Impact of ownership structure along the value chain in the manufacturing business

11 May 2016

In the chemical and petrochemical industry, it is quite common that the manufacturing of a final product is the result of several consecutive steps which can be owned and operated by one or many participants. Although not always practical, equal ownership among all partners along the value chain is often recommended as a way to simplify business structure, ensuring all partners share equally in the ups and downs of an uncertain market. In contrast to this approach, there are instances where more benefit can be derived from having different owners and operators along the value chain. Examples which are common practice in the industry are the supply of utilities (e.g., electricity), feedstock, and services. In these cases, the nonintegrated approach offers value as: It provides the operator of the upstream or utility plants the opportunity to specialize, for example, by operating very similar plants around the world. Such specialization enables the use of regional operating centers, minimum onsite cash costs, optimized operating conditions, minimized energy consumption, and the optimal use of other variable cost parameters. This article shows that if outsourcing results in a cash cost saving by an upstream operator, the benefit to the downstream owner will (in financial reward) be proportional to the cash cost saving achieved. In absolute terms, the magnitude of the benefit is moderated by the size of the downstream capital investment (The bigger the downstream investment relative to the upstream investment, the smaller the impact of the saving on the economics of the downstream company). As a “utility provider” an upstream operator benefits from lower risk in terms of offtake and market price uncertainties. Such owners benefit from a lower cost of capital, and as such also have lower return expectations than players further along in the value chain (who are exposed to all the uncertainties in volatile markets). This article shows that the positive impact of such benefits to the return of the downstream partner is directly proportional the difference in return expectations between the upstream and downstream company. Once again, the absolute magnitude of the saving becomes more substantial as the ratio of upstream capital investment increases relative to the downstream capital investment. Economy of learning may also enable a specialized upstream company to obtain an asset at a lower capital than a less specialized downstream operator. This article shows that the positive impact of such a benefit is very similar to that of a lower return expectation by the upstream company.