Downward Spiral - It is clear that the world is currently experiencing the most severe manufacturing recession since World War II. Overall in OECD countries, manufacturing went down well over 10% compared to 2008 while growth even in emerging countries is sputtering. The chemical industry, which provides raw materials and components for most downstream activities, has been hit faster and harder. At some point in 2009, global volumes even dropped 30- 35% in parallel with substantial price reductions.

This downturn is unprecedented in terms of its volatility, variability by region, and lack of visibility: this article will look to answer two key questions facing chemical industry executives:

1. How deep and long will the downturn be?
2. What is the best strategy to adjust your business to these volatile market conditions?

The Impact of The Downturn - A Fiery Mix

With the economy stabilizing, attention has decidedly moved to the timing and nature of the inevitable upturn. Various shapes are being invoked. Many observers meanwhile suggest a v-shaped recession with the upturn at hand. Still, we could revert to a w-shape, a first upturn that would quickly fall back before final recovery. For the chemical industry we might even see a u-shape - a recession with some time of depressed demand before the upturn, or a "bathtub" or l- shape - a drop in demand with no upturn in sight. Whatever the eventual path, when weighing the options, executives should consider three aspects that make the current downturn different from previous ones.

Recession Combined with a Financial Crisis

Comparing 122 slowdowns, the International Monetary Fund (IMF) has found that "normal" recessions reach their trough typically within three quarters and usually recover in another three quarters (fig. 1). However, today's recession combines a financial crisis with a global and synchronized drop in demand. These less common double-edged recessions generally take six quarters to reach bottom, and another four to six quarters to revert to previous demand. Putting the start of the recession in the 4th quarter of 2008 would mean an end to the recession by early 2010 and a full recovery by late 2011.

Balance-sheet Recession

Importantly, today's downturn is different from previous recessions in another way. Most post-war recessions followed a pattern of rising inflation, monetary tightening to counter these and a slowdown in response to higher interest rates. Unusually, today we are experiencing a balance-sheet recession, where demand is more fundamentally impaired as banks and households in many countries try to repair their financial position. This follows a period of unprecedented credit abundance, which ended in the collapse of the credit and housing markets. Building on the boom-and-bust phenomenon of this recession, we calculate that the current drop in demand could last into 2010, with a return to trend taking as long as six or seven quarters, i. e. until late 2011 or early 2012. A full recovery to (inflated) pre-crisis levels would not even be reached before 2014. Indeed, historical evidence show household balance-sheet adjustments take three to four years to settle.

Global Response

While the above assessment would not give much hope for the near future, an encouraging factor is that governments around the world have taken bold steps to stimulate their economies, and have done so in an unprecedented coordinated fashion. Such actions have undoubtedly round off the sharp edges of the recession. Of course when such measures wear off, it remains to be seen whether the economy can hold its own.

Balance-sheet Recession in the Petrochemical Industry

An intriguing feature of petrochemical industry performance since the 1970s is the predictability of its growth. Looking at eight basic commodities, global volume has increased annually with 5.4% from 1974 until 2000, with surprising consistency. Over the same period, prices have fluctuated but on average have increased some 3.5% per year (fig. 2). This can be seen as a direct effect of the world GDP growth following the globalization of the economy post-1989, and we regard it as the sustainable rate of volume and price increase for the world.

However, evidence of a bubble is clear from the unprecedented increase of petrochemicals pricing between 2000 and 2008, partly supported by the rapid price increase of the crude oil and gas. Interestingly, this price increase has had a negligible effect on supply, which actually grew at a lower rate of 4.1%. This means, in the last eight years end customers have purchased predictably more of the same goods, but at significantly higher cost. The ability to pay such prices has, obviously, been fuelled by cheap credit, implying a deterioration of end customers' balance sheets.

Between October 2008 and now, both volume and price have dropped, offering customers an opportunity to start repair their balance sheets.
Based on recent prices and volumes, we calculate that full mitigation of the "overpayment" for chemicals in the boom times suggests a return to the "sustainable trend line level" sometime in 2012, with new growth starting in earnest in the course of 2010 (fig. 3). Note that a return to the "inflated" revenue peak of mid-2008 will only be reached again in 2014.

Business Reactions

The current demand slump - despite today's cautiously positive signs - may well be more protracted than the typical recession we have experienced in the past 25 years. As the demand slump drags on, businesses are increasingly forced to reconsider their company structures. And in doing this, executives are wise not to postpone the inevitable. Only by staying profitable will businesses remain agile, react to changing market circumstances and be well positioned for the inevitable upturn.

Indeed, we have seen many firms taking action, reducing cost and restructuring to adapt to new circumstances. This cannot be a one-size-fits-all exercise. While some businesses see a general drop in demand, others have seen sales plummet in specific segments, with milder effects in other areas. In today's market circumstances, Arthur D. Little believes businesses should frame its actions based on two measures, as shown in figure 4:

• The level of profit improvement needed; and
• The level of market dislocation experienced, i. e. the extent to which business circumstances have permanently changed.

Taking into account only the necessary profit improvement for the company as a whole overlooks the inevitable asymmetry in how the business is affected. In our view, it is vital that business teams develop a clear, quantified perspective of which parts of their business portfolio will be long-term affected, and of which parts the drop in demand is more temporary. Although general, across-the-board cost-cutting measures are sometimes in order, in most cases executives should want to reduce costs forcefully in structurally distressed businesses, while leaving mildly affected businesses able and ready to benefit from the coming upturn.

Conclusion - Challenging Times Ahead

The chemical industry, like other industries, should expect another challenging year ahead. To formulate the right reaction, each business has to come to terms with the nature of the current downturn, one that, more likely than not, is going to be more protracted than any other recession in the past 25 years.

Just One More Thing...
Brandi Schuster asked Edouard Croufer, director, Global Chemicals Practice Leader at Arthur D. Little, for his insight on the affects of the recession on the chemical industry.

CHEManager Europe: What lessons should the European chemical industry take from the recession?

E. Croufer: Of course, as a vital part in the supply chain to automotive, construction and electronics, the chemical industry is affected by a recession. That said, the industry was in relatively good shape going into the recession. However, even independent of the recession, there has been a global rebalancing of demand. This is the root-cause of the problem and the key to the solution, and forces the European industry to rethink its strategy. Having previously supplied emerging markets with chemicals on an export basis, the building of emerging market capacity leads to overcapacity in Europe for some time to come. The industry will have to be innovative to use this capacity differently either directing it to emerging markets or creating products more desired locally. Companies should learn to serve emerging markets, particular China, to benefit from good business circumstances there.

Many companies have reacted to the economic crisis with measures that yield almost immediate results - spending cuts and headcount reduction. How disciplined do you think the industry will be in implementing changes in business processes - and even in behavior and thinking -that calls for long-term commitment?

E. Croufer: Companies have been surprisingly disciplined with the reaction to the crisis. Generally speaking, companies have a more difficult time implementing business process change than reacting to short-term needs for cost cutting. Arthur D. Little believes that the most successful companies are those that not only keep cost in check, but also invest in a number of long-term, global trends that determine demand in the future: the drive towards a sustainable planet; the increase of global population and wealth, particularly the emergence of a large, global mid market segment in developing economies; the need for transparency; and the importance of innovation in making both affordable luxuries as well as providing solutions.
We also believe that there are large sources for further optimization of optimization "outside the fence." Chemical companies have spent the last decade optimizing their own processes "within the fence." Now, looking over the fence, there are many local and regional cluster opportunities particular in Europe that can help the industry achieve further cost optimizations relative to competitors farther afield. However, this requires a cultural shift towards balanced partnership -the industry isn't there yet.

What do you think the European chemical industry landscape will look like after the predicted full recovery in 2011?

E. Croufer: We believe full recovery may take more time than perhaps predicted or hoped for. Many consumers in Europe and the U.S. as well as many companies, including banks, have come out overleveraged from the long economic boom ending in 2007. History has shown us that on average, economies need four years to pay down debts and reach a new equilibrium. Until that, end-consumer demand in the developed economies will remain weak, or weaker. It is vital, though, for European chemical companies to build on one key strength: proximity to high-end, sophisticated markets where sustainability, and the innovations needed for that, is in high demand. Sustainability comes naturally to European players, given the continent's history in that area and a political context that will drive the issue forward.
Consequently, we see the European chemical industry getting out of the crisis stronger and fitter to play the leadership role that they have always played. Competences are there and chemicals are more than ever a part of the solution, not part of the problem.