In the third quarter of 1994, the European petrochemical industry emerged from the recession. Demand soared, outstripping capacity and producing a supply-constrained market with double-digit price increases. Clearly, a downturn will eventually happen again. But there are signs that, with reduced demand and structural overcapacity, the next downturn may not be followed by a further upturn.

Short-term outlook

Capacity utilization—and prices—are expected to remain high well into 1996, for a number of reasons. Demand will continue to grow, driven by GDP growth and the fact that plastics are still priced competitively in relation to other materials. Current material shortages indicate that capacity utilization at the bottom of the cycle was higher than reported. Many polyethylene plants are old, their expansion potential has been exhausted, and little of the new capacity announced recently will come on stream in the next 12 to 18 months. Moreover, the impact of recycling is likely to be limited in the short term.

Tough new climate

The long-term forecast, however, looks more like a change in the climate than a change in the weather. External forces and industry reactions are conspiring to create overcapacity. As growth in demand slows and demand declines for some products, that overcapacity could become structural.

Recycling for real. Until now, the impact of recycling has been limited, but it will soon become an important factor thanks to technology improvements, national legislation, EU directives, and general environmental awareness. Recycling could dramatically reduce the demand for virgin polymers in commodity applications. We believe that recycling will limit overall demand growth in Europe from around 2000.

The impact of imports. Europe has lost ground to companies exporting from the Far East. Imports of polyethylene bags and sacks from some Asian countries tripled from 1988 to 1992, the labor cost advantage far outweighing freight costs. Some estimates suggest that as much as 20 percent of European polyolefin volume could be under threat from this source. Middle Eastern exporters have a cost advantage in plastics feedstock. Falling tariff barriers following the recent GATT agreement will increase their competitiveness in Europe, and capacity expansion projects could give them, by 2000, an export capacity of some 2 million tonnes of polyethylene and polypropylene. For LLDPE (linear low-density polyethylene), the export capacity could be as large as 50 percent of total European capacity. Even if most of these volumes will be exported to the Far East, the capacity will be a constant threat, fueling the European overcapacity problem.

The commoditization crunch. European producers will be forced to try to differentiate their offerings for the local market. However, automatic EU-wide approval with one registration will reduce entry barriers, enabling more companies to compete across the region. (Up to now each national market has had its own product specifications, and national registration has been required for each product, based on achieving approval at the necessary level in tests, for example, for long-term stress. For a product such as specialty pipe, for example, this approval process can take several years for each country.) As more players compete for market share and as formerly high-margin specialty products become commodities, specialization is unlikely to provide any kind of lasting outlet for structural overcapacity.

The dilemma of capacity expansion. The immediate reaction to an economic upturn is to add capacity. To be viable, such capacity would have to be on a world scale. If all competitors do likewise, overcapacity will drive down margins to a level where returns are far below the cost of capital. If, on the other hand, a company fails to add capacity, it will lose market share and technological knowhow; the value of its assets will depreciate; and it will no longer be a viable business. In the face of this dilemma, all too many producers are likely to take the easy path and add too much capacity in the current upturn. The result: overcapacity that will become permanent once these developments slow demand growth or even reverse it.

Umbrella strategies

If this scenario plays out, smaller European producers may be forced to leave the industry or to consolidate. Larger companies that aspire to be among the winners beyond 2000 will need to take a more expansive approach and establish positions in the growth markets outside Europe. In the near term, the Far East seems the most promising region, with the Middle East coming second; in the longer term, Russia is likely to emerge as a market with potential.

Leading European producers should use the flexibility afforded by current high margins to enter the Asian market, either on their own or in association with others. This will enable them to leverage their capacity more broadly and to maintain their technological knowhow and competitiveness. Such entry is risky and must be based on a clear value proposition. Strategic alliances with local partners may well be needed, both to obtain project approval and to master the necessary project management skills. While expanding overseas, companies should maintain their market position in Europe, and take steps to exit any poorly positioned, outdated local plants. A relentless focus on cost reductions and increased efficiency will be required.