The
nimble prosper: Dynamic resource allocation in chemicals
Crafting a strategic road map and responding
rapidly to external shocks are critical for superior value creation in
chemicals.
The global chemical industry continues to
experience massive change. In the past 20 years, North American petrochemical
production has swung from low cost to high cost and then back to low cost,
thanks to increasing use of shale gas as a cheaper input. Meanwhile, China has
moved from exotic curiosity to the world’s biggest chemical market—albeit with
squeezed profitability. And several of the largest companies are actively
restructuring, with major carve-outs and industry-shaping mergers and
acquisitions in the news.
Research by McKinsey across a range of industries has shown that
at companies where capital and other resources flow more readily from one
business opportunity to another, returns to shareholders over the medium to
long term are higher, and the risk of falling into bankruptcy or into the hands
of an acquirer is lower.1 New
research that we have undertaken in the chemical industry bears out the
conclusion that more active resource reallocation correlates with higher
shareholder returns. It also shows that the performance difference is even more
pronounced in chemicals.
Dynamic resource
allocation correlates with superior performance in chemicals
In chemicals, as in the broader sample across industries,
companies generally are slow to move resources among businesses—taken in
aggregate, the current year’s allocation of capital expenditures is
consistently close to the previous year’s allocation . But a more detailed look
shows individual companies exhibiting very different levels of activity and
outcomes . We measure the degree of resource movement for an individual company
with a reallocation score, which represents the fraction of resources that have
moved among businesses over a multiyear period
The results show a striking correlation between more active
resource reallocation and total returns to shareholders (TRS) . From 1990 to
2013, dynamic companies—representing the top third reallocating their resources
over the period—showed a 10.8 percent TRS compound annual growth rate. This
compares with 2.5 percent for low reallocators, comprising the bottom third.
Over that 23-year period, a dynamic company would grow to be worth six times
more in market capitalization than a low-activity one. Persistent reallocators
also scored higher shareholder returns than their less persistent peers:
companies that made more than 15 significant resource shifts (more than 5
percent of their total capital-expenditure allotment) far outperformed less
active peers in TRS.
Companies that are active reallocators are also more likely to
stay independent: the survival rate of active reallocators is 30 percentage
points higher than low ones .
The best way to allocate
varies by chemical subsegment
The way in which chemical companies allocate resources varies by
industry subsegment . In petrochemicals, high-volume plastics, and other
commodity chemicals, the key success factors are access to low-cost feedstocks,
operational excellence, and process R&D. As a result, executives typically
organize strategy and resource allocation around these factors, focusing on the
regions where companies produce and the value chains in which they participate.
For example, several major polyethylene players organize their reporting
segments geographically and by value chain.
The most successful companies tend to establish attractive
positions in chains where cost curves are steep (for example, ethylene, where
production costs vary significantly across the industry globally), and they are
either based in regions with feedstock advantages or can use their financial
clout or process technology to gain access to such advantaged feedstocks.
In specialty chemicals, key success factors are end-market
selection, product selection, and the scope for value add and differentiation.
Specialty companies typically organize around these factors, focusing on end
markets and product families.
For example, coatings players may organize around markets such
as architectural, automotive, and industrial. Producers active in multiple
specialties sectors organize themselves in a similar way around the different
constituents of their portfolio.
Larger diversified chemical companies, with integrated
portfolios across commodity and specialty products, balance more
dimensions—geographic selection, value chain, end market, products, and sources
of differentiation.
In some niche segments, primary performance drivers—service
level, cost structure, and competition—are regional. Examples include
industrial gases, cement, and other low value-to-weight products (such as
sulfuric acid). In these niches, strategic decision making and resource
allocation are typically regional.
Speed of response is
critical
Although resource allocation is critical to long-term value
creation, companies tend to react to—but not anticipate—shifts in the
competitive and market landscape. We see this across both end markets and
feedstocks.
For example, there were indications from 2008 to 2010 that the
rate of growth of North American shale-gas supply was so high that it could
become a competitive advantage for the region’s petrochemical companies. One
such indicator was the pronounced increase in the ratio between naphtha and natural
gas that became evident in 2009, resulting from the new shale-gas supply to the
North American market. But most petrochemical companies only began
significantly shifting capital expenditures back to North America in 2012.
Initial investments were aimed mostly at feedstock flexibility for existing
assets, with a wave of new crackers announced in 2012 and construction
occurring in 2014 to 2016. Companies that reacted first were able to secure
lower-cost inputs (engineering and skilled trades, for example) and earn
superior margins by starting production with advantaged costs earlier .
Similarly, the chemical industry’s reaction to changing economic
circumstances also shows a lag. GDP growth hit an inflection point and started
to go down in Russia in 2010 and in Brazil and India in 2011. However,
chemical-industry capital expenditures started to decline in those countries
two to four years later—in 2013 for India and in 2014 for Russia and Brazil.
It obviously takes time to reduce capital spending. Projects are
multiyear undertakings, and it’s likely there will be delays between deciding
to cut investment and actually doing so, as it is rarely feasible or desirable
to abandon an incomplete project. Second, companies are likely to wait a year
or more to make sure trends will persist: it would be difficult to justify a
billion-dollar plant without a clear line of sight on feedstock availability
and other factors. But the fact that this is a capital-intensive industry
dealing with high-price, multiyear investments only makes it even more
imperative that companies react in an appropriate and decisive way to a trend
once it clearly manifests itself.
Getting on track to do
better
So how can chemical companies do better? They must define
strategies based on their most important value-creation levers, align budgets
to those strategies, and overcome natural decision-making biases. While
conceptually straightforward, in our experience, companies encounter a range of
challenges when trying to achieve these goals.
Selecting
the right value-creation levers for the strategic road map
The first step is defining the strategic road map for the
company. It should be structured around the decisions that most drive return on
invested capital and growth, potentially including value-chain participation,
end-market participation, regional footprint, and product differentiation. This
can be challenging for some companies; failure to frame the discussion around
the right levers can hobble strategy development. For example, for several years,
one leading chemical company defined its strategy based on specific subproducts
when the most important lever was regional participation, and as a result, it
found it difficult to drive necessary decisions.
A strategic road map should lay out priorities for the portfolio
and for growth and investment, including a target business composition five to
ten years out. It should be grounded in market attractiveness (growth, returns,
sustainability of market structure), company positioning, and potential for future
advantage. This longer-term strategic road map sets the company’s overall
direction, but if the attractiveness of markets, businesses, or geographies
changes, the company should react nimbly. Over the past decade, a number of
chemical companies have been able to navigate such changes, for example,
divesting commodity businesses that were becoming subscale and acquiring new
businesses to reposition themselves as better-performing, differentiated
specialty producers.
One company that does this particularly well uses corporate-wide
categories for its businesses—its categories correspond to “rapid growth,”
“core earnings,” “sustain with limited investment,” and “improve or exit.” The
categories enable comparison across subbusinesses and establish a natural
framework for differential resource allocation.
Aligning
budgets to strategy
The strategic road map should be translated into annual budget
commitments, covering both organic investments and M&A. Businesses
identified for growth should command greater resources, and businesses that
offer limited upside should be run lean. In commodity chemicals, the most
critical resource-allocation decision is often how to assign capital
expenditure (for example, new plants or debottlenecking). In specialty
chemicals, resource allocation is often a mix of operating expenses (selling,
technical service, or R&D investments) and capital expenditures.
Companies can encounter a number of barriers in differentially
allocating resources against strategic priorities. These include the pressures
from near-term earnings and cash-flow needs, risk aversion among managers when
asked to make large bets, and reluctance to withdraw resources from healthily
performing areas to fund promising opportunities elsewhere.
Several techniques can help break the inertia. These include a
harvesting rule, where a percentage of assets (for example, 3 to 5 percent) is
identified for disposal each year; while the assets may not be divested, this
rule shifts the burden onto businesses to justify why the assets should be
retained. Another tool is to give the CEO discretion for a portion of the
annual capital budget (for example, 5 percent), allowing him or her to
stimulate resource reallocation outside the bottom-up planning process.
In addition, our work with clients highlights the power of
categorizing a portion of the portfolio as “sustain” during the annual
strategic-planning process. The “sustain” businesses could then be managed in a
lean fashion, with resources transferred to more promising areas.
Simple tests to measure how resources align relative to strategy
and resource reallocation can also provide insights. For example, when one
company compared its different business units by measuring business quality
(margins, growth, and market attractiveness) against resourcing levels
(investments in R&D and sales), it found little distinction in resourcing
despite clear differences in opportunities. An internal reallocation
metric—such as what percentage of selling, general, and administrative expenses
and capital resources has shifted among businesses over the last five
years—will also reveal whether companies are indeed following a strategy with
their budget.
Finally, companies must ensure budgeted investments are actually
realized. One challenge is gating and pulling back investments: when a negative
development affects quarterly results, there is a tendency to reduce spending
across the board. While prudent fiscal management is important, companies
should take care to preserve differential funding for growth investments. A
potential countermeasure is the regular tracking of growth-investment
deployment—not just earnings results—for prioritized growth areas.
Overcoming
bias and reluctance to change
A recurring issue is that planning and budgeting processes tend
to reflect the prior year’s allocations, with only minor adjustments
forthcoming based on recent developments. There can be a natural bias among
executives that last year’s allocation was good, resulting in a reluctance to
make dramatic shifts. This pattern also influences managers’ mind-sets—leaders
of businesses that have historically received limited investment are often
hesitant to propose bold new ideas.
To overcome the bias, companies can use “counteranchors.” A
counteranchor consists of examining data outside what is normally used in the
company’s budgeting process and using it to guide a hypothetical allocation of
resources. Examples of useful counteranchors include GDP growth rates at the
country or regional level as a way of informing regional resource allocation,
externally published forecasts of market-growth rates as opposed to internally
generated ones, and analyses of industry profit pools—estimates of the total
profit-generation potential of a given market sector. We have found that this
approach can stimulate discussion and reframe the nature of the planning
dialogue to help overcome biases and inertia.
In chemicals as in other industries, resource allocation is
critical to translating strategy into action and delivering superior performance.
Yet dynamic resource allocation remains a challenge. Chemical companies should
focus in particular on defining strategies aligned with value drivers in their
subsectors. They must also remain vigilant about identifying and reacting
quickly to changes in the market environment. The fundamental requirements of
planning—a strategic road map, budgets aligned to strategy, and overcoming
natural biases—are straightforward in theory but require well-structured
processes and decision making to achieve in practice.
About the
authors
Marja
Engel is an
associate principal in McKinsey’s Minneapolis office, Chris Musso is
a principal in the Denver office, and Jeremy Wallach is a
consultant in the Chicago office.
The authors
wish to thank Scott Andre, Gantavya Bajpai, Michael Birshan, Maureen Gaj, and
Sam Samdani for their contributions to this article.
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