Recently the economist Michael Mandel wrote on his blog ‘We have only two ways out of our current global economic mess: innovation and inflation. And as the saying goes, we should hope for the best (more innovation) and prepare for the worst (higher inflation).’ (Source: Michael Mandel, Innovation and growth, dated 26^th Oct 2011. http://innovationandgrowth.wordpress.com/)

Innovation has certainly been a key strategic focus in many corporations, and the current crisis does not alter this reality: Since ‘we should hope for the best (more innovation)’ corporations usually prepare for higher R&D costs because of some underlying trends at work for a decade:

• Increased externalisation of R&D cost in many industries (automotive, pharma, packaging, etc.)
• Shorten product life cycle coupled with greater product complexity (communication goods, FMCG, etc.)
• Longer development cycles in many industries and countries

The pending requirements to higher R&D costs are higher success rate & magnitude of these R&D operations. What does it mean? Let’s have a look at Executives requirements with regards to R&D:

• Increase productivity of R&D spending
• Minimise financial risk of innovation & technology choices
• Adapt to shorter cycles
• Create innovative products that are affordable in emerging countries
• Strengthen pus innovation internal forces

Needless to say that the role of R&D and innovation teams has changed: On top of researching & developing, R&D and innovation teams also have to reconcile discrepant frameworks (low yield & high risk vs. productive and risk-free) and timeline (long R&D cycles vs. short consumption cycles).

In other words, R&D and innovation teams must adopt multidisciplinary skills & codes (in particular, finance, marketing and strategy) i.e. ‘external’ input, since expected outcome have changed. When observing corporations we notice different models (emerging or in place): 

Obviously the choice depends on the industry, corporation size, internal capabilities, internal processes and set-up, and so on.

Whatever the model, R&D and innovation teams are a combination of people, budget and processes in a specific organisation. If now daily work goes beyond labs then this combination of budget, people, and processes is called for change:

But what about the daily work change? R&D remains about improvement and innovation for sure, but has to comply with higher success rate requirement. This means higher return, better differentiation leveraging competitive advantage. Even better, ensure it on various time scales:

So, when Michael Mandel said ‘we should hope for the best (more innovation)’ we should say ‘for more productive innovation’.

One success factor lies in R&D teams’ ability to adopt Executives language & frameworks in order to promote their innovations, improve their chances of success and their R&D performance.

And this means new practices adoption and new external collaboration to help R&D reaching its new goals.

High feedstock price is the new norm

‘Back in 2005, when oil price peaked at US$60/bbl, the community started admitting that a US$100/bbl price was a realistic work hypothesis. 6 years have passed since then, we have pushed the ceiling several times.’

This is exactly what we can expect for agricultural products too. Firstly, prices are related to oil price. Secondly, demand keeps growing (with a significant impact of biofuels). Thirdly, temporary and permanent risks upon supply & demand balance have a direct impact upon prices. Historical prices show an increase trend (circa +7% pa since 2000), with levels never seen before (figure 4).

There is a consensus that high prices will remain and this impacts the industry economics in 2 ways:

- Impact upon competitiveness vs. chemicals to be substituted (if the green chemical becomes costlier, buyers switch to petrochemicals)

- Impact upon margin levels

Questions are therefore: Which attrition can we accept? Which raw material cost burden can we handle? What can be passed over our selling price?

Figure 4: Oil price vs. agricultural crop prices (Frost & Sullivan analysis, based on IMF & USDA 2011)

Feedstock price volatility is the norm and is likely to worsen

‘Demand for agricultural commodities is quite price inelastic’ reminded the OECD/FAO in 2009.

Growing demand and more frequent weather events have impacted all agricultural commodity prices. Speculative trading also increases this volatility. The analysis of recent prices shows that price volatility is getting more frequent and has greater magnitude (figures 5 & 6).

There is no evidence that volatility frequency and magnitude will reduce dramatically in the coming years. Actually, it is a working hypothesis on many plans which points a central question: how do we address this negative factor given that:

- Cost risk increases with volatility

- And return is not certain, in particular when price peaks dissuade purchase

There is no single answer; both financial choices and industrial choices are concerned. Therefore, which mix of mitigation measures shall be adopted?

Figure 6: Palm oil & Rapeseed oil price volatility (Frost & Sullivan analysis, based on USDA 2011)

Mitigation measures: Some food for thoughts

Financial instruments have been largely used in agricultural business and remain valid risk mitigation measures to offset logistics and/or raw material costs (through swap and/or hedging). However, long term risks need upstream responses.

On top of these financial instruments, the biofuels industry gave example of feedstock diversification: For instance, Abengoa operates with barley, maize and wheat. Some plant can be feedstock specialised; other can be designed to handle various type of grains, this flexibility brings better cost resilience.

Not far from the biofuels challenges, the surfactant industry frequently faces the backward integration question, in particular with the new Indonesian crude palm oil tax raise (+25%). Not surprisingly, P&G is considering a JV in that space, according to Reuters (dated 23^rd May 2011).

The idea of (re-)organising the raw material supply is also defining the local ecosystem in the Champagne region, France. The network of companies, subsidiaries and neighbours (ARD, BioAmber, Soliance, etc.) creates a nearly circular supply system leveraging main/co/by-products: Each player takes a specific block (starch, glucose, straw, etc.).

This French example is equivalent to a fragmented bio-refinery; on the other hand, integrated chemicals platforms are also developed irrespective of the feedstock type, as illustrated by Martek/DSM (algae), Roquette (cereals) or Borregaard (wood). The use of the entire plant and the operations by building blocks certainly address some economics challenges: Value creation, operating cost, supply cost, etc.

The development of alternative routes can lead to differentiated feedstock, this way contributing to supply risk mitigation. Some companies intend to take advantage from this technology platform diversification. P&G, for instance, has ties in cellulosic chemistry (development agreement with Zeachem) and in sugar-cane-based chemistry (development agreement with Amyris).

Green chemicals feedstock plans are closely connected to technology choices. Similar to renewable energies, we probably have to build a mix of green chemicals technologies to cope with feedstock challenges. New generation of feedstock (wood, algae) are certainly seen as long range solution, Solazyme >$1billion IPO being an illustration of the hope lying in algae.

However, the economic equation remains fragile and partly depends on the equilibrium between bulk green chemicals & specialty chemicals, the former providing scalability the latter offering superior sales prices. This last point is a direct input to the ability to rapidly amortise the industrial assets, while the feedstock choice will the ability to capitalise on high conversion yields. The CHOREN bankruptcy in July 2011 is probably a good reminder that feedstock economics indeed count a lot.

Illustrations cited here can be found on Doris de Guzman’s blog: http://www.icis.com/blogs/green-chemicals/

The green chemistry industry is developing fast because of a set of 3 major trends:

- Oil progressive scarcity

- Durable high (if not skyrocketing) oil price

- Continued population & demand growth (in particular middle class)

Needless to say, the industry is growing in a context of deteriorating environment, which also has an impact upon ‘green’ feedstock.

Many players are rightfully focusing their effort on technology development but I believe that feedstock strategy is equally important to enable a sustainable business. Although the industry currently has a small footprint, there is no doubt that major challenges will remain offer & demand balance and price, both aspects being impacted by feedstock. Feedstock risk lies in security & stability challenges. The way we address those challenges will alleviate or build up further price levels & volatility risks.

Supply security risk is hardly predictable but is real

 ‘September 2018: In this repeated context of draught Governments have decided intervention actions in the agricultural market: While the USA and Argentina have stopped exporting wheat, the EU Commission has prohibited irrigation for maize. In Brazil & China, sugar cane plantation is limited to force farmers to harvest food crops.’

The scenario may be pessimistic; however the risk is real because a limited number of countries produce the key green chemicals feedstock (figures 1 & 2). Let’s consider this: 4 countries hold 51% of wheat production; Brazil, China and India bring 65% of the sugar cane production; China and USA represent 61% of maize production; 2 countries hold 80% of palm oil production.

We often witness temporary regulations (due to adverse weather event). The risk is to have tougher regulations (quota; tax; etc.) due to more structural issues (permanent water stress & repeated adverse weather conditions; misbalance between food & feed and industrial crops; reduced capacity to finance agricultural subsidies).

This supply security risk goes beyond feedstock access & predictability issues: Are we fit to face an input shortage? What is the impact on our economics if we have to face a 15% input shortfall?

Figure 1: Global sugar cane production shares (source FAO, 2011)

Figure 2: Global palm oil production shares (source FAO, 2011)

Supply stability risk is certain & real

‘2014/2015 campaign: As nearly every couple of years the major grain producing countries are facing a severe drop in harvest due to the impact of drought. The situation is particularly dramatic in China and USA.’

This scenario is not far from reality (figure 3). If we look at the past 100 years the warmest years were in 2010, 2005, 1998, 2003 and 2002. Each time there was a severe draught in at least one (often 2 or more) of the key producing regions, meaning fewer volumes produced. Nearly each time prices skyrocketed.

The agricultural output & price levels can’t be 100% guaranteed since it depends on weather conditions. This output have a nearly captive market: Food & feed industries, in a context of demand growing faster than production, remain even more the prime end markets. The risk is to see more frequent adverse events impacting/ disrupt feedstock supply. Incremental production and yield will provide a limited solution: Arable land is limited, best soils are already exploited, yield gains are less and less important.

In the end, instable volumes raise operational issues: What & where to source? What’s the impact upon logistics? Instability put our economics at risk: What’s the impact of volume/price deviation upon margins, upon cash flow?

Figure 3: Wheat production, price & major droughts (Frost & Sullivan analysis based on USDA 2011 and National Climatic Data Center 2011 data

About Food for Thoughts

That’s a whole purpose of this blog: Keep a tangible print of thoughts, some kind of idea inventories, hoping they may feed & fuel further discussion. It is food for thoughts.

Food for thought = anything that:

• Provides mental stimulus for thinking
• Put issues into perspective
• Helps identifying innovative solutions to address future challenges

About The Blogger

How on earth can a non-chemist and non-agro guy be interested in chemicals & agriculture?

Both are involved in nearly every business and have a major impact on our lives. Both are based on a lot of transversal and specific knowledge. Both are at the heart of future challenges and solutions. Both have become Loic’s main area of interest since his career start at Frost & Sullivan.

Loic is a Principal Consultant, based in Paris. He joined Frost & Sullivan in 2005 after a short experience in other consultancies. Loic holds a Master in Business from the ESCP-EAP school (Madrid, Oxford), a Master in Corporate Law from Universitat Pompeu Fabra (Barcelona) and a Maitrise in European Law from La Sorbonne (Paris).

He has been working with international companies across the global involved in agro output (Food & beverages; Personal care; Green chemicals; Biomass energy), chemicals (Green & Petrochemicals) and equipments (Energy; Industrial; Transportation).

His typical assignments are strategy & strategic marketing projects, with a strong B2B focus: Industry landscape analysis (value chain, segmentation, distribution, supply), Value proposition modelling, Scenario & business modelling (outlook, prospective, business cases), Investment evaluation (greenfield, acquisition), Portfolio modelling (feedstock, products, technologies, suppliers), Benchmark (financial, organisation, operation practices, competition)

To send questions or comments, email at loic.cesbron@frost.com