SECTION III. IMPACT OF ENERGY PRICE INCREASES

In setting the stage for projecting the impacts of energy price increases on the U.S. cement industry, a number of factors must be taken into account.

There is no substitute for cement in most of its end uses and there are no visible new cement manufacturing technologies which could result in a major change in energy efficiency. Energy efficiency gains will be from replacement of older plants and optimization of others. The capital intensity of the industry and the long life-cycle of cement plants and will constrain the rate of plant replacement.

Based on capital cost estimates, replacement of the existing 21.9 million metric tons of wet capacity would cost the industry between $2.4 and $4.0 billion depending on whether the new capacity is at the existing facilities or at greenfield locations. Similarly, replacement of the 46.2 million metric tons of old capacity, which includes wet and dry kilns built before 1975, would cost between $5.1 billion and $8.5 billion.

Energy accounts for 30 - 40% of manufacturing costs. And, because of the limited ability of the industry to mitigate energy price increases, higher manufacturing costs will result in higher prices for domestic cement.

Cement price increases would not significantly change overall demand. Cement demand is directly related to concrete demand which is a function of construction activity. There are no substitutes for concrete in most of its applications making cement consumption relatively insensitive to price.

The U.S. cement markets. particularly in the coastal areas and those accessible by water, are vulnerable to imports. Imports accounted for 20% of the U.S. market in 1987 and currently satisfy 13% of cement demand. A direct impact of energy price increases in the U.S. and OECD countries will be a price advantage for cement from non-OECD countries which do not face the same energy cost increases. This price advantage will translate into greater market share for imports from non-OECD sources. These market share gains will be primarily at the expense of domestic cement producers, but also by replacement of imports from OECD

countries.

Quantifying the Impact of Higher Energy Costs

The approach to quantification is to establish a set of assumptions. This is followed by calculation of the increase in manufacturing costs resulting from higher energy prices. The

increase in manufacturing cost is assumed to result in an increase in selling price. The fact that not all countries are subject to the same fuel cost increases means that price differences occur between suppliers. An elasticity of substitution factor is used to estimate the change in relative quantities from different suppliers based on percentage differences in selling price.

The weighted average costs of energy for the three geographical regions were calculated for a base case and for each of the two scenarios. The data is summarized below in terms of cost

increases over the base case. The highest increases in both scenarios occur in Japan where energy costs push manufacturing up by $17.07 per metric to in 2015 in scenario 1.

European scenario 1 and 2 add factors are identical. In scenario 2 the manufacturing cost increases are very similar to those of the U.S. but in scenario 1 European producers gain an advantage of $6.68 per metric ton in 2010.

The impact of the higher energy prices in the U.S. is greatest in 2010. The decrease in manufacturing costs in 2015 is due to the improvement in energy efficiency from 4.60 mmBtu/t in 2010 to 4.42 mmBtu/t in 2015 as in the base case. It is assumed in scenarios 1 and 2 that the higher energy costs will not accelerate the trend to greater energy efficiency over the base case because the capital investment needed to achieve this will probably not be made in a climate of industry contraction.

It is assumed that the increase in manufacturing cost is passed on to the consumer as a price increase. Taking the 1996 first quarter twenty city average cement price of $78.17 per metric ton to represent the average price of domestic and imported cement, and applying the manufacturing cost increases, percentage increases in cement price are derived.

To simplify the analysis, it is assumed that the price difference of cement from non-OECD sources enables it to replace imports from both Europe and Japan. Thus, the question becomes the extent to which the price difference between U.S. and non-OECD cement will increase import penetration from non-OECD sources into the U.S. market. The degree to which this occurs will depend on the elasticity of substitution.

The elasticity of substitution is the percent change in relative share of a good resulting from a 1 change in relative prices. The U.S. International Trade Commission (USITC), in 1990, estimated the elasticity of substitution of imported cement to domestic product to be between 5 and 10. This report assumes an elasticity of 7.5 which is the mid-point of the range.

The case of the Mexican exports provides an example of the effect of a price increase on a source of cement. In 1989 cement imports from Mexico were 4.0 million metric tons. This was 28% of total imports in that year and 4.7% of the U.S. cement supply. In August 1990, the U.S. International Trade Commission ruled that Mexican cement was being sold in the U.S. at less than fair value and was materially injuring the domestic industry. Duties averaging about 56 % were imposed. By 1991, the first full year that the duties were in place, imports dropped to 0.9 million metric tons and to 0.6 million metric tons in 1994. Some of this decline could be attributed to the effect of the business cycle, however, total imports of cement into the U.S. rose in 1994, but those from Mexico continued to decline. This case does not necessarily support an elasticity of 7.5 but it does indicate the extent and rapid response by cement purchasers to price signals.

In practical terms, the loss of market share by domestic producers would result from an exporter offering cement at a reduced price in order to increase his sales in the U.S. Other exporters would respond by lowering their price as would the domestic producers in the affected market areas. Exporters exploiting their production cost advantage could be expected to continue to seek additional market share by further price reductions. Ultimately, an

equilibrium would be established at a lower price. The higher cost domestic producers which were unable to compete at the equilibrium price would withdraw from the market. Cement exporters in the OECD countries affected by the proposed energy price increases would behave in a similar way, withdrawing from the U.S. market when it ceased to be profitable.

Taking the relative price difference of 11.03% under scenario 1 in 2005 as an example, then, with an elasticity of 7.5, a change of 82.73% (7.5 x 11.03) in relative quantities can be expected. Starting with the base case import share of 17.76% in 2005, the elasticity acting on the percentage price difference would increase the market share of non-OECD imports as follows for scenario 1.

The projected import market share for both scenarios are shown in the bar chart below.