Producers of commodity chemicals have long been plagued by cyclicality, which causes huge swings in prices and thus in operating margins. At the top of a cycle, the return on invested capital (ROIC) can approach or exceed 100 percent; in a trough, it can drop well below a company’s cost of capital for prolonged periods (Exhibit 1).

Such volatility causes difficulties for managers making strategic and operational decisions. Annual returns can be judged only in the context of a full cycle (although it is difficult to judge when a cycle begins and ends), while decisions about investments costing hundreds of millions of dollars may have to be considered during periods of poor—or even negative—operating returns.

Not surprisingly, much has been written about how companies might manage cyclicality. But to manage it effectively, we need to know what drives and sustains it—and here there is little consensus.

A common view in the chemicals industry is that the supply/demand balance is upset when additional capacity comes on stream in large lumps—because of the need to capture economies of scale—rather than gradually. A second hypothesis, put forward by some academics, is that companies mistime investments because they are unsure of other suppliers’...