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June 17, 2014
Innovation will be critical to survival in North American chemicals.
By: Paul Bjacek

The high oil-to-gas price ratio has brought an enormous amount of chemicals and other industrial investment in North America.  However, in all this momentum, chemicals manufacturers should not miss the chance to take advantage of technology and improved business practices to prevent cost creep in construction, operations and distribution, nor should they be secure about their prospects for maintaining, let alone gaining, domestic market share. Innovation is still demanded and a lack of it can destroy the advantages gained by abundant, low priced natural gas derived feedstocks, which resulted as well from technology, in this case, fracking and horizontal drilling methods.

The recent book “Big Bang Disruption”, by Larry Downes and Paul Nunes (the later from Accenture), presents a useful model illustrating a Big Crunch period typically experienced by industries following a “Big Bang” investment period, like the North American petrochemicals investment we are currently seeing.  In fact, the effects of disruption are already clear in our discussions with industry participants, with construction costs rising, primarily from talent shortages, and distribution delays increasing, due to railroad bottlenecks and truck shortages.  These were not necessarily unpredictable and companies with a strong emphasis on foresight and learning from past experience will manage through disrupters better.

Just focusing on product innovation, it is clear to us that producers will need to be more aggressive in this area. In a recent survey we conducted with ICIS Chemical Business of chemical companies planning to invest in North America, 77 percent selected North America as a primary target for the products they plan to produce. Given the fact that several chemical segments will go into oversupply in North America, this suggests a high probability of intensive market share battles in the next two to five years.

Furthermore, the domestic North American market is becoming more selective in the types of chemical products and services it is requiring. Customers of chemical companies that are “re-shoring” are those with a focus on adding value in terms of product and/or production processes (see related blog here), so they are demanding more stringent raw material specifications and innovation from chemical suppliers that can help make final products faster, better and cheaper1. As an indicator, Figure 1 shows the surging value-added nature of US manufacturing versus China and Germany. Statistics for manufacturing value-added output over gross output can indicate the change in sophistication and/or productivity of manufactured goods. This “value-added” growth in the US relative to other regions is encouraging re-industrialization in autos, appliances, electronics and other industries, even before accounting for low cost natural gas, since these industries are significantly less dependent on energy in their cost structure (see related blog here). Therefore chemical suppliers will need to focus on innovation to serve North American customers.

Let’s take the polyethylene industry as an example. Nearly 6 million metric tons per year of new capacity is likely from expansion projects currently planned for construction in North America between 2013 and 2020. The domestic market is only expected to use 2 million metrics tons more by 2020, and new capacity announcements may still occur. North America is already exporting 2.5 million metric tons (2013) of polyethylene and the additional excess is roughly equivalent to eight polyethylene plants, without assuming an operating rate.

Producers will prefer to sell domestically, since export netbacks are generally less attractive, especially with shipping costs alone deducting 5 to 10 cents per pound from netbacks to Asia, for example. On a world scale polyethylene plant, even 1 cent per pound less realization is equivalent to an $11 million per year decrease in revenue. Therefore, significant revenue opportunities are at stake for North American producers.

All producers will enjoy the lower cost base (of gas cracking, when viewed on an integrated basis), but some announcing capacity additions have less experience and technology in the polyethylene business. Also, it is more or less conventional wisdom that a better product may not get you a better price, but it may make you the preferred supplier for a particular customer. Those producers not preferred by value-added plastics converters are likely to be forced to export, or sacrifice domestic netbacks to the point where supply and demand dictate.

We developed a cursory/theoretical view of what we term the “technology factor” against cumulative polyethylene capacity by 2020 (Figure 2), to give a starting point for understanding how competitive the market will be when accounting for the availability of “value added” or improved  polyethylene grades.  Our “technology factor” is based on how often individual patents are cited by other patents related to the same originally filed version, representing a higher industry relevancy and impact2. We used this in inverse form on the graph, showing lower as better.  About 66% of expected polyethylene capacity by 2020 will be held by producers with strong process and product technology positions relative to the rest.  These producers would be expected to meet the most demanding customer needs and their capacity is sufficient to meet the requirements of the entire North American market.  The remaining 34 percent, which also happen to sit beyond the expected level of North American demand by 2020 (17,500 thousand metric tons) on this curve, will be forced to compete on price and serve lower netback customers in the export market. This is only a theoretical starting point and it may be likely that a portion of “value-added” production will be exported, depending on global customer preferences and realizations. Some technology can also be licensed.

Therefore, based on the expected increase in competition in many chemical products, chemicals producers will need to plan in advance for new and changing market conditions. Innovation will not only be critical for products, but also business processes, such as in reducing the cost of supply chains to get product to market anywhere in the world at a lower cost. Using analytics solutions to create flexibility in supply chains is one example of doing this.

We will address supply chain disrupters further in a future blog.

1 Also propelled by greater automation, miniaturization, etc., which demand ever-increasing materials performance.

2 Patent analysis is not entirely representative of companies’ intellectual property, depending on patent filing strategies, etc.

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