Are Semiconductors the new oil?

November 3, 2022

Printed circuit board and chip.

In the past year or two, semiconductors have been under the spotlight across industries and countries, even in our everyday conversations. People around the world have started to realize just how much this small component affects their daily lives in significant ways, from long lead times in car purchasing, to being unable to get hold of a PS5 game console. Modern defense capabilities also rely on sophisticated electronics systems powered by advanced semiconductor components. No wonder semiconductors are considered the new oil, given their wide-spread consumer, military, and strategic significance.

However, the key difference is that chipmaking is even more concentrated geographically than oil production. The three biggest oil producing countries, the United States (U.S.), Russia, and Saudi Arabia, accounted for 15%, 13% and 12% respectively of global production in 2021. Taiwan, on the other hand, supplies 20-25% of the world’s semiconductors every year, while the U.S. only accounted for 12% in 2021. When it comes to leading-edge chips (10 nanometers and smaller), Taiwan has 92% of global production capacity. Meanwhile, China is expected to emerge as a leading player in chip manufacturing. The country plans to add about 40% of the global new capacity by 2030 and is expected to reach 24% of world’s total capacity by that same year, according to Semiconductor Industry Association. China’s potential leading position has raised concerns that it might threaten the economic advancement and national securities of other countries, especially the U.S.

In light of these threats, the U.S. government has been tightening regulations on chip exports to China. Last month, on October 7, the U.S. Department of Commerce announced reinforced regulations on cutting-edge semiconductor technology exports to China. Export controls to China already existed before this new round. So what’s new this time, and why has the market been so nervous about it? Well, this new set of restrictions have been broadened substantially. First, the expanded list of restricted exports to China now includes the most cutting-edge chips as well as chips that are one to two generations behind the cutting edge. In addition, the new rule restricts the ability of Americans to support the development or production of Integrated Circuits (ICs) at China-located semiconductor fabrication facilities without a license.

The cumulative effects of these restrictions could have major implications on the industry. For example, many scientists and engineers with U.S. citizenship or permanent residency work in the Chinese semiconductor industry, including several top executives in Chinese companies. The new controls will likely force them to choose between their U.S. citizenship or their jobs.

The new rules will affect Chinese companies the most. Without new supplies of equipment from the U.S., Chinese chipmakers could be unable to expand their production lines and wind up stuck with existing capacity for the time being. Even for existing capacity, they may not be able to get maintenance services from the U.S. suppliers, which could affect the quality of the products.

The global market for wafer fabrication equipment is also expected to be hurt by these regulations. According to Jefferies, total investment value by Chinese companies in this market in 2022 is projected to be US$18 billion. This makes China the largest investor in this global sector by far.[1] However, the impacts of these new regulations on chip exports might affect around US$5 billion of Chinese investments in wafer fabrication.

American companies could suffer as well. China is the largest market for the three biggest U.S. semiconductor equipment manufacturers, accounting for roughly 30% of the revenue at Applied Materials, Lam Research and KLA Corp. Applied Materials declared the new regulations will reduce its fourth quarter net sales by US$250–$550 million, and a similar impact is to be expected for the following quarters. Applied Materials’ 2021 annual sales, as a reference, was about US$23 billion. Similarly, Lam research also warns the U.S. ban could lead to sales loss of US$2–$2.5 billion in 2023 (their 2021 annual sales was about US$17 billion).

Japan also has a major presence in the semiconductor production equipment (SPE) industry. At present, Japanese companies are not subject to regulatory constraints if U.S.-made parts and software are 25% or less of their products. This may potentially give Japanese SPEs a boost versus their U.S. counterparts. However, a regulation-induced slowdown of investment by Chinese companies could eventually diminish overall orders with Japanese SPEs.

What is the potential impact of all this on our portfolio?

While we do not invest in semiconductor manufacturing companies directly, a few companies we invest in Japan do have semiconductor equipment manufacturers as their clients.

Horiba (6856 JP) is a Japan-based manufacturer of measurement equipment. We have introduced their automotive emission measurement business in previous commentaries. Horiba is also a leading supplier of mass flow controllers, with 60% global market share. Their measurement equipment is used to regulate gas and liquid flow rates and is a key component in the production of high-quality semiconductors. Over half of the segment revenue comes from their Japanese customers, but Lam Research and Applied Materials are also among their key customers. The revenue from its semiconductor segment is over 40% of total revenue, the demand for this segment has been strong, and the company has revised up its 2022 guidance as a result. Horiba will report its third quarter result on November 11 and is expected to comment on the impact of the new regulations.

Kurita Water (6370 JP) is a Japanese manufacturer of water treatment equipment and chemicals. There is a growing need in the water treatment industry for advanced, comprehensive solutions, especially in the semiconductor and electronics manufacturing industries. Kurita is the only company in the world that has businesses in both water treatment chemicals and facilities. The company is the leading manufacturer in the water treatment industry in Japan, and over the past several years, Kurita has expanded its presence in the U.S. and European markets. As the semiconductor makers and other U.S. high-tech companies are bringing production bases home, this will present Kurita with business opportunities. There are still many uncertainties on the magnitude of this new set of restrictions and its potential impact. We will provide updates in future communications as we gain more clarity.

[1] Masahiro Nakanomyo, “Impact of Stricter US regulations on Exports to China”, Jefferies, Oct 16, 2022

Global Alpha Capital Management Ltd.
November 3rd, 2022