the short-term, because they don’t have enough product to do so.

What is Trevor’s new water demand? It hasn’t changed, it is still four jugs a month. But the shortage has tremendously impacted his buying (ordering) behavior. Now traditional economists would find fault with my story, claiming that if demand is 4 jugs, the rational action would be to order 4 jugs. However, I think behavioral economists would agree with my conclusions. Heck, if Trevor were thirsty when he was placing his order, he may have even ordered more.

Now under classic economics, the price of water would rise to alleviate the shortage. We are going to assume the water companies are going to use allocation in the short-term instead of price, so as to not alienate their long-term customers when the shortage ends.

The Reality of the Class 8 Truck Market

Now, you cannot argue that the story is not realistic, because it is based on what has happened in the Class 8 truck market this year. Orders for the last two months have been at all-time record levels. In fact, six of the top order months ever have occurred in the first eight months of 2018. Over 477,000 truck orders have been placed in the last 12 months, shattering the previous best 12-month period of 400,000 in 2005-2006. Those orders resulted in the peak production year of 376,000 trucks in 2006. The industry will be stretched to build that many in 2019 due to factory closings since 2006.

The primary reason for the high orders is a vibrant economy generating outstanding freight growth. Earlier this year, however, component suppliers could not keep up with this surge in truck demand. This shortage of components led to a severe shortage of Class 8 trucks. At one point, OEMs had around 1,000 semi-completed trucks parked, awaiting final components before they could ship. Some truck dealers waited over two months before receiving much needed inventory. OEMs could not raise prices to alleviate the shortage due to contracts and not wanting to damage long-term customer relationships.

The truck shortage has been abated for now, and suppliers are doing a much better job of meeting delivery dates. However, the supply chain is still very tight and could easily reemerge as an issue in the near future. Therefore, since demand remains robust, the response from fleets and dealers is to order trucks in record numbers, for delivery up to 12 months out, hoping to reserve more trucks if they are needed.

What is true demand? Unfortunately, its difficult to tell by looking at orders alone since some of the orders are to hold build slots, months out in the future. And backlogs are inflated, but by how much? Regardless, demand is extremely strong, and the fundamentals for freight and equipment demand are solid into mid-2019.
  
What Happens Next?

OEMs have to ramp up production to build all the orders they can, and suppliers have to keep pace. FTR (Freight Transportation Research) forecasts that freight growth will begin easing in the second half of 2019. If fleets have adequately increased capacity by that time, excess orders will begin to be cancelled and squeezed out of the backlog. If the economy stays at its current pace into mid-2019, the shortages could reappear, and the order deluge will continue.

This post first appeared on the FTR website with minor changes here..  FTR is the leader in analyzing and forecasting the commercial transportation industry.  For more information on FTR reports and services, please click here.)



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