June 01, 2012

Many of the newest technologies, including TVs, laptops, electric vehicles, and advanced medical devices, are made possible by highly specialized materials. These materials may be extremely rare and available only in limited quantities. Further, market supply and demand for these scarce materials may be dominated by a few large players, which can present risks related to price volatility as well as supply shortages and disruptions.

Due to these various risk factors, a supplier’s use of rare, highly specialized materials can be especially important to consider in commercial disputes involving claims for lost profits and others damages. While the basic lost profits framework is applicable in many lost profits damages claims, supply and price risk associated with raw material inputs may significantly impact the calculation of incremental costs as well as assumptions regarding risk.

Rare Earth Elements (REEs), also commonly referred to as Rare Earth Metals (REMs), are described as:1

Rare earth elements are a group of seventeen chemical elements that occur together in the periodic table (see image to the right). The group consists of yttrium and the 15 lanthanide elements (lanthanum, cerium, praseodymium, neodymium, promethium, samarium, europium, gadolinium, terbium, dysprosium, holmium, erbium, thulium, ytterbium, and lutetium). Scandium is found in most rare earth element deposits and is sometimes classified as a rare earth element.

The rare earth elements are all metals and the group is often referred to as the “rare earth metals.” These metals have many similar properties and that often causes them to be found together in geologic deposits.

Rare earth elements are not as “rare” as their name implies. Thulium and lutetium are the two least abundant rare earth elements – but they each have an average crustal abundance that is nearly 200 times greater than the crustal abundance of gold (1). However, these metals are very difficult to mine because it is unusual to find them in concentrations high enough for economical extraction.

Increasing Reliance on Scarce Materials

Palladium and other Platinum Group Metals (“PGMs”)2 have long been utilized in automotive catalytic converters as a means to reduce toxic emissions from internal combustion engines. Automotive catalysts have historically accounted for approximately half of the overall demand of palladium.3 Given the unique properties of palladium and other PGMs, these materials are a pivotal component for the functionality of catalysts, and demand requirements related to these applications are relatively inelastic. Further, more than 80% of the world’s palladium production comes from only two countries: the Russian Federation and South Africa.4 This often leaves suppliers of catalysts and their components subject to significant supply and price risk.

Several companies have historically recognized significant losses on materials utilized in production due to volatility in pricing. For example, in 2002, Ford Motor Company lost approximately $1 billion when it stockpiled palladium only to be left with excess quantities of palladium when prices later fell by 75%.5

Palladium is just one example of a rare material utilized in manufacturing parts. New and evolving technology has increasingly required the use of rare and specialized materials. Prakash “Krish” Krishnaswamy, President of EASi, a division of Allegis/Aerotek Group, and a supplier of specialty engineering and design services to global car makers in the U.S., Europe, China, and India noted in a 2011 guest post for Forbes that “Automobiles must and will incorporate more unconventional, even rare and exotic materials in the future.”6 For example, lithium demand has increased with the expanding use of lithium and lithium-ion batteries for a variety of electronics as well as electric and battery-powered vehicles. Not only are supply reserves and sources limited for such materials, but ownership of the related mines can be even more concentrated in the hands of a very few (governments or corporations). With the expectation for rapid increases in electric vehicle sales, in early 2010 some industry participants projected that demand for high-grade lithium could increase by as much as 150 percent over the next six years.7 Further, elements such as rhenium, which are utilized in the production of superalloys for aerospace applications such as turbine engines, have experienced growing demand in recent years. However, supply sources for materials such as rhenium are limited, and significant risk may be borne by suppliers relying on rhenium and similar materials in production.8

Material scarcity is common among many manufacturing industries. For example, in the steel industry, steel is often coated in zinc in order to protect against corrosion. There is no real alternative to zinc for this application, as it offers the best corrosion protection as compared to other materials. However, due to its high demand, it is estimated that the ratio of zinc reserves to current consumption is approximately 20 to 30 years.9

In addition to PGMs and other rare materials, the world demand for Rare Earth Metals is continuing to rise. Specifically, demand for REMs has swelled from 40,000 to 120,000 tons per year over the last decade. Meanwhile, China, who owns a monopoly on REMs, has been cutting its exports and imposing tariffs and export restrictions.10 These actions by the Chinese government have caused prices of these metals to increase by as much as 3500% since January 2010 in some cases.11 In response to these rising prices, new markets for recycled PGMs and REMs have evolved. For example, SustainableBusiness.com reported in April 2012:

“Honda Motor and Japan Metals & Chemicals announced they have developed a process to recycle earth metals and are starting mass production at a recycling plant. The feedstock to be recycled will come from chemicals they extract from used parts in Honda products. This month, the partners will begin removing rare earth metals from used nickel-metal hydride batteries collected from Honda hybrid vehicles at Honda dealers worldwide. Honda has sold 800,000 hybrids worldwide since 1999. Carmakers rely heavily on rare earths and are also examining alternatives that reduce the quantities used or can replace them altogether. Nissan’s 5-year plan, Green Program 2016, sets a recycling target and adopts comprehensive closed-loop recycling, including steel, aluminum and plastic – the first automaker to do so. It will use materials from production waste or end-of-life vehicles. It also has a goal of reducing rare earths in its cars. Last year, Creative Recycling Systems, Inc. announced it would recycle rare earths in the US.”12

REMs are utilized in a variety of new technological applications, including color television and flat panel displays (cell phones, portable DVDs, and laptops), permanent magnets and rechargeable batteries for hybrid and electric vehicles, generators for wind turbines, and numerous medical devices. While these metals are abundant in earth’s crust, mining them is often difficult, as they generally do not exist in large deposits. As such, supply has become concentrated within low cost regions such as China.13 In fact, China now produces 97% of the total world’s supply of REMs14 and the U.S. has become reliant on imports of REMs, primarily from China.15 Concerns regarding China’s control of the REM market and its mining practices are ongoing. On June 20, 2012, the New York Times reported that China’s cabinet had issued a “white paper on rare earth industry policies,” which cited poorly regulated mining practices for rare earth metals.16 This white paper raises concerns that such practices will squander already scarce supplies of these minerals. China’s control of rare earth mineral production is demonstrated in the “Rare Wealth” chart below.

With these ongoing concerns regarding the control and restriction of supply, as well as the efficiency of extraction processes, U.S. manufacturers may be exposed to significant risk associated with the supply and pricing of these materials.

The General Lost Profits Framework

Damage claims involving lost profits generally involve a calculation of revenues that would have been experienced in the “but-for” world less the incremental costs necessary to attain such revenues. This “but-for” profits scenario is then compared to the actual scenario (i.e., what really happened) to calculate total lost profits. While reasonable assumptions may be utilized in calculating incremental revenues and costs, there is nevertheless some level of uncertainty that the damaged party would have received the calculated future cash flows in the “but-for” world. As such, the calculated lost profits are commonly discounted to account for risk and the time value of money through the application of a discount factor that is consistent with the inherent risks in achieving the cash flows.

A damages expert may consider a variety of factors in calculating the revenues that likely would have been experienced in the “but-for” world. In many cases, a calculation of lost revenues may be based on historical data, contract and pricing terms, or other known factors. Incremental costs are then estimated in a similar manner based on a calculation of the incremental (i.e., marginal) cost of producing, assembling, and shipping additional products. Depending on the case, future incremental costs may be more difficult to measure, such as in cases where there is greater variability and risk inherent in the cost structure of the given product. In the event there are significant risk factors and uncertainties relating to the revenue and cost assumptions, it may be appropriate to account for this risk with an appropriate upward adjustment to the discount factor.

Lost Profits Concepts in Cases Involving Scarce Materials

Lost profits calculations will often vary depending on the facts and circumstances of each case. As discussed, certain future lost profits scenarios involve significant risk associated with the incremental revenue or cost inputs. This certainly may be the case in the event the product or program in question is dependent on the use of rare or highly specialized materials.

Similar to other scenarios, lost revenues in cases involving raw material scarcity may be calculated by several means. For example, in the case of an alleged breach of a purchase agreement by a customer, lost revenues may be based on quantity and price terms as defined in the contract, or may be based on historical prices observed for the product in question. However, the calculation of incremental costs associated with the lost revenues may be more challenging. As discussed, future prices for scarce materials may be significantly higher or lower than the prices observed at the time of the breach. As such, careful consideration of incremental cost assumptions may be necessary. To the extent there is inherent risk in the incremental revenue and cost calculations, this risk is often accounted for through the application of a discount factor. Generally, the greater the risk of achieving the future cash flows, the greater the discount factor.

Price volatility is not the only factor contributing to supply risk. In cases where the supply of a given material is dominated by a single supply source, there is often risk that the material needed for production becomes unavailable. For example, a supply cut-off could occur if a country decides to limit the exports of a given material in order to meet domestic demand. A variety of other circumstances could also impact availability, including political unrest, mining or production complications, natural disasters, or other factors. For example, in the 1970s, many products were dependent on the use of cobalt, including aircraft engines, turbines, magnets, and cutting tools. The supply of cobalt was dominated by two countries, Zaire and Zambia, who in the 1970s controlled approximately 2/3 of world production. Due to political instability in Zaire in 1975, the supply of cobalt from this country was completely cut off for five days and was further impacted for several weeks.17 Events such as these can contribute to increased price volatility due to a shortage in supply as well as speculation in the market. Further, the perceived risks of similar events occurring in the future can impact the market price of the material long after the event takes place, as was the case for cobalt in the late 1970s.

If other sources of the material are not available, an event impacting the supply source may have a significant impact on the manufacturer’s access to the material. As the supply source of a given material is often determined by where deposits of that material occur naturally, manufacturers may have little control over this aspect of supply risk.

Suppliers often consider limiting exposure to raw material risk. As indicated in one report, “Recycling, substitution and dematerialization were actions taken or encouraged by firms in the manufacturing industry that reduced the impact of scarcity. These responses take time to implement, are not available to all and lead to permanent market changes.”18 Such actions may reduce long-term material risk for some suppliers, but may result in increased incremental costs. As such, this may be an important consideration in certain lost profits calculations where the supplier was utilizing or had plans to utilize such strategies.

Considerations Regarding Supplier Risk Management Practices

The calculation of lost profits may be significantly impacted by the ordinary risk management practices of the damaged party. When a material is particularly scarce and subject to future supply and price risk, sophisticated buyers will often choose to engage in hedging activities to offset some or all of their exposure to future price risk. For example, a company engaged in the production of catalytic convertors may enter into palladium futures contracts to reduce their exposure to future palladium price increases. The use of hedges may impact “but-for” assumptions utilized in calculating lost profits. For example, it may be found that in the “but-for” world, the hedges in place would significantly offset the risk associated with future price volatility. In such a scenario, raw material risk may not be a significant factor in developing a discount factor as the incremental materials costs may be reasonably expected to fall within a tight range. In these cases, the cost of the hedging techniques would need to be considered.

When raw material hedging is not utilized by the damaged party, the calculation of lost profits may be significantly different. Absent hedging, there may be greater uncertainty regarding the price the supplier will ultimately pay for certain raw materials. To estimate the future material costs, a damages expert may consider a combination of historical price trends or industry data regarding projected future material prices. However, price fluctuations are common for rare materials, as even minor fluctuations in supply or demand can significantly impact price. As such, incremental costs may be expected to fluctuate based on these market dynamics, and the risk of the damaged party achieving the calculated lost cash flows may be significantly greater. Consequently, it may be appropriate to utilize a higher discount rate, causing the calculated damages to be significantly lower.

The practice of hedging may require additional considerations. In the event of a contract termination, there is often a question regarding how a damages calculation should consider the supplier’s cost of performing a hedge. In the event the supplier’s use of hedges was contemplated by both parties at the time of contracting, it may be reasonable to consider the hedge in a damages calculation. Alternatively, the decision to hedge may have been made internally by the supplier to manage its risk, and the breaching party may have had no visibility to its hedging activities.

Further, some suppliers may simply decide to purchase and hold excess inventory of raw materials when it is available as a means to protect themselves from future supply and price risk. However, the cost associated with excess inventory that is not required to meet foreseeable supply requirements should be carefully considered as a component of damages. Often, these costs are the result of the company’s own risk management practices and may not reasonably be attributed to the actions of the other party.

Conclusion

While the basic lost profits framework is applicable in many scenarios, careful consideration is often necessary when there is significant uncertainty associated with individual inputs. As many forms of new and expanding technology often require the use of PGMs, REMs, and other rare and specialized materials which are subject to supply and price risk, computing the incremental cost component in a lost profits calculation can be challenging. A lost profits analysis should contain reasonable inputs for revenue and cost components based on the information available, including historical trends, current projections for future prices and supply, and the supplier’s risk management practices. Still, as the markets for rare materials are often subject to significant unforeseen price volatility and other supply risks, there is often greater uncertainty and risk associated with the calculated lost profits.

Also a contributing author:

Jacob M. Reed

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1 http://geology.com/articles/rare-earth-elements/.
2 PGMs include elements such as platinum, palladium, rhodium, ruthenium, osmium and iridium.
3 Luke Burgess, “Palladium in Play: Demand Up, Supply Down,” September 17, 2010.
4 Halah Touryali, “A Russian State Secret May Push Palladium’s Price to $1,000,” October 21, 2010, www.forbes.com.
5 BBC News, “Ford hit with $5bn loss,” January 17, 2002.
6 Prakash Krishnaswamy, “Megabets And Megarisks: Remaking The Auto Industry,” Forbes Magazine, Guest Post, November 29, 2011 http://www.forbes.com/sites/ciocentral/2011/11/29/megabets-and-megarisks-remaking-the-auto-industry/.
7 Kristine Owram, “Electric Cars to Spur Lithium Demand,” March 29, 2010.
8 Steven Duclos, Jeffrey Otto, and Douglas Konitzer, “Design in an Era of Constrained Resources,” MEMagazine, September 2010 Issue.
9 Materials Innovation Institute, “Material Scarcity” November 2009, page 50.
10 Connexion, “Rare Earth Metals: The Impact of Short Supplies,” www.connexiones.com.
11 Connexion, “Rare Earth Metals: The New West,” August 1, 2011, www.connexiones.com.
12 S ustainableBusiness.com – http://www.sustainablebusiness.com/index.cfm/go/news.display/id/23615.
13 March Humphries, “Rare Earth Elements: The Global Supply Chain,” Congressional Research Service, September 30, 2010.
14 Connexion, “Rare Earth Metals: The Electrical Industry’s Newest Issue,” June 8, 2011, www.connexiones.com.
15 March Humphries, “Rare Earth Elements: The Global Supply Chain,” Congressional Research Service, September 30, 2010.
16 http://www.nytimes.com/2012/06/21/business/global/china-vows-tighter-controls-over-rare-earth-mining.html.
17 Elisa Alonso, Massachusetts Institute of Technology, “Material Scarcity from the Perspective of Manufacturing Firms: Case Studies of Platinum and Cobalt,” page 45-46, February 2010.
18 Elisa Alonso, Massachusetts Institute of Technology, “Material Scarcity from the Perspective of Manufacturing Firms: Case Studies of Platinum and Cobalt,” page 3, February 2010

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