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New Capacity in a Shrinking Market

Big companies are pulling out of the petroleum refining industry. In the last year, Shell, Chevron, Valero and Sunoco have put refineries up for sale or shut them down. There is simply too much capacity in the industry. But there seems to be one guy coming in through the exit doors in the refining industry. Marathon Oil just opened a new $4 billion addition to its Louisiana refinery. Further, the company announced that it made a profit in all six of its other refineries in the U.S. in 2009. 2009 was a terrible year for the U.S. refinery business. 2010 isn’t much better.

Why would anyone add capacity in a hostile market with clear overcapacity? These capacity additions turn out to be commonplace. (See “Audio Tip #103: Capacity Creep Expansion of Industry Capacity” on StrategyStreet.com.) In Marathon’s case, the company started its capacity expansion in 2007, while the refining industry was roaring along. It simply took until 2010 to bring the refinery addition online. So this addition, while large, is really the result of expansion in the good times. The new capacity shows up when times have turned bad.

But, virtually every hostile industry sees small amounts, at least 1% to 2% per annum, increases in industry capacity every year. This capacity addition is the result of companies learning how to run their existing capacity with greater efficiency and effectiveness. It is almost a free addition to industry capacity. We call this annual capacity addition, despite overcapacity, the learning curve capacity addition. We named it after the well-known Boston Consulting Group strategic concept from the early 70s. The rate of this free capacity addition depends, in part, on the rate of growth in the industry itself. The faster the industry grows, the more free capacity will come online each year due to this learning curve effect. This effect can be pernicious. In the newsprint industry, the learning curve effect added more capacity every year than demand in the newsprint industry grew. During most of the 90s, the capacity industry’s addition due to the learning curve effect outstripped the growth of industry demand. Every year, hostility got just a little worse because of it. Real prices remained under pressure the whole time. (See “Audio Tip #133: What Tells Us Prices Will be Under Pressure?” on StrategyStreet.com.)

Posted 4/19/10

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