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$200 billion and counting: How to separate profit from risk in times of plunging oil prices

By Walter Baker, Jorge Postigo and Georg Winkler
$200 billion and counting: How to separate profit from risk in times of plunging oil prices

Capturing all the potential value from oil price volatility depends on how companies manage and implement a new approach to pricing.

The price of a barrel of crude oil has tumbled more than 50 percent from its high, with analysts offering mixed predictions on its future evolution. This price plunge is likely great news for the global consumer, who is seeing reductions at the gas tank and in home heating bills. However, for the chemical industry and many other industries that rely heavily on oil or oil-related products, the picture can be less rosy.

We estimate that in the chemicals and petrochemicals value chain, the drop in oil prices creates $200 billion of value at stake for industries who know how to react. But despite the fact that previously reliable business models are now turned on their head, many companies have been slow to react and adjust. Some are missing out on the untapped pool of value, while others are feeling helpless as they watch their fortunes slip away.

Price pressures and windfall profits

Chemical and petrochemical companies are feeling enormous pressure from customers. Many procurement teams are demanding immediate price reductions from their chemical suppliers. However, given the nature of the supply chain and inventory levels, in many cases the effects of the cost reductions for chemical manufacturers do not happen immediately. Thus when salespeople agree on price reductions, they are not only giving away the upside from the potential future reduction in raw materials costs, but often they are in fact destroying value by reducing prices (and therefore margins) without a reduction in costs at the same time. So companies in these industries are in a tough dilemma: their customers are expecting prices to go down across the board, while at the same time shareholders are expecting a windfall profit. Adding to the pressure is that this is a once-per-industry-cycle phenomenon that current “business-as-usual” commercial processes are ill-equipped to handle.

All this instability and pressure mask the reality of an estimated $200 billion in potential profits. Without a coherent plan of action, however, oil & gas, chemicals, and oil-dependent companies can expect the value to slip between their fingers. Companies should call on their crisis-management skills to protect as much value as they can. While the steady drop in oil price may not seem like a crisis in the traditional sense, it most certainly necessitates immediate action to protect the value at stake and provide guidance to all critical stakeholders—including customers, employees, analysts, and investors.

Key questions to consider:

  • Have price expectations already been set? If so, how? What concessions or promises have been made—if any—to customers and distributors? What has the sales force received in return for those concessions from customers?
  • How much value is at stake in terms of risks to, and profits for, the business? What are the opportunities?
  • How should companies organize themselves to capture these opportunities? What are the concrete actions to take while the window of opportunity is still open?

Five steps to protect and capture value

  1. Communicate clear “rules of engagement” and positioning to the frontline commercial team
    Most customers are not asking if prices will be going down, but rather when. For those customers who operate under indexed contracts, this will happen as per their contract. But for the remaining customers, companies must think carefully about how to adjust pricing and consider the many variables for doing so. For example, what happens with reserved capacity if you lower prices? Or how will a price adjustment—or even an anticipated price adjustment—affect order accuracy if, for example, customers withhold orders in anticipation of a price drop? This can have major implications on the supply chain and increase cost, which can be passed along. To set customer expectations around these types of questions and avoid making poor pricing commitments, leadership must provide immediate guidance to the frontline on revised policy changes and expected behavior. 
  2. Focus on where the value is
    Consider developing a heat map that defines the value at stake by customer and by segment, and highlights potential areas of risk. This in turn makes it easier to clarify priorities, and to decide how to tailor responses based on the “hottest” sections of the map. The heat-map analysis should provide insights into where there is room for price changes, where the company needs to stand firm, and what opportunities new pricing can open (e.g. ending the relationship with less-profitable index-contract customers, or cultivating relationships with different sectors and industries that would benefit from lower pricing.)
  3. Establish a “war room” to execute against the opportunities
    Line organizations, such as sales and supply-chain functions, manage day-to-day relationships with companies and are not architected, nor do they have the incentives, to respond quickly to significant shifts in the marketplace. For this reason, establishing a commercial war room is important since it enables senior management to take control and make both rapid and informed decisions to avoid margin loss.  A war room can be a physical space or a virtual one, and comprises a dedicated team of cross-functional senior decision-makers who have a mandate to take appropriate quick action. So when price-change requests from customers begin to come in, the war room can act as the central clearinghouse to evaluate each request against priority customers or opportunities (using the heat map for guidance), provide both direction and guidance with strong argumentation points for negotiations, and identify the actions to take for each unique customer scenario. That said, war rooms are not a long-term solution, especially when the market is stable. For this reason, major shifts in the marketplace are an opportunity to consider beneficial organizational or procedural changes that are often overlooked under normal circumstances.
  4. Coordinate price moves with procurement
    If pricing adjustments are not timed carefully, value can easily go right out the door. Depending on the inventory levels of raw materials and both intermediate and finished goods, it can take multiple months for the oil-price effect to pass through the value chain. While the raw material spot price might be low, cost of production can lag and still be significantly higher, with cost of sales lagging even further. Getting price adjustments right requires a clear understanding of how the value from an oil-price reduction is passed through the value chain. Accurate timing is necessary to stay ahead of changes in cost and to capture opportunities for margin expansion or simply to avoid margin destruction. It’s important to coordinate with procurement, supply chain, and manufacturing leaders to understand the impact and timing of cost decreases, and implement the cost relief when it makes the most sense from the standpoint of cost structure and inventory management. Regularly tracking the raw material spot price, the cost of production, and the cost of sales should be a core function of the war room.
  5. Set expectations with distributors and investors
    Communicating proactively can be immensely valuable in both reassuring distributors and investors and demonstrating that you are a shaper of events rather than just a reactor to them. Prepare talking points and key messages for distributors and investors. If there are pockets where you want to hold value, it is important to communicate your position to your distributors so they understand the implications. If they capitulate too quickly or reduce prices too much, it becomes harder to preserve value. Some companies may see their stock prices plummet largely due to investors’ lack of understanding of what’s happening. Those companies in particular will benefit from taking a clear, definite stance on pricing and clarifying their position to the market.

No one can accurately predict the price of crude oil, although the recent history suggests we are entering a period of significant volatility. Those companies that acknowledge how radically things have changed and move quickly to address the new situation, stand the greatest chance of claiming value by setting prices rather than just reacting to market pressures.

This article originally appeared in ICIS Chemical Business

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