A few weeks ago, there was this great post in The Column, a good newsletter to subscribe to if you are interested in chemicals, and it got me thinking about commodities versus utilities. Essentially, a question was posed of where value in chemicals gets derived and this statement popped up:

That's probably why economics professors and titans of industry argue that commodity chemical production is akin to a public utility, just to a lesser extent.

It’s been bugging me since I read it. In chemicals we often put businesses into two different buckets, but these buckets exist on a spectrum:

Commodities
Specialties

The commodities bucket is stuff that typically far upstream and close to oil derivatives. The price is often globalized and there are some private indexes such as S&P Global and ICIS that everyone agrees to be the truth. We can think of ethylene or xylenes as being commodities and then one step away from these commodity chemicals are the products that are produced such as polyethylene or terephthalic acid and are also essentially commodities. For the most part terephthalic acid or polyethylene produced in the US is the same as the stuff as produced in SE Asia or South Africa or Belgium. These chemicals’ value is not location dependent and anyone with the capital and willingness to enter the market can do it.

A lot of chemicals and polymers are commodities. We can think of Nylon 6,6 as being a commodity or polyethylene terephthalate or even polyaramid (Kevlar). These synthetic polymers, if you make them correctly, have only as much value as the customer can create through conversion into a finished good. Some of them are even traded like actual commodities in places like the Dalian Commodity Exchange. There might be differentiation amongst the grade, purity, or melt flow index, but for the most part it’s all the same stuff and it’s mostly interchangeable (when comparing a specific type and grade of polymer to another).

When it comes to specialties the best way to think of this is where there is IP protection via a patent, some sort of trade secret, or “magic” that a company has when it comes to their products. Thermosets have often found themselves in this area wherein how the monomers are made and “finished” in the reactor can play an important role in how they might work for a customer. Often, thermosets are custom made for specific customers or specific producers have very unique offerings that you just cannot get anywhere else. Polyurethane foams are a great example, and we don’t need to look any further than mattress companies.

Casper, Purple, Nectar, and more are all selling you polyurethane foam in some way, but how those foams are produced and formulated makes them a specialty. Commoditization can happen to specialties where there is too much supply and a “race to the bottom” on price occurs, but you could tell the difference between a Casper and a Nectar if you slept on one (I should know because my wife and I just sent our Casper back and got a Nectar instead).

Utilities

When we think about utilities, they are often in the form of some basic public service that we consume such as electricity, natural gas, potable water and sewage, and garbage and recycling removal. Electricity that gets to our homes and places of commerce is essentially the same if it comes from solar panels or a natural gas powerplant. The externalized consequences of how the electricity is generated is different, but from what we can tell it still charges our iPhones the same. Having no electricity would be devastating, but the business is essentially a government approved monopoly. If you live in California, then you probably have PG&E and all its associated problems:

Maintenance of the grid or lack thereof causing massive wildfires).
Extreme demand during heat waves and rolling blackouts
Probably more localized issues

The market isn’t free so it’s not like you can “switch” to a better provider like you can for your cellphone. There is only one electricity provider in town and what you get is what you get.

I think there are some benefits to this model such as relatively low prices, good regulation, and stability. In a lot of ways rail transport is a form of transportation utility because if we actually had a rail strike modern life would grind to halt in a few days. I see aspects of the chemical industry here in utilities wherein delivery of the chemical and/or polymer is critical for the economy to keep functioning. You might be thinking, “But Tony, with this reasoning then food production is also a utility, right?”

Food production, even now, is quite fragmented and crosses regions quite easily. Growers of sweet potatoes in Georgia are not the same as growers of sweet potatoes in Kansas and a drought in one state does not mean there is a drought in another. We can transport (by rail) sweet potatoes across the country quite easily. Plus, if there was a national shortage on sweet potatoes, I think we could probably get by on butternut squash and all of the other potato varieties available. Food production is simultaneously very local and coupled with the strength of supply chains that span the continent so I can still enjoy avocados on my tacos here in New England. Here is a good paper on Milk As A Utility from the Yale Law Review from 1933 and I think some of the reasoning still holds water today (I’m having my Goodwill Hunting Moment right now):

Two characteristics almost invariably are found in connection with any business regulated as a public utility. First, it supplies some common necessity, so that the public generally is dependent upon it. Probably all the businesses mentioned above, and many others, have that characteristic, in varying degrees. Second, its method of operation is such as to attain its greatest efficiency as a monopoly. Corporations supplying gas, electricity and water are not more essential than those supplying coal or flour or gasoline, but a distinction can be based upon their manner of doing business. A gas company, an electric company, a water company, a common carrier, a telephone company or a radio broadcasting company, because of the common interests it serves and because of the manner in which it operates, tends to become a monopoly through a bitter and expensive competitive struggle. It is a matter of experience that grain elevators, warehouses, stockyards, grist-mills and cotton-gins frequently manifest the same tendency when located in a community which is greatly dependent upon them. In the past the same evils have not been experienced relative to common businesses such as the grocer, the baker, and the butcher, who require a comparatively small outlay to do business, and until the advent of the chain, those have displayed no tendency towards monopoly.

Too Much Consolidation —> Path to Utility

Right now, what I’m seeing in the chemical industry is an overall move to “purer play” companies that are focused on a few end markets. Conglomerate companies such as the old GE allowed for investors to own diversity within a singular entity and downsides were typically offset by upsides somewhere else. Dow and DuPont were diversified chemical conglomerates but are now completely different than they were just five years ago. Dow became the commodity focused business while DuPont retained the specialty business. But this isn’t just in the US, it’s a global issue wherein global supply of a critical chemical might be distributed amongst 3 or even 2 large companies that dominate that end market.

We are in a cycle of consolidation because there is no more low hanging fruit to pick from a product perspective. A laser like focus on short term profits and returning cash to shareholders today as opposed to years from now means that consolidation or changing your business is the only way to keep your shareholders happy. It’s why DuPont is getting out/got out of the nylon business. It’s a commodity and the margins nylon once commanded is no longer possible.

The public doesn’t give a shit if nylon or polypropylene are commodities or utilities or specialties. They just want to know that when they click “order” or go to the store, the stuff they want better be available and the complex supply chain that enables it all better be working. Also, there is a general expectation that either costs will go down or value will go up, ideally both occur.

In a sense, we are approaching a situation (not there yet) where some chemical companies could be a utility, but it would be a mistake. If anything, having a government sanctioned monopoly in something like polypropylene or rubber making would make these systems of production more fragile and discourage new entrants into the market seeking to disrupt the poor management of incumbents. What level of efficiency would be gained by allowing monopolization or utilization to occur?

Already, we are seeing a new wave of chemical start-ups maturing and seeking to disrupt and innovate using old tools in new ways or using new technologies to re-invent those old tools. I hope they have enough cash to get through the coming contraction cycle. If these companies can succeed (I’ve written about a few of them in this newsletter) then it will help blaze a path for new entrants and we start another growth cycle in chemicals again as we did in the Post WWII era.

Tony

The Polymerist

The Utilization of Chemicals