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R&D: A casualty of spending cuts


By Jonathan Yates

Lost in the tales of woe brought forth by the crash of oil and natural gas prices is the story of how the market leadership for research and development (R&D) has shifted from Europe and North America to China, South Korea and other Asian nations.

There are many reasons for this, some inevitable, some induced by the market and others from the “law of unintended consequences.”  No matter why, the end result is that expenditures from South Korea, China, and others on overall R&D is rising.  South Korea spends more than 4% of its gross domestic product on R&D, while the U.S. only spends 2.7%.  China spends just over 2%, while the European Union spends only 1.94%.

The trends in R&D spending tell an even greater saga of a shift in product innovation.

Even though it commenced nearly a decade ago, the impact of The Great Recession is still being felt on R&D spending.  While economic growth declined in the European Union and the United States during The Great Recession, Asian economies rose. This was especially true in China and India.  And when the economies of the two most populous nations in the world, about 40% of those living on the planet, were growing, so did their neighbors’.

China is also shifting its economy away from being export focused to propitiating domestic consumer spending. Critical to China’s increasing consumer spending is bulking up its transportation sector.  The more planes, trains, motorcycles and automobiles in China, the greater the need for fuels and lubricants.

As with anything and everything, the law of unintended consequences has reduced the amount spent on R&D, especially in the United States.

This had to do chiefly with low interest rates, which result in more mergers and acquisitions, as it is easier to finance a deal.  Debt is cheaper, whether in the form of a bank loan or corporate bond. Due to low interest rates, mergers and acquisitions were at a record high in 2015.

The largest acquisition, USD 70 billion, was made by Royal Dutch Shell of BG Group PLC. The 10th largest deal last year, USD 32.6 billion, was made by Energy Transfer Equity LP for Williams Co., the pipeline operator.  Schlumberger Ltd., the world’s largest oilfield service company, acquired a rival in the sector, Cameron International Corp., for USD 12.7 billion.

When two companies merge, R&D is one of the areas cut first.

This improves the bottom line in the short term as expenditures are reduced.  From that, profits increase in the short term.  It is not a particularly wise strategy for the long term, however, as a market-leading position can easily be lost by reducing the innovation pipeline.

At present, this is taking place with the merger between Dow Chemical and DuPont, which both have massive R&D departments.

In an article in Fortune magazine by Chris Mathews, “The Death of American Research and Development,” it was noted that, “In the eyes of many investors in the U.S. today, however, it is the large research departments that are holding them back.”  Activist investor Nelson Peltz forced out Ellen Kullman as CEO of DuPont, in large part due to her support for heavy spending in R&D.  “What Kullman defended as a commitment to science and solving the world’s big problems, Peltz saw as empire building that DuPont’s investors could ill afford,” Mathews noted.

While it is difficult to pin down exactly what R&D spending is, there is no neat phrasing required by law for companies to report, certain outcomes can be measured.

For economists Ashish Arora, Sharon Belenzon and Andrea Patacconi it is the share of publicly traded corporations whose scientists publish in academic journals. The findings of their study released in 2015 revealed a disturbing trend for the future of R&D in the U.S. corporate sector. They found that by 2007, just 6% of publicly traded companies were publishing research in scientific journals, down nearly two-thirds from 1980.

For many in the investment community focused on short-term results, that decline is looked upon favorably, especially when reduced spending is needed to make corporate transformation work by improving the bottom line. Studies have shown that more than half of all mergers do not meet their objectives.  Some say it is as high as 80%.  When a merger or acquisition fails, for whatever reason, the impact can be devastating.

The USD 12.1 billion acquisition of Petrohawk by BHP Billiton in July 2011, the world’s largest natural resources company, is instructive.  Primarily known for copper, BHP Billiton endeavored to become a “Big Oil” firm too, lured by the twin siren calls of rising fuel prices and growth in Asia over the last decade.  This would allow for it to provide “one-stop shopping” for commodities to China and other Asian countries.  As so often happens, BHP Billiton overpaid, not just once, but several times, for American oil and gas assets.  It bought Petrohawk when oil was around USD 90-100 a barrel.  It also bought bought natural gas holdings in the Fayetteville Shale in Arkansas that same year from Chesapeake Energy for USD 5 billion.  At that time, natural gas futures were nearly USD 4.15 per million Btu. Natural gas futures are now trading under USD 2.

BHP Billiton has desperately tried to peddle many of its oil and natural gas assets it had acquired, but so far, there have been no takers.  Failing at selling these assets, the company was forced to slash dividends and “…plans to reduce its already bare-bones operating budget even further in 2016 due to depressed oil and gas prices.”

It is from the operating budget, the yearly spending for production-associated costs, that income is generated to pay for R&D.

Overspending in the billions as BHP Billiton has done in the past will eventually show up in reduced R&D outlays, where R&D spending has been falling steadily since 2008 and is now one-fifth of what it was then.