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. 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 (Exhibit 1). But a more detailed look shows individual companies exhibiting very different levels of activity and outcomes (Exhibit 2). 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 (see sidebar, “How we measured reallocation”).
The results show a striking correlation between more active resource reallocation and total returns to shareholders (TRS) (Exhibit 3). 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 (Exhibit 4).
The best way to allocate varies by chemical subsegment
The way in which chemical companies allocate resources varies by industry subsegment (Exhibit 5). 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 (Exhibit 6).
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.