In hardly any other sector do companies find themselves exposed to such a fierce price competition as in the chemical industry. In order to strive for the goal of profit maximization and to establish themselves on the market in the long term, chemical producers are entering a direct and exhausting competition. In this competition, manufacturers set their prices based on their manufacturing costs and constantly try to minimize them so they can reduce their own product prices and undercut the competition with regard to their prices. Industry experts are almost unanimous in their view that direct competition is not necessary in many cases, in which only a few companies will prevail in the long run.
In this blog post, we explain which factors influence chemical prices and how chemical companies circumvent the commodity trap through a pricing strategy.
Pricing Problems: Volatile Environment due to High Crude Oil Dependency
It is no secret that there is high price volatility in the chemical industry. However, only a few people are aware of what causes this volatile environment. In order to understand why chemicals are subject to recurring price fluctuations, it is necessary to take a look at oil production. Around 96 percent of all organic chemicals are largely produced from crude oil.
In the past, the Organization of the Petroleum Exporting Countries (OPEC), controlled the production of crude oil as the sole monopoly power. OPEC suspended production temporarily to prevent saturation of the market and to be able to maintain consistently high prices. With the increasing demand for crude oil, new companies have been founded. Since other companies also participated in the sale of the crude oil, OPEC was not able to push up prices by throttling supply anymore. To prevent decisive market shares from being lost to the competition, OPEC was forced to adjust prices in line with market developments from 2014. In contrast to OPEC’s oil reserves, however, tight oil reserves are very limited. In many cases, half of the peak output is reached in the same year that production is started. In addition, the economically independent U.S. companies are repeatedly accused of collusion. As soon as OPEC reduces its prices due to the sale of oil, the majority of U.S. companies cease production until OPEC raises their prices again.
The dependence of chemical producers on the fluctuating price of crude oil has a considerable influence on the pricing of chemical products. Price changes on the crude oil market promptly lead to changes in the pricing of chemicals such as ethylene, propylene, naphtha and LPG.
The Commodity Trap: The Competition for the Lowest Price
In addition to their high dependence on crude oil, chemical producers are exposed to high competitive pressure as a result of their chosen pricing policy. In 2013, the EPP Pricing Platform investigated price formation in the chemical industry and came to a devastating conclusion: „60% of the chemical companies indicated that a dedicated price optimization strategy is a ‚must have’ business initiative. And today companies are still suffering to determine the right pricing method for their solutions.” (Pricing Maturity Survey, EPP 2013)
Basic chemicals such as inorganic and petrochemicals are characterized by a low possibility of differentiation and a price-sensitive clientele. Therefore the most obvious pricing strategy would be cost leadership, which, however, can only be regarded by only a few as profitable and sustainable in the long term. Companies whose strategy is price leadership also run the risk of stepping into the commodity trap. A commodity is a product that has lost its differentiating features from the customer’s point of view. The counterpart to commodity is a speciality chemical that is characterized by unique characteristics and therefore it is having a much higher significance for customers. Once a product is regarded by its customers as a commodity, it becomes difficult to convince them of the opposite.
There are three decisive factors that can lead a product into the commodity trap and reinforce each other:
1. customers — price-sensitive customers whose purchase decisions are exclusively based on price
2. competitors — in particular new competitors leading to substitutes and oversupply
3. technological progress — technological achievements favor the production of standardized and less complicated products
Realignment: Value Pricing as a Way Out of the Commodity Trap
The commercial company Deloitte examined in the context of a study, how chemical companies bypass the commodity trap and determine for their products the correct price. As a result of the study of the cost structure of basic and speciality chemicals, Deloitte found that speciality chemical producers charge a higher profit margin than basic chemical producers do. This is possible because suppliers of speciality chemicals are less likely to be in direct competition, as their products are usually highly specialized and customers are willing to pay a higher price because of their special nature. Such products not only have a higher chance of establishing themselves on the market, but usually are less subject to price fluctuations because their relative share of crude oil costs is lower.
Therefore experts advise companies whose products have a high differentiation potential to resort to a value-oriented price strategy. Value-enhancing properties of the product or additional services do increase their value from the customer’s point of view and allow greater leeway in pricing. At the same time, however, this presupposes that the companies deal with the research of their products and the integration of new structures. In addition to the further development of products into speciality chemicals, express deliveries, ISO certifications or technical support would be steps towards differentiation and away from the commodity trap.
For many companies, especially small and medium-sized ones, cost leadership will prove to be an impasse in view of the fluctuating crude oil price and high competitive pressure. In addition, although the above factors allow cost savings, they limit product differentiation. Products from companies pursuing such a strategy run the risk of falling into the commodity trap. In many cases it is therefore advisable to consider changing the price policy strategy and specializing in speciality chemicals. In the area of speciality chemicals, volatility is less pronounced due to adequate prices. The result: Buyers enjoy constant prices and manufacturers can make higher profit margins.
Originally published at https://www.chembid.com.