Will the Chip Shortage Become a Chip Surplus?

The chip shortage has eaten its way into late 2021, and foundries are responding with enormous expansion deals. Demand for semiconductors and other advanced chips remains sky-high, especially as consumers head to stores and online retailers to complete their holiday shopping lists.

While the foundry expansions are certain to add more chips into production, the increase in chip production isn't expected to meet the current demand for at least a couple of years—as the new foundries and fab plants can't be built overnight. And before you say, "Well, thanks, Captain Obvious!" Allow me to get to my point, which is this:

What happens if chip demand declines in the coming years?

Introducing: the bullwhip effect

The bullwhip effect is best defined by the Chartered Institute of Procurement and Supply (CIPS):

"The bullwhip effect (also known as the Forrester effect) is defined as the demand distortion that travels upstream in the supply chain from the retailer through to the wholesaler and manufacturer due to the variance of orders which may be larger than that of sales."

In other words, this effect often results from improper forecasting and miscommunication between the hierarchies of procurement and supply. Let's use a simplified example, to make things clear:

A computer store sells 10 laptops a day and typically keeps 50 laptops in stock. The store usually orders 10 laptops from its distributor to replace the 10 that are sold daily. Yet one day the store sells 50 laptops and believes it to be the start of a large influx in business. So the store increases its typical replacement order from 10 laptops to 50.

Now, the distributor may see the rise in demand and order 100 laptops from its manufacturer, just to be sure supply doesn't run dry on their end. After all, what if the store continues to sell more and more laptops? The distributor doesn't want the store to have to place orders at rival distributors to fulfill demand.

So the manufacturer produces 120 laptops, just to be safe, and you can see how easily a temporary influx in demand can create ripples across the supply chain and result in overproduction of a commodity.

The bullwhip effect applied to the chip shortage

Let's apply the bullwhip effect to the ongoing chip shortage. The current consensus on the shortage is it has been primarily caused by Covid-19 and the pandemic's rippling effects on demand and supply chains. The pandemic has resulted in shipping container shortages, factory shutdowns, and heightened demand for all things electronic—due to work-from-home mandates and people being at home more often due to quarantines and lockdowns. This much we know.

And while this may be our "new normal," there is also the possibility that we clear this ongoing, "third wave" of the pandemic and begin going back to our pre-covid lifestyles: less time spent at home, less of a risk of factory shutdowns, and less of a need for consumer electronics.

But if this demand begins to decline in the coming years, will there be a chip surplus due to all of the newly built chip fabs and factories? Industry analyst Daniel Nenni believes there will be unless "there is some big boom in semiconductor demand" that extends beyond the current panic buying that's been caused by the pandemic. And this is how the bullwhip effect relates to the shortage—the current demand and panic buying of chips is amplifying the projected need for chips down the supply chain. Meaning, potentially, manufacturers are expanding capacity for a potential demand that is much higher than it actually is.

Translation? Manufacturers could be preparing to make way more chips than will be needed a couple of years from now.

Let's take a look at some of the biggest chip manufacturers and their plans for expanding chip capacity:

• TSMC: Spending as much as $100B on capacity expansion over the next three years.
• Intel: New fabs planned to be built in Arizona and New Mexico, with expanded sites in Oregon.
• GlobalFoundries: Plans to expand manufacturing sites in Singapore and New York and boost capacity at 12-inch fab in Dresden, Germany.
• UMC: $3.58B expansion project planned for its 12-inch fab site in Taiwan.
• SMIC: Had initiated capacity expansion projects in Beijing, Ningbo, Shanghai, and Shenzhen, with further plans to build new wafer fabs at each site.
• Automotive IC IDMs (Integrated Device Manufacturers): STMicroelectronics, Infineon, and Texas Instruments each plan to expand chip capacity to deliver ICs for automotive and 5G products.

It is this extreme increase in spending and capacity expansion that has created some apprehension among industry analysts, including Lillian Li, VP and senior credit officer at Moody's who has expressed her concern over these investments, saying, "These major investments could lead to overcapacity and inefficient investment allocation."

If these overcapacity concerns turn out to be true, then the following question must be asked: who will be hurt the most by a chip surplus?