Managing Director & Senior Partner, BCG Fellow
China’s economic slowdown has led to overcapacity in many sectors and a significant fall in the prices of many commodities. Although many businesses will regard this as a short-term, cyclical challenge—one they can weather through capacity adjustments—it may prove for others to be something entirely different. It may mark the onset of commoditization, a secular and more severe challenge for which businesses may be wholly unprepared.
Commoditization is not necessarily a death sentence. (See “Escaping the Doghouse: Winning in Commoditized Markets,” BCG Perspectives, April 2015.) But surviving it, or even benefiting from it, can entail drastic measures, such as rethinking strategy, repositioning the company in the industry’s value chain, and overhauling its operating model. Many businesses facing commoditization fail to respond with anywhere near the required boldness or speed, however. Indeed, some may not even recognize or acknowledge the challenge, let alone succeed at crafting an effective plan to address it.
Eventually, all products become commoditized. (See “BCG Classics Revisited: The Growth Share Matrix,” BCG Perspectives, June 2014, and “Adaptability: The New Competitive Advantage,” BCG article, August 2011.) A company’s optimal strategic response will depend not only on the industry’s current state but also on its likely evolution. In attempting to gauge the latter, a company must try to determine whether it can establish a sustainable position on the basis of any one of three factors: its cost position; whether, and to what extent, there are imperfections in the market that it can exploit; and its ability to redifferentiate its product. (See Exhibit 1.)
Many businesses will instinctively lean toward redifferentiating their product (if possible) or creating a cost advantage (if necessary), ignoring the opportunity to exploit market imperfections. But there is potentially significant value to be gained from all three courses, depending on how the industry evolves. Companies that have built the capabilities necessary to exploit market imperfections, for example, can succeed with relatively modest capital expenditures and a moderate level of risk, making this an attractive option under the right circumstances.
Cost-Based Advantage. Whether a company can achieve cost-based advantage hinges on the evolution of the cost curve and the company’s relative position on it: the flatter the curve, the smaller the potential for advantage in the sector. The potential for cost-based advantage is particularly limited if the process used to make the company’s product is itself commoditizing—that is, if the process is becoming available to any competitor and most of the input factors are commoditized. This situation is exemplified by such companies as IBM (which, in selling its PC unit to Lenovo, exited the laptop business) and Nokia (a market leader in the first, pre-2005 generation of mobile phones), both of which were unable to develop significant, sustainable cost-based advantage within their respective industries despite enjoying substantial market share.
In contrast, if the product is commoditized but the process used to make it is not, then cost-based advantage is possible, and low-cost producers can potentially enjoy high margins as high-cost producers create a price umbrella for the industry. Upstream oil is an industry in which these dynamics hold. A variety of technical and political challenges result in a very steep cost curve; by focusing on the right segments, players can develop a significant cost-based advantage for themselves.1 Notes: 1 Further down the energy industry’s value chain, differentiation based on cost has become more difficult. In refining, for example, it has become challenging to be a pure producer. Refining processing units are manufactured and operate at similar costs; this makes it challenging for complex refineries to significantly differentiate themselves on cost. Such refineries can, however, differentiate themselves by successfully leveraging regional market imbalances.
Exploiting Market Imperfections. The ability to create a competitive edge by exploiting market imperfections of course depends on the prevalence and nature of those imperfections. Imperfections make it difficult for companies to understand where demand will meet supply and, hence, to predict prices. This often leads to high price volatility. Players able to detect and react to such imperfections can generate significant value for themselves through market arbitrage. The window of opportunity may be finite, however, because market imperfections may disappear as the market commoditizes.2 Notes: 2 In the case of a disease outbreak, for example, the distributor of a generic medicine with the right supply rights will benefit from tight supply. As time goes by, other producers of generics will start to produce the molecules, and the abnormal profit linked to the original market imbalance will disappear. But imperfections can endure if at least one of the following conditions is met:
Product Redifferentiation. The overhaul of a product’s characteristics and value proposition can be a highly effective way to confront commoditization. Redifferentiation is often the default path of players in commoditizing markets. But companies must be wary of wishful thinking. Successful redifferentiation is possible only if a company can create a premium product that pays off, meaning the market value of the premium exceeds the company’s associated costs. Redifferentiation can be difficult to achieve in the following circumstances:
Many of these challenges are present in the case of mobile phone carriers. Although the sector has many of the characteristics associated with a natural oligopoly (such as high fixed costs, network effects, and concession dynamics), regulatory measures and consumer familiarity have promoted commoditization, with predicable results. The value of subscriptions is becoming increasingly transparent to customers; customer acquisition costs are rising; and customer loyalty is decreasing. This has forced incumbents to think about their commoditization strategies and how to avoid a race to the bottom.
For companies that are in premium positions within their respective industries, product redifferentiation is typically the default strategy for dealing with commoditization. While the strategy can work quite well for some—Starbucks, for instance—many companies will find it tricky to execute successfully. Achieving cost-based advantage or advantage through the exploitation of market imperfections may prove to be more viable approaches. We devote the rest of this article to how companies can build classical or dynamic advantage when redifferentiation is likely to fail.
To capture maximum value from opportunities to create classical and/or dynamic advantage in a commoditized industry, a company will need to deploy the right business model. The choice of model—producer, arbitrageur, or producer-arbitrageur—should be driven by the dynamics of the industry and the company’s access to value-creating capabilities.
Producer. A producer extracts its value from the difference between the market price of the company’s product and its cost of production. To maximize profitability, a producer will likely pull all available levers to decrease its cost position. These levers include the following:
A producer that successfully combines many of these levers should be able to create a first- or second-quartile cost position for its production portfolio, ensuring profitability.
The current environment, with its glut of capacity in many industries, may offer many producers good opportunities to be countercyclical investors. This holds especially for upstream oil. In the long term, the steepness of the industry’s cost curve should protect its profitability; simultaneously, current valuations of assets are discounted compared with their fair intrinsic value (at least according to some expectations regarding the likely evolution of oil prices). Recent M&A activity in the industry illustrates the opportunity for companies to exploit this situation and potentially create significant long-term value.4 Notes: 4 This strategy could, however, backfire if it turns out that the oil industry is not merely experiencing a cyclical adjustment but rather undergoing a profound shift in its nature. And such a shift may indeed be occurring. There is a plausible argument that fracking, new technologies such as horizontal drilling, and the discovery of new shale oil reserves will profoundly reshape and flatten the oil industry’s cost curve. If this happens, the classical producer response might be counterproductive for oil industry players.
Arbitrageur. An arbitrageur extracts its value from market imperfections. We describe this value as “extrinsic” because it is related not to the classical producer margin (the “intrinsic” value) but rather to price signal discrepancies. (See Exhibit 2.)
Arbitrageurs do not necessarily own production assets—and, if they do own them, it is typically as a means of acquiring information about imperfections and exploiting pricing inefficiencies rather than earning a producer’s intrinsic margin. Makers of generic pharmaceuticals, for instance, do not necessarily produce all the molecules of the drugs they package and market. (In some cases, though, they might consider doing so if it enabled them to be more reactive to market opportunities, such as sudden outbreaks of disease, or if it allowed them to take fuller advantage of short-term pricing spikes.)
In fact, what makes an arbitrageur’s business model unique is not its production footprint but rather its operating model. The key characteristics of that model are the following:
The current environment offers arbitrageurs an interesting opportunity to improve their position. Many producers find themselves challenged in their core business because their margins have fallen substantially. In response, they have opted to refocus their efforts on first- or second-quartile cost assets and sell marginal or logistics assets, such as storage facilities or subscale refineries—many of which have the potential to deliver considerable value to arbitrageurs. We have seen large oil producers, for example, selling refining and logistics assets to oil merchant-traders that are focused on extrinsic value.7 Notes: 7 Vitol, Trafigura, and Gunvor acquired refining, logistics, and distribution assets from some of the largest oil players between 2010 and 2013, a period when intrinsic refinery margins were low.
A subset of the arbitrageur model is what we call “platform” business models. Companies like Amazon and Sotheby’s are able to control the market platform itself, either digitally or physically. This allows them not just to extract extrinsic value from the market through superior market information but also to monetize value as monopoly platform holders. (Discussion of the necessary market dynamics and requirements for companies that would deploy such models is beyond the scope of this article.)
Producer-Arbitrageur. For companies in an industry with a steep cost curve and structural market imperfections—crude oil is an example—a producer-arbitrageur model should prove compelling. In most cases, however, producers do not opt to expand into arbitrageur-type models. Many of these businesses are unaware of the potential value at hand—an EBITDA margin of as much as 5%, depending on the sector and situation—which can be captured with minimal capital investment and limited risk. Many producers with good profitability are also reluctant to increase the complexity of their business model in an effort to gain access to their industry’s extrinsic value. They are typically hesitant to dedicate management attention to this pursuit and are afraid of derailing a business model that they understand well and that is extracting significant intrinsic value from the industry.
These concerns are legitimate. The operating models, cultures, and skill sets required of producers and arbitrageurs are quite different. Nevertheless, a number of businesses, including several oil companies, utilities, and pharmaceutical companies, have successfully blended the two models and are reaping substantial rewards.8 Notes: 8 Examples of oil companies include BP, Shell, and Total; examples of utilities include EDF, Engie, and Statkraft. Best practices of such companies include the following:
Commoditization is inevitable for most businesses and is happening with increasing speed. But it is ultimately survivable and potentially advantageous, provided a company recognizes and understands the challenge it faces and responds strategically, quickly, and with rigor.
Leaders facing commoditization pressures in their industry should ask themselves the following questions in order to become a beneficiary of commoditization rather than a victim: