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The chemical industry in 2025: Welcome
to a new world
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The
chemical industry, with a key role to play in modern society, has delivered
consistently better returns to investors than several other industrial sectors,
both upstream and downstream to it.
But
that is the past. Will the future be any different? Will the chemical
industry in 2025 be dancing to a very different tune? These are questions
McKinsey, a consultancy, has attempted to answer in a recent article, and its
conclusions are not reassuring.
First,
some perspective. The global chemical industry has, over the long term,
generated total return to shareholders (TRS) that has outperformed the market
as a whole. Within the industry, both commodity and speciality chemical
companies have shown similar performance, though diversified companies have
somewhat lagged. This runs against a popular notion that companies in the
business of speciality chemicals – immune to the shocks of commodity cycles
and far removed from the volatilities in oil & gas prices – are a better
bet from an investment perspective.
Reasons for robust performance
There
are several reasons for the industry’s robust performance, but productivity
gains, a consolidated industry structure and strong demand growth top the
list.
Over
the last few decades, the chemical industry in the developed world has
invested significantly in improving productivity of production and management
processes. Just as importantly, and unlike in many other industries, it has
been able to keep at least some of the gains so realised for itself, instead
of having to pass it on to demanding customers.
A
lot of this capability has to do with the consolidated structure of the
industry, at least in some segments, which has allowed companies to bargain
from a position of strength when it comes to sales to customers or purchases
from suppliers. Mergers & acquisitions (M&A) – by strategic players
in the industry and, more recently, private equity investors – have played a
key role in this and the process is ongoing.
But
the pivotal reason for the strong performance of the industry has been robust
demand, driven essentially by China. Over the last two decades, demand from
the country has represented more than three-quarters of global incremental
demand and served as a strong incentive for capacity builds in the country
and elsewhere in several chemical value chains. It has allowed producers in
North America, Western Europe and Japan to grow even as their domestic
markets were static or even shrinking; supported a vibrant export-oriented
industry in several countries of South East Asia (Korea, Taiwan, Singapore);
and provided large projects in the Middle East (mainly in basic
petrochemicals) a ready outlet for their sizeable surpluses over small
domestic demand.
Early signs of reversal
But
McKinsey believes this golden period is about to end and that early signs of
this reversal in fortunes are already visible. Take TRS for instance. The
value generated by the industry since 2011 now lags the overall market,
bucking the long-term trend. Furthermore, the industry’s return on invested
capital has flattened and in some chemical sub-sectors, decreased –
indicative of the pressures on margins.
Why the change?
The
main reason for this change is the highly competitive environment in several
parts of the industry, thanks to the emergence of several new entrants. The
emergence of North America as a new petrochemical centre, for instance, has
intensified competition in petrochemicals and brought a new low-cost producer
to take on well-entrenched players in the Middle East. US suppliers of
ethylene, using shale gas as feedstock, have a cost structure as good as
those running on cheap ethane in Saudi Arabia – unthinkable a decade ago!
The
build-up in manufacturing capacity in China, in particular, has been
staggering. In several fine and speciality chemicals, for instance, China has
gone from short to long in less than half a decade. The ramp-up, once
technology has been mastered, spurred by availability of abundant cheap
capital, has sent ripples across global markets. The build-up has been
innovative – it has circumvented feedstock constraints by deploying alternate
routes using locally available resources; and overcome technology acquisition
problems by indigenous efforts involving partnerships with academic &
research centres. No better example of this than the use of cheap coal in the
northern and northeastern parts of the country to make olefins, polyolefins
and several other chemicals.
The
second factor that could slow growth in the industry is demand. China is
settling to a new normal of GDP growth – still impressive, but lower than the
double-digit numbers seen for more than a decade. Per capita chemical
consumption is now decoupling from economic growth, and the
infrastructure-driven boom is over. While there will be qualitative shifts in
the chemicals consumed – especially speciality chemicals – the quantum in use
will be on a lower growth trajectory. This mirrors a trend seen in more advanced
economies that have passed through this phase of China’s growth, and
eventually settled to a sedate pace driven by services.
The
shift to a circular economy, involving a greater recycle of plastics and
lesser diversion to landfills, will impact demand for virgin thermoplastics,
in particular. The trend, emerging from the developed world, will percolate
to the developing where concerns of sustainability, pollution and waste
management, are rising. Government regulation will be the stick that will
drive the pace of adoption of recycling efforts, but user industries will
also have a role.
McKinsey
estimates that the last decade’s growth of 3.6% per annum in petrochemicals,
may decline to anywhere between 0.5-2.0% per annum for the next decade,
depending on assumptions for GDP growth. With the annual capacity creep in
the petrochemical industry expected to be in the range of 1-2% per annum, and
new centres of production emerging (in Iran, for instance), this marks a
dramatic shift that could adversely affect the profitability of high cost
players.
Other
sectors of the chemical industry will also not be immune from these dynamics.
The agrochemicals industry, for instance, is changing dramatically – impacted
by developments in agricultural biotechnology (genetically modified crops,
high performance seeds), and environmental regulations restricting use of
conventional agrochemicals. The pharmaceutical industry has put the
blockbuster model clearly behind and biological drugs are increasingly
replacing small molecules made through traditional chemical transformations.
The skillsets needed to compete in the former are very different from what
exists in the chemical industry, and not easy to acquire.
Shifting models of growth
Traditional
models of growth are also seeing shifts. Value creation by moving downstream
into specialties has long been touted as a way to sustainable and profitable
growth, but this is now being challenged.
Vast
swathes of the speciality chemicals value chain have been commoditised, and
the universe of true specialities that deliver a compelling & unique
value proposition to a customer or an industry is shrinking by the day. This
is evident from the consolidation efforts ongoing in the speciality chemicals
industry. Aside of the agrochemicals and pharmaceuticals, where innovations
still lead to new chemical entities, one would be hard pressed to name a
single chemical blockbuster developed in the last ten years.
While
the markets of India and China still have headspace for growth, the appetite
for premium products is still limited, and too many are vying for a piece of
the pie.
Digital
technologies – especially e-commerce platforms – could hasten the pace of
commoditisation in the chemical industry, as they have done in several
others. The chemical industry is very early in the adoption of digital
technologies and yet to benefit from the productivity gains, value creation
or market expansion opportunities it potentially offers, but Internet
platforms such as Alibaba could quickly threaten margins.
A very different future
If
just a few of the above-mentioned trends gain significant momentum, the
industry will face a future very different from the past. Surviving and
thriving in this new world will require the industry to equip itself with the
right strategies, capabilities, portfolio, scale, geographical spread and
business structures. The industry will need fewer new builds and most
investments will either replace existing assets or will need to displace
others. Only the fittest will survive. More restructuring will be needed,
including through M&A, especially in China, to combat fragmentation.
By
2025, the centre of gravity of the chemicals industry will be in Asia and
markedly towards China. Companies that have aspirations beyond their shores
will need to have a China strategy to participate in its growth story, but
even those who do not will need to tackle the impacts that its industry will
have on them.
Opportunities
in India – unlike in most other places in the world – will continue to
expand, but so will the competitive environment. Finding profitable and
sizeable growth opportunities will increasingly become challenging.
Welcome
to a new world.
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RAVI RAGHAVAN
CHWKLY 21MAR17
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