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Chemical Makers Grapple With E-commerce
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February 26,
Volume 79, Number 9
CENEAR 79 9 pp.23-30
ISSN 0009-2347

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Electronic commerce may affect chemicals' bottom line in reduced costs, pressure on margins, and more financial risk management


To say that last year was a bloodbath for the dot-com world is an understatement. And those that had emerged for buying and selling chemicals were not immune to what is called the "dot-bomb" syndrome. Several--including Covalex, e-Chemicals, and fobchemicals--first shifted strategy, then closed down. However, while the dot-coms suffered, brick-and-mortar companies accelerated their own proprietary efforts and joined together forming product- or industry-based networks for e-commerce.

ONLINE TRADING Enron Online operates the largest e-commerce website for physical and financial commodities.
Courtesy of Enron
Back in the real world, as opposed to the virtual one, chemical companies began facing extremely tough conditions toward the end of 2000 and into this year. The industry is plagued by high oil and gas prices, weakening end-use markets, and pressures on margins from the inability to raise prices much above production costs. Companies continue to look for ways to reduce costs and improve profitability.

"If we look at the opportunities in e-business and find ways across the supply chain to reduce a cost or improve a value even by an incremental amount, the payoff can be huge," says Bill Gaughan, e-business and information technology vice president for Bayer's polymers and chemicals divisions.

E-commerce in chemicals is opening up new and varied business channels, divided largely into public and private marketplaces and exchanges. Private websites run by single companies focusing on customers do much to protect seller interests in maintaining prices, margins, and customer relationships. Larger networks among chemical firms are expected to streamline interactions for contractual relationships and the large proportion of intra-industry buying and selling. Public marketplaces or exchanges, which tend to be buyer-centric, have taken on procurement issues, auctions, and spot market trading.

Drivers behind e-business include lower costs for transaction processes and products, greater convenience, increased efficiencies, improved inventory management, better information exchange, and greater reach either to suppliers or customers. Companies say they anticipate, but have yet to prove, that there will be new business opportunities and increased market share through e-business initiatives. Early adopters should benefit the most before e-commerce becomes an established way of doing business.

Significant sales volumes are expected to move to electronic channels in just a few years, chemical producers say. But whether this represents any real market gains or is just a shift in selling patterns is uncertain, as is the ultimate impact on the bottom line. Chemical industry analysts point out both the costs involved and the expected challenges, risks, and threats to the industry.

The speed and efficiencies of e-commerce are expected to reduce costs, but these savings must ultimately be passed on to customers, suggests Sergey Vasnetsov, research analyst with Lehman Brothers. Companies can also save on raw material and other supply costs through improved procurement and lower pricing. But just as chemical producers are achieving these savings, so too will their customers want to drive down their own costs.

The net effect on margins, Vasnetsov and other analysts concur, will be negative, and it is estimated to be a decrease of a few to several percent, although the magnitude is still uncertain. "I think it's pretty clear that you're going to lose more on sales prices as compared to how much you can save on raw materials, simply because you are selling more specialty products compared to what you are buying," he says.

 THERE COULD be a more grave impact, Vasnetsov suggests, on industry profit cycles. E-commerce is unlikely to change prices in the troughs where they are constrained by feedstock and production costs, he believes. However, falling prices would decrease the peak heights. The peaks account for a disproportionately large portion of profits and average return on investment across the industry cycle. Looking at historical data for ethylene, this average return is about equal to the cost of capital and anything lower, he notes, would be an unacceptable return.

"E-commerce represents a 'flattening' and thus a threatening long-term trend," Vasnetsov says. "And some companies are better positioned than others to adjust." Several companies, such as Dow Chemical, DuPont, and Eastman Chemical, are considered early leaders, with the rest described as "early followers" and "reluctant observers." The last group contains a majority of U.S. commodity and diversified firms. E-business approaches are not mutually exclusive, Vasnetsov offers, suggesting that companies pursue, at the least, the defensive routes, such as e-procurement, and also offensive and opportunistic strategies, which include new business models and venture investments.

Chemical industry analysts see specialty chemicals as the most threatened by e-commerce. As more deals are transacted on the Internet, especially trading in public exchanges, pricing is expected to become more visible or transparent. Prices also may become more volatile as the Internet helps disseminate market information faster and wider, and speeds up the rate and number of transactions. Commodity chemicals already are traded largely on price, whether online or offline, and there's little left to be wrung out. But specialties, where added value may be real or perceived, may see price erosion.

"Specialty chemicals can be priced on a value-added basis, but if there's a ready market that's online, it may be hard to say that my product has superior qualities to another, and I may be forced to sell at the market price," explains Jim Walker, senior analyst with Forrester Research. "Maybe I still can charge a certain premium, but that premium's going to be measured against the market benchmark price, and I may not be able to get as high a margin as I could have when prices were hidden."

Suppliers are rightfully worried that online market information will help buyers squeeze prices, Walker comments. Specific tools such as online reverse auctions, in which a buyer takes bids from multiple sellers, have met some resistance from sellers wanting to avoid this form of price competition. Anonymous trading through exchanges also strips away brand identity, and standardized product descriptions in online catalogs can eliminate distinguishing characteristics.

"Chemical companies hope that they can differentiate their products, and don't want to be in commodity businesses," Walker says. "Their initial response is that they're not producing a commodity, although, when talking further, they recognize that it's much more of a commodity than they thought." But, he adds, there are "gradations" of products, and more specialized products can exist alongside commodities online. "But they'll have to be more responsive in terms of price to the commodity market."

 MOUNTING PRICE transparency and what's being called the increased "commoditization" of products are expected to have at least two effects. One will be in how producers respond with changes in marketing products. The other will be in the ability of producers to use information in their negotiations and to manage price risk in trading of commodity chemicals. Chemical industry exchanges see the trading of online financial risk management tools as their endgame.

Although many chemical dot-coms have struggled, relatively speaking, some chemical exchanges have prospered. What's more unique about these ventures is that they've stuck fairly close to their original business plans. Three have emerged as the leading sites for online chemical trading--ChemConnect, CheMatch.com, and EnronOnline. Shell Chemicals announced last fall that it would create a neutral, commodity chemicals exchange. Mark Hurley, the company's vice president for hydrocarbon procurement and products trading, has said his firm is talking with potential partners on a business model, investment plan, and technology platform, and is expected to launch something in the second quarter.

ChemConnect boasts 8,000 companies from 125 countries as members on its exchange, double what it was a year ago. More than 100 firms are corporate members, meaning that they make a trading commitment to the site, and 33 of those have invested in the dot-com. During 2000, it raised more than $105 million. Its world chemical exchange was launched in late 1999, followed by a commodities floor for qualified users in October 2000. By the end of 2000, trading on an annualized basis had reached $2 billion, says Linda Stegeman, ChemConnect's senior vice president for marketing. CheMatch has also seen growth and claims more than 700 trading members, a nearly sixfold increase from a year ago. Since its commodity trading exchange was launched in February 1998, more than 1.8 million metric tons of materials have been traded, worth more than $500 million altogether. Transactions today are averaging $500,000 each, the company says.EnronOnline--operated by Enron, a commodities trading and energy producing company with $101 billion in annual revenues--has the largest online commodity exchange, which it launched in late November 1999. In just over one year, more than 620,000 transactions have been conducted, at a notional, or speculative, value of $395 billion as of Feb. 5. A significant number of transactions per day are conducted with the chemical industry, including the physical trading of aromatics, methyl tert-butyl ether, and methanol, and financial trading in polymers, olefins, and aromatics, says Douglas S. Friedman, director for Enron Global Markets.

Enron differs from ChemConnect and CheMatch in that it is a "market maker," and takes a position, and thus has a vested interest, in trading on its site. Whereas the dot-coms hope to match up buyers and sellers in "many-to-many" exchanges and stress their own neutrality, Enron, by taking title to products or backing the financial instruments, operates a "many-to-one-to-many" exchange. ChemConnect and CheMatch make money based on transaction fees that are a percentage of each deal conducted. Enron makes money through its ability to buy and sell products. Enron's transaction figures represent both the buys and sells that it conducts.


Net effect of e-commerce to be lower costs,
but also lower profits

SALES PRICE 100% –8% 92%
Raw material costs 65 –4 62
Selling, general & 10 –15 9
administrative expenses
R&D expense 3 0 3
Transportation 3 0 3
aBased on earnings before interest, taxes, depreciation, and amortization. SOURCE: Lehman Brothers

AN ARTICLE by Richard Wise and David Morrison of Mercer Management Consulting in the November/December 2000 Harvard Business Review suggests that online many-to-many exchanges "suffer from meager transaction volumes and equally meager revenues," and points to chemical industry examples. "The hard truth is that few of these exchanges will ever create the liquidity needed to survive," the authors say.

Three major flaws exist, they conclude. They believe that price-driven, competitive bidding runs counter to recent best thinking on buyer-seller relationships and needs. Exchanges also deliver little benefit, but rather place overwhelming pricing pressures on suppliers, such that buyer-biased exchanges will not be able to build critical mass in participants and transactions. And last, they say, the business models of most exchanges are "half-baked."

Building liquidity--that is, the actual flow of buy- and sell-transactions through a site as opposed to merely creating traffic or website hits--is a critical challenge, the exchanges admit. Neither ChemConnect nor CheMatch has reported a profit, and their prosperity, not to mention survival, will depend on how much cash they burn relative to investment capital on hand and revenues coming in. To create liquidity, both buyers and sellers must have the incentive to come to a site, find another party offering exactly what they want, and complete transactions.

Stegeman says ChemConnect will focus on pointing out to suppliers the upside of using the Internet. On the buy side, the prospect of lower prices is an obvious driver, whereas sellers naturally want to protect their position. Introducing suppliers to new buyers and having attractive credit and financial services will be among new offerings, she says. "In virtually every industry that buys and sells chemicals, it's been a company or handful of companies separating themselves from the pack," she says. "So we're optimistic that there's a herd behind them to fuel our growth."

Enron offers guaranteed liquidity, says Alan C. Engberg, director for Enron Global Markets. "There's always going to be a two-way market--the ability to buy or sell--at our location." The crux of market making is not just posting buy and sell bids, Friedman adds, but posting "reasonable two-way indications," so that customers actually want to make deals. Just recently, Enron took an equity interest in the chemical-company-backed network Envera. Enron will link its trading system to Envera, which will become the preferred network for members settling petrochemical transactions with Enron.

Liquidity is important not just because it brings in revenues, but also because it creates information flow. This information includes market conditions and pricing. With a steady and reliable flow of this information, as from a liquid online market of sufficient size, exchanges can create price indexes. These indexes in turn can be used to create what Forrester's Walker calls "designer or customized pricing," namely financial products including futures and price risk management tools such as swaps and other hedges. And financial trading, as already occurs in energy markets and other commodities, far outstrips the value of physical trading.

In January, CheMatch launched two proprietary products. Its Market Trak price product follows prices on an intra-day basis for six commodity chemicals--benzene, methanol, mixed xylenes, methyl tert-butyl ether, styrene, and toluene--in regions including the U.S. Gulf Coast, northwest Europe, and Asia. Its second product provides online news and commentary about markets for the six chemical commodities. Until April, these products are free on a trial basis, but after that will be available only to trading members or nontrading subscribers.

"We chose these six bulk commodity chemicals because they have the most liquidity and traction on our trading platform," says Roberta Kowalishin, CheMatch's vice president for business development and technology ventures. "Members of the exchange, as well as companies that haven't used it, are very, very interested in this product. There is a real desire to get more accurate information to settle contracts."

 PRICE INDEXES have long existed, provided by pricing services that survey the market, but indexes derived from Internet trading are expected to be updated faster, the exchange says. ChemConnect and Enron also require that bid and offer postings be public to ensure transparency, whereas transactions can be moved offline at CheMatch. The company is "fighting to have price transparency as part of the evolution, so we discourage that very much," says Clifton Currin, CheMatch's vice president for OTC Derivatives.

Stegeman suggests that ChemConnect is taking a more conservative approach and doesn't envision a reliable index being established and financial risk management tools being introduced until 2002. It does let users create customized views of postings, prices, and transactions, say for a specific product. The company also has taken a major step on its commodities floor by standardizing product postings and the regional hubs through which products are traded.

"Where the most liquidity has been developed is where there have been very standardized contracts," Forrester's Walker explains. "For example, in futures markets like the New York Mercantile Exchange, where crude oil and natural gas have some of the largest volume of any commodity markets. As a result of that standardization, it allows for those interested in contracts to 'meet,' if you will, at one place."

CheMatch signed a unique, exclusive deal with the Chicago Mercantile Exchange (CME) in September to offer chemical futures trading. The two have designed a futures contract for benzene and are awaiting regulatory approval, Currin says. Assuming there are no holdups, they anticipate that trading could start in the second quarter. Trading will occur on CME with access via CheMatch. Because futures contracts are traded by a wide range of speculators, he says it will "allow the chemical industry to shed risk outside itself."

Enron also offers standardized contracts and has been in the business of offering financial risk management tools for many years, now trading them online. Since about 1996, Enron, as well as Shell Chemical Risk Management, Koch Industries, and Louis Dreyfus, have been backing risk management tools using traditional indexes. Shell intends to make its tools a major component of its proposed commodity exchange.

Unlike Enron, Shell, or others, ChemConnect and CheMatch are not expected to be principles behind these offerings. Instead, they will post others' risk management offerings or requests from those wanting hedge deals, and then charge transaction fees. CheMatch, for example, has been actively talking to traders in energy markets, suggesting that chemicals are a natural extension for their business, Currin says.

Online trading of financial risk management tools is a tremendous business opportunity for chemical exchanges. However, the chemical industry hasn't been a very transparent market and hasn't adopted financial risk management tools as fast as their proponents would like. But they believe that the impetus is here both online and offline. Describing this trend, Vasnetsov and Walker propose similar four-stage evolutions of online chemical or commodity markets and the changes that will come to the industry.

Vasnetsov first sees traditional channels being cannibalized by e-commerce, followed by an expansion of spot markets and short-term buying, and eventually an opening of new channels with new partners (often referred to as "unbundling"). Walker's view begins with intensifying supplier competition and pricing pressure, followed by transparent pricing and unbundled supply chains, leading to long-term fixed-price contracts giving way to short-term or indexed contracts. Both envision the final stage being a liquid market for options and futures trading and financial risk management.

 VASNETSOV IS cautious about making predictions as to when, and if, the fourth stage will come. Although he believes that better financial management could help producers improve their earnings stability, he doesn't believe that companies will change overnight. "It will take a few years before the reality of this e-commerce-driven evolution will get accepted by chemical executives in the form of new business strategies," he says. However, with oil and natural gas markets already there, Walker anticipates that benzene and ethylene markets will reach stage four by 2002. Caustic soda, polyester, and polyvinyl chloride markets will follow in 2003.


Although e-business is expected to further pricing pressures and commoditization, the Internet is largely a facilitator in the face of considerable real-world pressures and an underlying fundamental need to manage earnings and businesses in financially sound ways. "Earnings throughout the petrochemical and plastics industry were pummeled last quarter due to record natural gas, natural gas liquids, and crude oil prices," explains John Nowlan, vice president for Enron Global Markets. "Companies are now actively searching for innovative ways to manage their risk due to price volatility."

"Companies will want more flexibility to match their input prices to their output prices," Walker says. Despite the chemical industry's historical fondness for long-term contracts and established relationships, companies tell Walker that they'll try to maintain the relationships, but look for greater and more creative price flexibility. Chemical operations that are part of oil and gas producers accustomed to using these tools may have ready access to in-house expertise, as will more sophisticated producers that already hedge currencies.

Financial risk management and hedging become a strategic decision at the executive level, Walker believes. "In the past, a company would have brought in all its suppliers, asked for the best price, and had a one-year contract," he says. Now companies must consider the design and amount of hedging they want, depending how much exposure to the market they can tolerate and on whether they think prices will rise or fall.

Chemical producers seem reluctant to dwell on the negative aspects that e-commerce may bring. "We've heard some of the fears suggesting that our products are at risk," Bayer's Gaughan says. "But in some cases that risk will be there anyway, as some products have more of a chance of becoming a commodity than others." And, at an industry e-business meeting last fall, Edward Muñoz, CEO of Ticona, admitted that this was a possibility for familiar specialty chemicals.

Contract markets will continue to exist, and supply and demand still will be a major factor, along with the change e-commerce brings. Companies that move quickly may be able to reap some of the initial cost savings that e-business can offer. Financial risk management then may allow for improved cash flow and earnings stability that could translate into improved sentiments on Wall Street. But longer term, companies will need to stave off price pressure and commoditization in other ways. Increased market share and new business opportunities are just two approaches, analysts suggest.

One approach is increased customization and other means of product differentiation. Initially, companies are pushing for online catalogs to communicate the value they are delivering and are fighting back with new services, Walker says. He suggests that companies analyze their customer segments and respond with calculated marketing approaches. These include targeting product attributes to customers; offering designer pricing; charging explicitly for guaranteed access to supply or production flexibility; and understanding customer behavior.

Even GE Plastics, which surpassed $1 billion in online sales at its GEpolymerland.com site last year, continues to make changes in response to customer needs. It has significantly redesigned its http://www.geplastic.com site to help users of it and GEpolymerland "design products, research and select materials, cost and purchase resins, and troubleshoot production processes." It also contains data sheets, engineering tools, online seminars, and links to industry specific pages.

As e-business evolves, "suppliers will build a real option portfolio to maximize future revenues within uncertain markets," Walker notes, adding that "all players must prepare for a shift."


Exchanges To Offer Tools To Manage Financial Risk

I n addition to trading actual physical commodities, online chemical exchanges want to provide financial risk management tools. Although these tools have existed for years, their use in chemicals is relatively untried compared with other industries. However, the Internet is a new channel and potential impetus. Forward contracts, to lock in prices; futures trading; and options--which specify the right, but not the obligation, to buy or sell product in the future at a set price--are appearing online. Other tools include swaps, caps, floors, and collars.


SWAPS let producers or consumers trade the risk of floating prices for an ensured fixed price. For example, assume a producer can sell polymer at 35 cents per lb and achieve a comfortable margin over production costs. To avoid the risk of losing that margin if prices change, the producer enters into a contract with a risk manager for an agreed-upon index price of 35 cents. When the market price rises above 35 cents, the producer pays the difference to the risk manager. When it falls below, the risk manager pays the difference to the producer. The net price, after combining the actual selling price the producer gets and the swap contract, is 35 cents. For consumers wanting to maintain raw material costs, the direction of the payments is reversed. In exchange for price stability, producers or consumers give up some ability to capture favorable price movement.

 CAPS & FLOORS are two variations of protection that let users benefit from favorable or avoid unpredictable price movements. The user pays a premium, often based on the volatility of the commodity, to get some price protection. Unlike swaps, which set a fixed price, caps and floors pay only when the price of covered purchases moves beyond a set level. Caps, sometimes called "call options," protect when the price exceeds a set level. For example, a commodity buyer pays a premium of 1 cent per lb for a cap price of 40 cents. If the price goes above 40 cents, the buyer is paid the difference. When the price is below 40 cents, the buyer can take advantage of buying at lower prices. In the opposite sense, floors, or "put options," can protect sellers when prices fall below a set level, essentially setting a minimum price they'll get.

COLLARS are a combination of a cap and floor and control prices within a price range. They can be used by consumers and producers. Some profit may be given up in exchange for limiting exposure to negative price movements. For example, a producer would pay the difference in price to the risk manager when prices move above a cap or ceiling price. When they fall below the floor, the risk manager pays the producer. No money is exchanged when prices fall in the range between. These agreements can be structured to include no up-front or zero net premium payments.


Company Networks Gain Momentum

I n the rapidly changing world of e-commerce, months can seem like an eternity. The chemical industry, often described as slow to adopt change and new technology, has been moving apace to create networks or hubs for their business-to-business (B2B) transactions. These new ventures are to operate as neutral, independent entities. In the past 12 months, they have constructed business plans, put management in place, and conducted their first transactions. They've also come out with chemical e-commerce standards that are considered critical for operating (C&EN, Feb. 12, page 26).

"The era of pure-play, dot-com dominance is over as major industrial companies are becoming much more active in forming and participating in e-commerce companies," says Sergey Vasnetsov, a research analyst with Lehman Brothers. However, he expresses concern about governance issues--that is, how truly independent these ventures will be of their owners--and the uncertain effect this will have on their agility, strategy, and ultimate competitiveness.

Among the first to step out was Envera, which was launched in March 2000 and had its first transaction on Oct. 1, 2000. Spawned by Ethyl, it quickly had a management team in place--largely from Ethyl. Today about 10 chemical firms are strategic partners, hoping to improve the efficiency of their supply chains and B2B transactions. With technology and consulting support from IBM and webMethods, Envera has also partnered for logistics support, as well as banking and transportation services.

In August 2000, Elemica was created. What it may lack in speed and first-mover advantage, it makes up in industry muscle. Investors include 22 major global and diversified chemical producers. By early this year, Elemica finally had filled out its management ranks. Cap Gemini Ernst & Young and Manugistics are providing technology and consulting support.

Focusing on B2B contract buying and selling of chemicals, Elemica's first transaction was conducted on Jan. 1 as part of a beta-testing phase by 16 companies. In the first quarter of this year, Elemica expects to involve a broader client base and move to rollouts of enterprise resource planning system integration services starting in the second quarter.

Omnexus was started in April 2000 by producers with a focus on plastics end-users. Until recently, it was managed largely by people from Andersen Consulting, now called Accenture. Technology support comes from IBM, Ariba, and i2 Technologies. With more than 20 major suppliers, the site began with catalog listings in October 2000 and conducted its first transaction in December. Already operating in the U.S., the firm has a European rollout planned for this quarter, followed by Asia and elsewhere by 2002.

Likewise, producers in the elastomers area created ElastomerSolutions.com in April 2000 for participants in that industry sector. It has 10 company investors today and business and technology support from . and VerticalNet. Initial transactions started up in December.

Other B2B and e-marketplaces are being created by corporate groups focused on products or industries, or by producers in geographical areas. "The emphasis is on connectivity and efficiency," Vasnetsov says about all these ventures. "Because the savings will be spread around to the participants, there is no individual company advantage."

Major antitrust issues have not yet emerged, although regulators reportedly are keeping an eye on things. It's also unclear whether these ventures will offer business models that add value for producers and create profits for themselves, and how many the industry can support.


Online Bidding--Opportunity Or Threat

P robably nothing has generated more fear among chemical suppliers than the dreaded "reverse auction." When BASF conducted one of the first online reverse auctions through ChemConnect in March 2000, it created a stir. BASF wanted to buy several thousand tons of methanol and saw sellers drop their offers 10% below current market prices during the four-hour event. A month later, Bayer was quoted as downplaying fears that e-commerce will increase pressures on prices, suggesting instead that laws of supply and demand still apply.

The panic seems to have subsided. Supply and demand still does influence prices and online trading, the chemical exchanges say, reflecting the broader market. Auctions, both reverse and the more usual forward type, now are
commonplace e-business tools. Several dot-coms, such as FreeMarkets, have made this a major thrust of their business for various industries. In chemicals, most dot-coms list auctions among their offerings.

Auctions are a growing business area at both ChemConnect and CheMatch. "Private auctions for contractual business really helped fuel our growth in 2000," says Linda Stegeman, ChemConnect's vice president for marketing. Popular for procurement, auctions offer speed and efficiency, she says, and the opportunity for finding suppliers, for creative supply deals, and for better pricing (averaging about 15% relative to reverse prices).

Both CheMatch and ChemConnect say auctions require a fair amount of customer service. Services, explains Eli Ben-Shoshan, CheMatch's vice president for auctions, can involve structuring the event, prequalifying participants, providing customized technology, training all parties, running the event, and follow-up. "It's very important to remember that our customer is not just the initiator, but all parties involved," he says. "We want everyone to be prepared right up front so there aren't mixed expectations and to come away feeling like it was a fair process."

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