The economics of a chemical plant: costs, prices and profit: Markets: sizing demand and forecasting price
Understanding Chemicals / Module 3: The economics of a chemical plant: costs, prices and profit Part 2 of 5Markets: sizing demand and forecasting price
Sensitivity studies keep finding selling price and sales volume to be the inputs that move project returns most, yet both must be forecast years before the first sale. This part covers the main ways to size a market, how a price is built from a floor cost and a competitive margin, and why forecasts so often fail together.
2.1 Market size is estimated from end uses, trends, economic links and other countries
Brennan offers four ways to estimate volume and advises using several, because each is imprecise.
End-use analysis starts from the customer industries. For low-density polyethylene he assumes 34% goes to film and sheet (26% packaging, 8% construction, household and farm uses), 26% to injection moulding and 40% to other uses such as cable insulation and coatings. Each segment is sized, the share LDPE holds is estimated, and future penetration is forecast against competing materials. Field surveys are costly, but errors in different segments tend to cancel, so the method is reliable.
Statistical projection fits a trend to past consumption and extends it. Products tend to follow an S-shaped life cycle: a slow initiation phase, rapid growth as bigger plants cut costs and lower costs widen the market, then maturity. Logistic or Gompertz curves describe the S; industry shorthand is an exponential growth rate. The hard part is knowing where on the curve a product sits.
Correlation ties demand to economic aggregates such as GDP, capital investment or industrial production, or to one sector: PVC demand follows building activity. Per capita comparison looks at consumption in more industrialised countries and asks how fast a developing country may follow.
Growth also stops. Brennan lists the brakes: high cost or price, technical limits, limits to equipment scale, and health or environmental concerns, which in the extreme ended the market for chlorofluorocarbons in the 1990s.
- Brennan (2020), Ch 2 Market evaluation and forecasting · pdf pp. 24, 30-34, 53-54
2.2 Price is a floor set by the best cost, plus a margin that competition erodes
Brennan, following Rudd and Watson, splits a selling price into two parts. The floor price is the lowest price that covers production cost with the best available technology and scale, plus a minimum return on capital. The margin is whatever extra the market allows. A new product can carry a large margin to repay research and risk; as rivals arrive, the margin shrinks. Both parts fall in real terms: the floor through better technology, larger scale and learning, typically by 1-4% a year, and the margin through competition, typically by 10-20% a year.
In a glut, suppliers cut towards the floor and may briefly sell below it; in a shortage the margin widens.
Where imports are allowed, the ceiling is import parity: the lowest price at which imported product can be landed. Brennan builds one for a polymer shipped from Europe to Australia. The FOB price (free on board, the price loaded on the ship at origin) is 1,200 euros a tonne; duty at 10% of FOB adds 120, freight 160 and landing charges 20, for 1,500 euros, or A$2,400 at 1.6 Australian dollars to the euro. Exchange rates therefore move the ceiling, which makes it hard to forecast.
Some products escape import competition. Liquid chlorine is too toxic to ship far, and for some products transport costs are too high relative to value to ship them over long distances, which shields local plants. Their derivatives may still face import competition.
| Element | Euros per tonne |
|---|---|
| FOB price in Europe | 1,200 |
| Duty at 10% of FOB (hypothetical tariff) | 120 |
| Freight (say) | 160 |
| Landing charges (say) | 20 |
| Landed import parity price | 1,500 |
| In Australian dollars at A$1.6 per euro | A$2,400 |
A local producer cannot sustain prices above this ceiling while imports are free to enter.
Source: Brennan (2020), Ch 2 Market evaluation and forecasting, pdf pp. 35-36- Brennan (2020), Ch 2 Market evaluation and forecasting · pdf pp. 34-36, 39
- Brennan (2020), Ch 4 Operating cost estimation · pdf p. 120
2.3 Elasticity, lead times and the investment cycle make forecasts err together
Price elasticity of demand measures how strongly volume responds to price. Brennan defines it as the fractional change in volume divided by the fractional change in price. Demand that ignores price is inelastic; demand that falls away sharply when price rises is elastic. The main driver is the availability of substitutes. Glass beer bottles face aluminium cans, so their elasticity is high. A petrol car cannot switch fuel, so short-run elasticity for petrol is low, but over years people buy different cars. Long-run elasticity is larger than short-run.
Brennan notes 2-3 years from sanction to commissioning, then several more before demand fills a new plant. Over-optimistic forecasts led to worldwide petrochemical overcapacity in the early 1980s, falling prices and closures.
Wittcoff calls this the old paradigm: overbuilding, and building at the wrong time. Rising demand lifts prices and profits, firms invest, and because plants take years to build, the new capacity arrives as demand turns. Prices fall, plants close, and the overshoot in closures sets up the next shortage. He quotes 4-5 years for a full cycle. Small imbalances have large effects: in chemicals a shortage may be only a 2-3% shortfall. When three US crackers and plants elsewhere were damaged in 1994-95, profits jumped, then fell back once repairs were done.
The forecasting record shows the bias. World ethylene forecasts underestimated demand in the 1960s, then overestimated it in the late 1970s and early 1980s, because forecasters were guided by decades of rapid growth and underrated the effect of expensive oil.
| Period | What happened |
|---|---|
| 1940-55 | Consumption grew about 16% a year (130,000 tons a year by 1946) |
| 1955-73 | About 11% a year; forecasts of the 1960s underestimated growth |
| 1973 to early 1980s | Growth sharply slowed as crude rose from about $2 to $12 (1974) and $28 per barrel (1980); forecasts overestimated demand |
| 1985-95 | Growth restored to about 5% a year |
| 2016 | US ethylene about US$660 a tonne, global about US$1,000 |
| 2018 | World production 154 million tonnes, double the level 25 years earlier |
- Brennan (2020), Ch 2 Market evaluation and forecasting · pdf pp. 33, 36-38, 55-56
- Wittcoff (2004), Ch 1 The chemical industry · pdf pp. 48-52
See it in the table
Al AluminiumAu GoldCl2 ChlorineC2H4 EthylenePVC PVCCheck your understanding
Using Brennan's import parity build-up, what landed price in euros does a polymer with an FOB price of 1,200 euros reach?
1,200 FOB + 120 duty (10% of FOB) + 160 freight + 20 landing = 1,500 euros. The A$2,400 figure is the same price converted at 1.6 Australian dollars per euro.According to Brennan, what most strongly raises the price elasticity of demand for a product?
Where a substitute exists, as aluminium cans do for glass bottles, buyers switch when price rises, so demand is elastic. Where switching needs new equipment, as with car fuels, short-run elasticity is low.In the Rudd and Watson model used by Brennan, which part of the price typically decays fastest in real terms?
The floor falls slowly (1-4% a year) as technology and scale improve; the margin falls quickly (10-20% a year) as competitors enter.