The conflict in Ukraine is a reminder of the fragility of global automotive supply chains. The March light vehicle production update from S&P Global Mobility (formerly IHS Markit automotive team) is expected to revise its 2022 forecast down from 2.6 million units (equivalent to 81.6 million). The breakdown of the downgrade will globally include just under a million units from lost demand in Russia and Ukraine; and the rest is split between 1) worsening semiconductor supply issues and 2) loss of Ukrainian sourced wiring harnesses and other components respectively. Additionally, the complete loss of Russian palladium is a tail risk that is likely to become the industry’s biggest supply constraint.

Pent-up demand reduced by about a third

Prior to the February 24 invasion of Ukraine, the global auto industry had already spent more than a year under conditions of constrained capacity, with (we estimate) pent-up consumer demand for up to 10 million units. (or 12%) above this year’s achievable production. The sudden loss of economic confidence (via high oil and commodity prices, weak equity markets and tightening interest rates) is dampening demand and could now reduce this shortfall by around a third – although that significant pent-up demand remains.

The supply chain remains the constraining factor

While macroeconomic concerns are important, the supply chain (and do not underlying consumer demand) will continue to set the upper limit for vehicle unit sales over the medium term. The main critical issues affecting production levels after the invasion fall into two broad categories: Semiconductor materials supply (notably via Ukrainian neon and Russian palladium), and electrical wiring harness supply.

Specialized hardware failures could limit semiconductor recovery

Semiconductor supply problems are worsening on two fronts: neon gas supply disruptions. Ukrainian companies control about half of the supply of high-purity neon to the semiconductor industry, where the element is used in lasers that etch patterns on chips. Our channel checks suggest the immediate risks are low thanks to semiconductor makers holding sufficient gas inventory, but visibility is poor. The second challenge is the availability of palladium, used in semiconductor plating and finishing. In an additional negative twist, China Covid-19 cases at a 2-year high trigger quarantines and factory shutdowns in northeastern manufacturing hubs including Shenzhen and Changchun. All of the above increases the risk of losses “failed” chipsi.e. semiconductors for which the “right” car cannot be built due to other constraints.

Ukrainian wiring harnesses difficult to replace

Our channel checks suggest that the cable harnesses built in the Ukraine were likely intended for around 0.5-1 minute vehicles before the invasion. These harnesses include complex, hand-built cable assemblies. Although there are some dual sourcing agreements, most of the time, switching will be difficult due to already limited harness capacity in Europe and around Europe. Production relocations could take 3 to 10 months due to machine waiting times and staff training times of several months. Almost half (45%) of cable harnesses manufactured in Ukraine are normally exported to Germany and Poland, which puts German automakers with high exposure. Our analysis suggests that VW is the most exposed (via Leoni, Sumitomo and other suppliers), followed by BMW. On the positive side, once ramped up, lost production could be quickly recovered through the end of 2022 and beyond.

Palladium: next “black swan” candidate

Although the probability is low in the current state of affairs, palladium has the potential to become the industry’s biggest supply constraint. Russia produces 40% of the palladium mined in the world according to the USGS. About two-thirds of palladium is used in vehicles, where it is the active element in catalytic converters for exhaust gas aftertreatment. If the Russian supply of palladium were suddenly interrupted (due to a Western boycott or Russian supply shutdown), production of all vehicles using such a supply (including hybrids) could potentially collapse. Stop. Although platinum is an alternative element, it is just as expensive and also largely of Russian origin. Any substitution is a regulatory minefield since design changes require regulatory re-registration, which can take months. We do not currently factor major palladium disruptions into our forward baseline scenario.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.