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Chemicals and capital markets: Regional differentiation

Sep 17, 2023 | Public | 0 comments

After decades of outperformance, the global chemical industry now trails the broader stock market. This is due, in part, to challenges specific to each region, as well as to a slowdown in innovation. At the same time, the performance difference in TSR between well-performing chemical companies and those that have lagged behind has risen significantly in recent years. The difficulties facing these underperforming companies require bold actions.

In our annual review of chemicals capital markets, we explore these regional challenges, success factors, and actions that industry executives can take to bolster competitiveness.

The importance of regional variations

Following post-COVID-19 highs, 2022 and early 2023 saw major market corrections across all sectors. Even against this backdrop, the chemical industry has underperformed compared to the broader market in the last two years. The sector fell about 3.7 percent per year in terms of TSR, as compared to the broader market, which has shown modest gains (driven by a rebound in early 2023). This is in contrast to the long-term trend of chemicals outperforming the overall economy—a TSR of about 10 percent, compared with 6 percent from 2002 through early 2023 (Exhibit 1). These gains were achieved mostly in 2007–12, in 2016–18, and then after the initial COVID-19 shock. As we have outlined in a previous article, this was mostly driven by three factors: growth in Asia (especially China), improvements in functional excellence, and the one-time positive shock of unconventional feedstocks such as shale gas in North America.

The chemical industry underperformed the world index over the past more than two years, following a trend of overperformance.

The picture is not uniform. For the past 20 years, we have talked about “the global chemical industry.” This concept is predicated on interconnected supply chains, a free flow of capital (financial, intellectual, and human), and globally equilibrated energy prices.

The last five years (and 2019–22, in particular) have shown that these foundational assumptions may be shifting. Supply chains and markets are becoming more localized; tailwinds for globalization are weakening in many places; and stark energy-price differentials have changed the dynamics of the industry. Further complicating the situation is an increasingly self-sufficient China, historically an important export market, especially for European chemical players. Therefore, a careful examination of the global chemical industry requires focusing on regional challenges to better understand market dynamics and the factors that underpin performance (Exhibit 2).

In the past decade, value creation has largely been propelled by China and North America.

Europe

The European chemical industry stands on a strong foundation and a long history of financial outperformance. However, as we outlined in an earlier article, forces impeding the growth of the industry have accelerated. First, the energy landscape has changed. Second, China, one of the most important export markets, is becoming increasingly self-sufficient. Third, regulation is becoming increasingly complex. And fourth, the structure of the labor force may be a constraint (age, cost, and rigidity). These factors have increasingly made selected chains less competitive globally.

Some companies are open about limiting their investments in Europe. Industry data confirm a lack of investment—and even an idling of capacity—in areas where Europe has traditionally been strong (for example, specialty polymers).

Even before some recent profit warnings, a 2020–22 TSR of –12 percent per year (before a small rebound) suggests that investors may be factoring in these challenges. As we will outline later, the fundamentals are likely to erode further unless companies pursue meaningful changes, raising questions about the long-term competitive position of and investment in the European chemical industry.

Japan

Over the past two decades, Asian economies such as China, South Korea, and Thailand have become more self-sufficient in chemicals. As a result, Japan can no longer rely on its privileged position to supply its neighbors to maintain growth. Given high energy and transport costs, Japanese players are on the right-hand side of most major petrochemical cost curves (meaning they are uncompetitive on global export markets). For supply security reasons, many Japanese companies maintain high levels of inventory and working capital, further depressing capital efficiency. Additionally, Japan has many of the same demographic and labor challenges that the European industry experiences, such as an aging, higher-cost workforce.

Asia outside of China and Japan

The Asian market besides China and Japan is too large to ignore. It accounts for about 10 percent of the capitalization of the global chemical industry. The region has benefited from strong economic relationships with the United States and Western Europe; geographical proximity to the Chinese market; a young and increasingly well-educated workforce; and a low-cost feedstock position (for some countries) stemming from proximity to hydrocarbon resources in or around the South China Sea.

That said, there are regional differences:

  • India. The Indian chemical industry has the highest TSR in the world over the past 20 years (albeit from a much smaller base than other major regions; even today, China’s chemical market capitalization is six times larger than India’s). National champions have matured, and domestic consumption has experienced continuous growth. Although Indian chemical companies have been more active regionally, export data show that the industry still primarily serves the domestic Indian market. In the future, continued growth may require competing on a global scale.
  • South Korea. Economies such as South Korea are typically global leaders in the production of chemicals for the semiconductor and electronic-materials industries. However, their overall chemical-industry profitability and TSR have been dragged down by high cost-base assets that serve the domestic market. On a landed-cost basis, imports from North America continue to be competitive in the South Korean and Taiwanese petrochemical markets because of differentials in energy, feedstock, and labor costs as well as operating efficiency.
  • Thailand. Thailand has benefited from low-cost Asia-sourced feedstock over the past several years. Thai chemical companies have successfully moved downstream and remain critical participants in a number of supply chains.

The United States

The United States has some long-standing advantages—notably, low energy and feedstock costs, a large domestic market, and a skilled workforce. However, there are some challenges on the horizon. Similar to Europe’s situation, exporting to Asia may become less interesting as the region (and importantly China) becomes more self-sufficient. Increasing natural gas exports place rising demands on US energy sources. In specialty chemicals, rethinking of supply chains and competition with China have made select inputs critical bottlenecks.

US industry profitability softened in the second half of 2022, following a strong 2020–21 period. Full-year consensus projections for revenue and EBITDA do not forecast a quick rebound and are roughly flat for 2023, resulting from higher feedstock prices and potential demand destruction from inflation.

China

The Chinese chemical industry has outperformed the global industry over a 20-year period. Before the decline in 2023, it was the only region with positive TSR in all timeframes (20, ten, five, and two years). Long-term TSR tells only half the story. Between 2002 and 2022, China accounted for almost 25 percent of the increase in global industry market capitalization. Furthermore, Chinese companies contributed close to 50 percent of all value from new companies added to our data set in those years as companies that were previously state-owned enterprises or private have been listed on the public markets (through initial public offerings and other new listings) (Exhibit 3).

Chinese companies contributed 47 percent of all value from new companies between December 2002 and May 2023.

In almost every major chemical sector, from polyurethanes to coatings, there are at-scale Chinese players competing in both domestic and global markets. Productivity metrics such as revenue and profit per full-time equivalent (FTE) still lag behind those in many of the other regions as labor costs equilibrate.

Middle East

The Middle East accounts for a relatively small portion of the chemical market capitalization (3 to 4 percent), but this leaves out the important state-owned enterprises and private companies in the region. Still, the industry’s strong TSR performance over the past few years cannot be ignored. The significant value creation is a result of two factors: a domestic push to monetize resources by participation in downstream value chains (notably, petrochemicals and plastics) and a push from Asian and European specialty chemical companies to increase supply security and source more basic chemicals from the Middle East.

What chemical companies can do to improve performance through a regionally differentiated strategy

The TSR gap between the top and bottom quintile widened significantly from December 2020 to May 2023. Whereas top-quintile companies have enjoyed TSR growth of almost 20 percent per year, bottom-quintile companies are losing close to 20 percent of their shareholder value every year.

The challenges outlined above are structural and will require more than incremental solutions to address. Returning to value creation will require undertaking larger, more aspirational transformations; allocating capital more boldly and decisively; and reestablishing true sources of differentiation through M&A, footprint, and rethinking innovation.

Pursuing larger, more aspirational transformations

The current macro environment combines a set of headwinds for the chemical industry that are more negative for some chemical businesses than those felt in 2008. In mid-2022, many customers built up their inventories in response to supply chain uncertainty. Now that demand growth is stalling in many end industries, from consumer goods to construction, customers are destocking before placing new orders. Additionally, increased margin pressure in times of inflation and rigid capacity structures in many value chains are forcing chemical executives to refocus on cost leadership. This raises the imperative for aspirational transformations that address costs from a holistic perspective rather than incremental savings in the current operating model.

For many companies, there is ample potential to reduce their cost base. On a global basis, companies stagnated in productivity performance before 2021. Revenue and EBITDA per FTE is down 4 percent per year (in USD) since the aftermath of the 2008 financial crisis (Exhibit 4). In all regions, productivity growth has slowed down markedly compared with a decade before.

EBITDA per full-time-equivalent employee fell 4 percent per year in the aftermath of the 2008 financial crisis.

EBITDA per FTE is an imperfect measure because it reflects commodity cycles, inflation, currency effects, evolving geographical footprints, and a shift to contractors rather than employee labor. Nevertheless, we see interesting regional variations in the productivity data. The United States saw a significant increase in productivity between 2002 and 2012, likely driven by the rise in shale gas output. Since 2012, the United States has experienced productivity growth at a much slower pace. Europe, starting from a similar place as the United States in 2002, has had more modest productivity growth through 2012 and sluggish productivity growth in the last decade. Starting from a low base, China has had consistent productivity growth over 20 years but remains at roughly half of US levels. Although the data are imperfect, Japan and the rest of the world have been stuck in “productivity purgatory” for the last decade.

The favorable macro environment of recent years hid weaknesses in productivity. Today, cost leadership has become paramount, especially in the most challenged regions. In the second half of 2022 and first half of 2023, many leading chemical companies have restructured, often much faster and more extensively than in the past. They have pursued several approaches, including the following two:

Radically rethinking the role of corporate functions. One multinational chemical company sought savings by designing fit-for-purpose G&A functions that distinguished between its specialty and commodity businesses. This company leveraged a low-cost “backbone” for finance, legal, HR, and IT to support commodity businesses. Management made selective investments in differentiated functions to support specialty businesses as needed, with a clear service catalogue that reflected the true cost basis.

Rolling out digital-first operating models. Advances in technology combined with high labor costs and skill shortages (especially in Europe and Japan) across the industry are making digital-first use cases compelling. Common applications in the chemical industry include both employing sensors, machine learning, and advanced analytics to improve throughput and lower downtime and optimizing energy efficiency.

Additionally, there are many opportunities to leverage technology to optimize commercial functions. Leading chemical companies are increasingly seeking online and digital customer-service channels that both lower costs and increase customer satisfaction. Furthermore, like many companies, chemical players often spend a significant portion of G&A expense to support internal reporting that could potentially be addressed with digital tools.

Changing resource allocation to be bolder and more decisive

Some players are in the enviable position of having globally differentiated businesses, a position in which further investments into gradual improvements can yield above-average returns. However, most companies will have to fundamentally reallocate their capital and human resources, addressing structural challenges through large strategic shifts and a regionally differentiated strategy. There are two steps that executives in the chemical industry could consider as they assess their companies’ starting positions.

Creating transparency and encouraging more autonomy and accountability for performance cells. One leading specialty chemical company broke down its entire portfolio from a few publicly visible business units to more than 50 “value cells.” (A value cell in a specialty chemical company might be broken down by region, business unit, and segment—for example Europe, catalysts, or automotive.) With this increased visibility, senior management could differentially manage by current performance (return on invested capital), by trajectory (revenue growth), and by specific competition. This granular view facilitated more-targeted performance management and capital allocation as the company embarked on its next strategic horizon.

Taking a fresh look at where to deploy human capital. One chemical company shifted 25 percent of its workforce to the region where its key segment showed highest growth. Another company built an engineering workforce in India to provide high-quality, lower-cost services for its businesses around the world.

Reestablishing true sources of differentiation

Long-term value creation and outperformance requires more than cost leadership and a bold capital-reallocation process. True leaders not only invest where necessary in their current business but also regularly redefine their companies and position in the industry.

Rethinking value chain positions. Evolving economic circumstances are forcing chemical companies to look more closely at the regional and value chain exposure of their assets and to make hard choices about the future of specific plants or even business units. One leading chemical company evaluated its global footprint for competitiveness over the next ten or more years. This included assessments of energy use, feedstock, human capital, and domestic and export competitiveness. The company also addressed natural capital, such as exposure to storms and access to process water. The assessment resulted in some radical portfolio moves, including shifting the company’s long and short positions in several value chains and switching from “make and sell” in one region to sourcing externally from another.

Of course, this also requires a thorough evaluation of supply chain options at every step, carefully considering the trade-off between efficiency, resilience, and reliability. Core levers include redundancy and dual sourcing of critical raw materials, as well as the optimization of supplier and production networks (with a focus on nearshoring).

For certain European players with heavy exposure to energy-intensive base chemicals, a reevaluation could lead to a pivot to more specialized areas further downstream, a recalibration of the production footprint, or significant investment in sustainability innovation. For US players, a move toward more national independence in selected core industries (for example, semiconductors) could require a buildup of local capabilities for the chemical industry. While many of these transformations can be achieved through dedicated organic investments, some may require M&A.

Leveraging M&A in new ways. M&A can be a catalyst for a variety of value-creating strategies. It can not only realign a company’s position and exposure to certain value chains but also accelerate the sustainability strategy, strengthen strategic positions, and close fundamental capability gaps. Our prior research has shown that a programmatic approach to M&A is the most successful, and this also holds true in the chemical industry.

A leading downstream company conducted a thorough strategic review and identified areas in which parts of its business lacked scale in specific core regions. After evaluating more than a dozen potential targets to close this gap, management focused on a specific opportunity to launch the next phase of its strategic journey. While some companies have the target landscape and time to incrementally build their portfolios, others will likely pursue large-scale M&A to drive a step change in positioning and value creation potential.

Doubling down on fundamental innovation. Transformative innovation that once characterized the chemical industry has become a thing of the past. One way the industry can return to its innovation roots is to focus on innovation in sustainable substances that can underpin the energy transition. While there has been some success in recycling and new materials to support the energy transition, much of today’s research and development is limited to application development. This dynamic reflects a truth that is not lost on chemical executives. Breakthrough innovation is difficult, slow, and often expensive.

While it is still early, high-throughput design of experiments, combined with machine learning and generative AI, could radically accelerate molecule discovery. In pharmaceuticals, these tools have produced two main benefits: they have directed researchers to unexpected areas, yielding surprising results, and have focused researchers’ time toward areas in which physical experiments are likely to have the most promising results. We think the successes in life sciences using these tools can be replicated in the chemical industry. Indeed, it is likely that they will become standard practice in the chemical industry of the future.


Regional challenges have created a new dynamic for the global chemical industry. Underperforming companies have an opportunity to overcome these hurdles by pursuing more aspirational transformations, making bolder resource allocation decisions, and reestablishing true sources of differentiation.

The post "Chemicals and capital markets: Regional differentiation" appeared first on McKinsey Insights

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