Europe’s commodity chemical sector has again entered a downturn. Opportunities for arbitrage mean that chemical prices around the world are increasingly set on a global basis. The crisis in Asia therefore spread quickly to other regions and produced an international slump, sharply cutting global demand and prices for most petrochemical products, including all of the major plastics—notably polyethylene, polypropylene, and polyvinyl chloride. Representing about a third of total chemical sales, these low value-added, cyclical products are used for a wide variety of applications: automobiles, bottles, packaging, and pipes, to name just a few.

The current situation is not likely to improve soon and may actually get worse when new capacity that is already committed or under construction comes on stream in Europe during the next two or three years. Additional pressure is building as Middle Eastern producers aggressively expand capacity with a view to entering new export markets, including Western Europe.

Europe’s chemical industry is ill equipped to face the downturn. Most of its subsectors are fragmented, which leads to recurrent overcapacity and price wars. In both the polystyrene and the polypropylene markets, 15 or more companies compete for European sales. Vivid memories remain of the last downturn, just three years ago, when European prices for major petrochemicals dropped by up to 50 percent in five months.

Furthermore, the European industry has a number of structural weaknesses, such as subscale, nonintegrated assets and high costs for naphtha-based feedstock. Sixty percent of Europe’s high-density polyethylene plants, for example, are small by world standards, and many of them are not integrated with a competitive source of feedstock, thus putting them at a cost disadvantage. As a result, their production costs may be up to 50 percent higher than those of Middle Eastern producers, which in general have world-scale, fully integrated sites and can use cheaper ethane feedstock.

Consolidation

The only long-term hope for the European petrochemical industry is consolidation through mergers, acquisitions, and alliances. Experience in other capital-intensive sectors shows that it is possible to escape the curse of cyclicality and to achieve more consistent profitability only when an industry consolidates, with the top four companies reaching a market share of at least 70 percent. At this level, there is still enough competition to comfort the antitrust authorities but not so much that prices collapse. The worst enemy for any capital-intensive sector is the "beggar-thy-neighbor" mentality: selling at cash cost or even forging ahead with expansion in capacity to increase market share at the expense of other producers.

It is an illusion to hope that a global recovery will solve the problem: the location of basic feedstocks and the desire of regions outside Europe to develop value added locally limit the export prospects of European companies. So Europe has only one choice—namely, to restructure at home. Consolidation would allow the industry to improve its profitability quickly and substantially by capturing synergies and economies of scale that would otherwise be inaccessible (Exhibit 1). We estimate that more than half of the savings from industry consolidation would come through closing production lines—offset, in part, by expanding low-cost capacity and developing new, world-class production lines.

Although Europe’s industry is going through a wave of mergers and acquisitions, the ideal level of concentration has so far been reached only in one major subsector: styrene monomer. As many as 25 additional deals among medium-sized players will be necessary to achieve that level of consolidation in all major petrochemical subsectors (Exhibit 2). Polypropylene, polyvinyl chloride, and polystyrene are closest to the ideal state; two more large deals in each would suffice.

If mergers, acquisitions, and alliances are the means to renewed profitability in the industry, how should companies go about choosing partners? A clear understanding of the value-creating potential of alternative deal options should underlie any decision—and narrow the strategic options. We estimate that in many European chemical subsectors, no more than 20 percent of all the remaining possible deals are truly attractive.

Finding a partner

Petrochemical companies with a number of businesses should first evaluate deal options for each of them. Most costs are incurred at the business unit level, so that is where to look for value-creating synergies. Deals—that is, big mergers—can be found at the corporate level but are less likely to create value. In one recent petrochemical industry merger, for example, synergies have been found on the oil side but virtually none on the chemical side, because the partners’ businesses did not overlap.

Deals at the business unit level have another advantage, too: they reduce the potential for conflict over corporate control, a point especially relevant for small or medium-sized companies that fear losing decision-making power by merging with larger conglomerates. A deal with a rival closer to your own size may reduce this concern.

Companies can assess the potential value of any deal by considering how much scope they have to capitalize on five important value drivers, which are described below.

A rationalized asset base

By joining forces, some players may succeed in closing high-cost production lines and capturing the associated savings without sacrificing market share. The larger size of the resulting entity may give the partners enough idle capacity to transfer production from their least efficient lines to more efficient ones, which would then run at a higher capacity utilization. One or more of the remaining lines may have to be "debottlenecked," or expanded at low cost, to accommodate the production volume that has been transferred from closed lines.

In other cases, joining forces may permit the partners to replace a number of subscale units with a single new world-scale one running at much lower cost. Such units should be located within large chemical complexes (ensuring lower feedstock and operating costs) and be close to a port.

Potential partners should evaluate opportunities to rationalize their asset bases by identifying the improvements each of them could carry out by itself and then identifying additional improvements that could be achieved only by joining forces. The latter represent the true synergies accessible through a deal.

In looking for production lines to close, companies should consider several constraints. It may, for instance, be hard to close lines that are physically integrated with feedstock, so optimum candidates for closure either will not be integrated, or they will be linked to feedstock pipelines that would permit alternative uses for the feedstock should they be closed. It may also not be possible to transfer production between lines using different technologies, because the products of these lines may be highly specific: emulsion polyvinyl chloride, for example, which is used for applications such as carpet backing, cannot be made in more common suspension polyvinyl chloride lines. Finally, it may not be wise to close some higher-cost lines, since they may well be devoted to high value-added products and thus operate at above-average margins.

An improved cost position

Technological innovation and operational improvements mean that gross margins for petrochemical products will probably deteriorate over the long term, leading to a relentless price-cost squeeze. It is therefore very important to achieve better cost positions. Moreover, European players face increasing volumes of imports from the Middle East—imports that could threaten the viability of one-third of the European asset base. The history of most petrochemical subsectors shows that only players with first- or second-quartile cost positions have covered the cost of capital across the cycle. This situation will not improve in the future.

Operational synergies

Mergers, acquisitions, and alliances—in petrochemicals just as in other industries—will generate opportunities to cut operating expenses in sales and marketing, distribution, purchasing, administration, and research and development. Synergies in the first four of those categories, which account for the bulk of potential cost savings that are not related to assets, will probably be highest for companies operating in the same areas.

Such companies may share a number of customers, and this could create opportunities to cut sales, marketing, and distribution costs, even for players in different subsectors, since many plastics have partially overlapping applications and can be sold to the same customers. Companies in the same areas usually also have better opportunities to reduce their purchasing costs: because of high transport expenses, a number of important raw materials, such as olefins, are typically purchased locally, and their producers tend to be fragmented geographically.

If more than half of the capacity of partners is located in the same country, they can probably achieve substantial operating synergies

While estimating the full extent of these synergies is difficult from the outside, potential partners can assess their likely order of magnitude. If more than half of the capacity of the partners is located in the same country, they can probably achieve substantial operating synergies. If more than half of it is located in adjacent countries, potential synergies are likely to be smaller, and they will be smaller still if most of it is located in countries that are not adjacent. Of course, potential partners may succeed in reducing the cost of maintaining their corporate headquarters and research-and-development programs (from 1 to 3 percent of return on sales) regardless of their geographic locations.

Transfer technology and skills

Petrochemical players can make themselves more cost competitive and increase their market penetration by focusing on technology and operating skills. A leading-edge process technology (Union Carbide’s Unipol polyethylene process, for example) can have a cost advantage of more than 10 percent over traditional process technologies. Such leading-edge products as metallocene polyethylene and polypropylene—chemicals that make it possible to manufacture better-quality end products at a lower cost—can revolutionize markets and give their owners a strong competitive advantage.

Deals can create value on the technology side if they unite players with different (but complementary) skills and strengths

Deals can create value on the technology side if they unite players with different (and, ideally, complementary) skills and strengths. That was the rationale behind a number of recent technology-focused alliances, such as the one between Union Carbide and Exxon in polyolefins; the former excels in process technology, the latter in metallocene technology. Clear synergies exist, since a producer can tailor a process to the specific needs and opportunities of new metallocene products.

Sharing manufacturing best practices and internal benchmarks can be a major source of value, especially when a deal unites players with widely different levels of skill. A typical deal of this sort would be a merger between a large global player and a smaller one, perhaps controlled, until recently, by the state.

Vertical fit between partners

Olefins, such as ethylene and propylene, are the key raw materials for most petrochemical products. No fully efficient and liquid merchant markets for olefins exist yet in Europe, because of the traditional integration of petrochemical players and transportation difficulties, which are worsened by the absence in Europe of an extensive pipeline network like that on the Gulf Coast of the United States. Such markets probably won’t be developed in the short to medium term, especially for relatively hard-to-transport ethylene.

To reduce sourcing risks, European petrochemical companies may thus benefit from at least some degree of backward integration, for olefins. Players with limited olefin production capacity are probably in the best possible position: they can secure supplies while avoiding the temptation to undercut prices of downstream products during downturns. Players with an excess of olefins may be exposed to this temptation in order to maximize the capacity utilization of their olefin production, whose fixed costs tend to be high. Any deal that brings potential partners closer to the optimal state would strengthen them.

However, increased integration into downstream businesses like plastics processing is likely to be less valuable, for downstream markets tend to be very competitive and require an understanding of consumer markets. Also, taking a downstream position that involves expansion into a customer’s business puts companies in a potentially uncomfortable competitive position.

Is there an alternative?

Sometimes the right partner for a merger, acquisition, or alliance just doesn’t exist, or it exists but its size is intimidating. Some medium-sized and small players are reluctant to enter into potentially attractive deals with their larger competitors for fear of losing corporate control over their affairs. In the absence of any truly attractive alternative, the temptation for them is to pursue leadership in their regions or customer groups of choice. While it is outside this article’s scope to discuss the virtues and problems of such strategies, they could obscure substantial, now-or-never value-creating opportunities. If most of the industry consolidates, capturing the available synergies, the competitive position of the remainder may be substantially weakened.

To avert that scenario while preserving corporate control, medium-sized or small players could consider smaller deals with partners of a similar size, followed by a larger deal with a leading player. This is not a simple solution, and some time may be necessary between the two deals because postmerger management is difficult.

Another strategy is to negotiate alliances or deals below the level of business units—arrangements that concentrate on a single asset or a single stage of the business system. An alliance might, for example, involve an agreement to share logistics with another player on a single site. A deal could involve the takeover of one plant from another company. There are many possibilities, though their value-creating potential is much smaller than it is for deals at the business unit level because there are fewer synergies: in polyolefins, traditional agreements and alliances below the business unit level can realize no more than 30 percent of the full potential improvement. Moreover, organizing a set of deals with a number of heterogeneous partners may prove extraordinarily complex.

Nonetheless, a few kinds of deals below the level of business units could be particularly attractive to petrochemical players. Such alliances or deals may also appeal to potential partners that would like to know each other better before entering into a total merger and to players that lack exciting merger, acquisition, or alliance options at the business unit level.

1. Improving plant specialization and swapping products. An alliance for joint production planning can improve the specialization of the partners’ plants and therefore promote longer production runs and increased output for the parties involved. Such an alliance would certainly have to include an agreement to swap products as needed. For high-density polyethylene players, this approach could lead to improvements on the order of a 1 percent return on sales.

An alliance of this type poses certain dangers. For one thing, its scope may be limited by the desire of one or both partners to protect proprietary know-how. In the second place, arranging product swaps can be complex and may require repeating a lengthy testing process with some customers a number of times.

2. Orchestrating freight and packaging. Players that share a single site may outsource packaging, storage, and distribution activities to third-party service providers. The opportunity is available for noncontiguous plants too. Through standardized design and engineering, as well as superior execution, specialized service providers may have an advantage over petrochemical players in developing a logistics platform. This advantage can be amplified when a number of customers share storage facilities—an arrangement that makes it possible to capture substantial economies of scale. The efficiency of shared storage facilities is so great that the service provider may be able to pass on to petrochemical players savings as high as a 1 percent return on sales.

3. Participating in the development of a condo cracker. Large units producing the essential raw materials for the petrochemical industry are called "crackers." Building a world-scale one can cost about $1 billion. No more than two new world-scale crackers will probably be needed to satisfy the increase in European demand for raw materials over the next eight to ten years. So European petrochemical players could join forces to build "condo" crackers owned by a number of them, each with the right to use or sell a fixed amount of a product at a predetermined cash cost.

Such condo crackers would let the industry maintain an even balance of supply and demand in Europe, while permitting the partners to secure access to cheap feedstocks. As compared with the alternative—the proliferation of small crackers, leading to higher production costs and overcapacity—the benefit would be substantial for the whole sector.

This is a difficult time for Europe’s petrochemical industry, but there is hope. Mergers, acquisitions, and alliances can give some players a unique opportunity to improve their fortunes, although the number of attractive deals is limited, and in many subsectors no more than two or three large deals could be consummated before antitrust limits are reached. Players that cannot or will not contract deals at the business unit level can find alternatives that will let them retain corporate control while extracting some, if not all, of the economic benefits of more sweeping deals.