Exxon takes up the cry: plants must go

19 July 1993 00:00  [Source: ICB]

The lack of urgency that has characterised even the most heated of restructuring talks seems set to sink into outright lethargy. Exxon Chemical is the latest to take up the baton and hammer home the underlying threat - if capacity is not cut, 1993 margins will be the none for years.

By Mary Heathcote

SEVERAL COMPANIES have now identified 1997 as the earliest point at which European petrochemical supply and demand will come back into balance unless some existing capacity is closed. It follows in this line of argument that, without decisive action, a recovery in petrochemical fortunes cannot be anticipated any earlier. But still there is no sign of decisions on the scale necessary to deal with the problem. One 150 000 tonne/year train at Baglan Bay does not come near the estimated 2m tonne/year supply overhang, and to date that is the only olefins gesture on the table.

More worrying is the apparent shift in the industry's mood. Given the dire state of markets in recent months - at the high point of the year - it is frankly surprising to find fewer signs of anxiety and gloom than a year ago. Not least as 1993 will be the first year in which volumes fall - a 2% drop in ethylene has been estimated for this year, compared with continuing growth until now.

What the current situation bodes for Q4 can only be a source of apprehension. So the prevailing feeling that matters are now in the hands of fate - but may be helped by an upturn in Europe's national economies - can only add to the sense of foreboding.

Against this backdrop, an emphatic reiteration of the structural weaknesses underlying the current malaise in European petrochemicals was more than timely from Exxon Chemical International supply and planning manager Mon Clinkspoor. His paper at the recent Chemical Insight seminar in London explained the planning tools used by Exxon for decision-making purposes to deduce the state of the industry and the outlook - a topic of some interest given the performance maintained by Exxon against a sinking industry average.

Clinkspoor's conclusions are bleak and, it must be emphasised, assume no capacity rationalisation:

• Today's margins are normal
• Do not consider 1993 to be a unique low point
• Margins will not change for several years as the operating rate will not recover. And there will be no recovery in operating rates even with good GNP growth
• There might be a recovery in the late 1990s, but any such recovery would be vulnerable because of a possible increase in imports.

'I have been in planning most of my career, so I know we should be modest with respect to our ability to forecast the future,' says Clinkspoor.

'I would love the outlook I portray to be wrong, but looking at this analysis, it would appear to me that many high-cost producers may be forced to mothball or scrap their capacity, at least if stopping the cash drain is of any importance to them.'

Exxon uses econometric models as one of its means of forecasting demand. Clinkspoor explains the process using PP as an example. Actual PP demand divided by GDP is plotted for Europe from 1970, producing the straight line shown (see diagram). Then a trial and error exercise is carried out, regressing the change in penetration with a number of macroeconomic parameters up to the point that a good fit is achieved - producing the regressed line.

Statistically the result is impressive, Clinkspoor explains, pointing to the statistical indicators achieved in the regression. 'So I suggest that we do understand in macro economic terms what it takes to consume more PP,' he says.

'PP is still a relatively young product from a life cycle point of view, so penetration should be expected to continue. Yet I would hesitate to show a demand forecast.'

The economic outlook is uncertain through the rest of the decade. Exxon's March outlook predicts that Europe will begin to grow out of the recession in 1994, Clinkspoor says. 'We expect an average growth rate of around 2.8% for the 1995-2000 period... but my fear is that we may well see much lower growth than most economists are currently forecasting. I would suggest the uncertainty range is at least 1% a year.'

Of course demand does not equal production. The difference is net trade. Exxon's estimates of Europe's net trade from 1985 to 1992 for ethylene, propylene, aromatics and derivatives is shown (see diagram). Europe exported about 2m tonne/year in 1985, and became a net importer in 1989. Net imports are now around 1m tonne/year.

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Clinkspoor has also plotted the DM:$ exchange rate on the graph - this was DM3:$1 in 1985 and DM 1.6:$1 in 1992. 'You will all know what this change means to our fixed costs relative to the US,' he emphasises. In 1992 the US had an average of $60/tonne of ethylene. Europe's average with DM3:$1 was about $50. However with DM1.6:$1, the figure is about $100/tonne of ethylene, so we are very cost-defensive indeed.

'I think those markets have gone forever,' Clinkspoor says of former European net exports. What I don't know is how much more will in imports. The Middle East is implementing a second wave of petrochemical investments against the background of reduced import needs in the Far East. Middle East imports should be expected to increase sharply.

'I am even more worried however about imports of fabricated goods from cheap labour countries - plastic bags, shirts etc - from the Far East and eastern Europe [see ECN 14 June p12]. The question is, how much is likely to be imported from these countries?'

All of this stacks up to a simple conclusion - the production level of 2000 is not predictable, or at least not with sufficient accuracy. 'You will see later what the impact on profitability is of a 10% change in operating rate,' Clinkspoor says. 'We simply cannot predict the 2000 production level with that degree of accuracy.'

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With GNP growth, for example, a 1% a year error means a 7% demand difference by 2000.

And on net trade, 100 000 tonne/year is 1% of European capacity and Clinkspoor believes Middle East PE imports into Europe by 2000 are uncertain by several hundred thousand tonne/year.

Central to Exxon's tools for forecasting margins is experience curves. The example given is ldPE, integrated with a naphtha cracker. The vertical axis shows value added - netback less total variable costs for a fixed PE plant and steam cracker - expressed in 1983 DMs. The horizontal axis shows cumulative worldwide production.

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It has been observed in many industries that this value-added declines linearly when expressing the units on a log/log scale, Clinkspoor explains. It is obvious, he says, that when following the progression which represents the years since 1965, this decline is also applicable to PE. 'When regressing the data we find an annual decline of 2.4%.'

Exxon was not carried away in 1988 and 1989, Clinkspoor emphasises, but continued to use for investment purposes a return to the trend line. Many companies continue to make the mistake of expecting that, since new capacity is required, the margins will provide a return for this capacity. This is not true.

'Maybe somebody is still playing around with the idea of adding steam cracker/PE capacity by the year 2000. If so,' he says, 'when looking at the 2000-plus period for investment purposes, it would be prudent to assume that, like in this model, variable margins will be a lot lower than the 1992 trendline margin which is shown here.'

Clinkspoor acknowledges experience curves are not a short-term earnings tool - 'look at the large swings'. He also emphasises just how exceptional the 1988-89 peak was, being based on the crude oil price collapse of 1986 and the DM3:$1 exchange rates of 1985.

'In future margins could be expected to overshoot again, but I would suggest not as much as the last time,' he says. An escalation of this nature can only come from an unexpected very fast increase in demand.'

If the magnitude of the 1988-89 peak is accepted as a one-off event, the trend line given may even be too optimistic, Clinkspoor warns. 'In fact, if one regresses the period 1965 to 1986, the trendline decline is 3.1%. probably a more realistic level than the 2.4% suggested.'

Clinkspoor strongly advocates the use of experience curves to evaluate potential large investments. 'I don't know of a better tool. It's not perfect but at least it offers one realistic check point, so do use it for estimating margins in the 2000-2010 period.'

The first longer-term portents come from the suggestion that the trendline decline for an integrated naphtha steam cracker PE unit could be as much as 3.1% a year, and certainly 2.4% a year. 'The derived conclusion is that it will be a challenge to recover the cost of capital, and that is an understatement.' Clinkspoor says.

'Historical returns have on average been very modest to say the least. Chem Systems' leader naphtha cracker only shows a return in excess of 10% in 1988, 1989 and 1990 in the period since 1980. They predict this leader cracker to have a 2% return until 1995 and a recovery to 6% by 2000. They are probably too optimistic,' Clinkspoor believes, amongst other reasons, because they do not reflect experience curve margins decline.

'The integrated PE business is most of the time a poorly performing industry with an exceptional hiccup,' Clinkspoor says. 'BASF may have the honour of having built the last naphtha steam cracker in Europe.'

Other tools are used by Exxon to predict near-term margins. Supply curves ranking the units of an industry as a function of their assessed production cost are a familiar sight these days. Production cost is plotted vertically, and individual plant capacity horizontally, with units ranked by their production cost.

Exxon's model for 1992 shows Europe's 32 steam crackers with total production capacity just short of 18m tonne/year of ethylene, average capacity of about 400 000 tonne/year and total production cost ranging from $310/tonne to $500/tonne. Clinkspoor emphasises two points.

'First, we refer to a total cost advantage. The chemical industry has the bad habit of making supply curves on a cash cost basis.

'Give me $2bn and I will build the lowest cash cost producer in industry. Capital is also a cost. We add depreciation and work with supply curves on a total cost basis.

'Secondly, a warning about the accuracy of supply curves. Feedslates and variable costs of individual units are in general reasonably available from published data.

'The average fixed cost of the industry is also available, for example from consultant benchmark studies. But individual fixed costs for a competitor's unit are only an educated guess.

'In addition, we don't always have data on the operating rates. And our fixed costs per tonne of ethylene assume full capacity, a lean organisation and no mishaps. It is a model, alas often not reality.'

In this model, the 1992 ethylene contract price turns out to match the cash cost price of the laggard producer, or rather the cash cost price of the laggard producer in ideal circumstances, observes Clinkspoor. Another reference period-Q1 1993 ethylene for example -looks quite different. Costs are lower and the ethylene contract price is lower. But the ethylene contract price still equals the cash cost of the laggard.

'The advantage of the lowest cost producers is defined by the slope of the curve,' Clinkspoor says. 'In the 1992 model the leader had a $150/tonne margin. In the 1993 model, the slope is flatter and the leader only has a total cost margin of $130/tonne.'

In a third example to reinforce the conclusions, Clinkspoor uses today's plants but takes 1980 feedstock and coproduct prices, with a naphtha price of $337/tonne. Once again the ethylene contract price - $721/tonne - is set by the laggard cash cost.

Higher feedstock prices produce a steeper slope and the low cost producer profitability increases. And the non-naphtha feedstock crackers are very profitable.

Most of Exxon's ethylene is converted to PE, so the integrated ethylene and PE margin is more important than ethylene price. To reflect this, it uses the variable margin versus operating rate tool, applied to integrated PE. On the horizontal axis is operating rate as a % of total PE nameplate capacity. Vertically, the integrated naphtha-based ethylene-ldPE variable margins expressed in 1983 DM are plotted, for each year from 1980.

Clearly visible is the margins collapse of 1981/82, followed by a recovery of operating rate and margins to the peak of 1988. But then this standard pattern breaks down. 1992 margins are less than the DM (1983) 650-750 of 1981/82, at below DM (1983) 600, despite a much better operating rate. And the current 1993 margins are even lower. 'We are missing more than DM (1983) 300/tonne margin,' Clinkspoor notes.

This failure of the longstanding operating rate/margin relationship has perplexed industry analysts for well over a year now. Clinkspoor believes he understands the underlying reasons for the change. In a separate plot, he displays the same data with two key differences (see diagram): the margins have been divided by the average naphtha price for the year in question; and the margin is expressed in current $ rather than constant 1983 DM.

The result is immediate. A nice correlation appears with only modest deviations. The most significant of these can all be explained by rapid changes in the costs - in 1986 crude prices collapsed and in 1985 exchange rates surged to DM3:$1. Not shown in the diagram here is the 1993 point - which is around 82% operating rate and has a margin:naphtha ratio which is also bang on the curve.

Assuming this correlation is correct, three observations can be made, Clinkspoor says.

First: 'Our assessment is that 1993, 1994 and 1995 demand increases and new capacity additions about match each other if our economics start growing next year.' This is a big if, he stresses. 'Today's margins are normal for several years,' is the message he emphasises.

Secondly: 'This assessment is only appropriate if we assume no capacity rationalisation. The curve allows you to establish what we call revenue factors. 100 000 tonne/year plus or minus PE capacity changes the 1993 margins by $27/tonne when naphtha is around $200/tonne.'

Thirdly: 'We have a dollar variable margin available. Our fixed cost is in DM however. Strong or weak European currencies make a lot of difference to the cash margin.'

But can the erosion of the 1993 margin against the early 1980s margin be rationalised with this tool? Clinkspoor believes it can.

'The correlation improves using current currency rather than constant 1983 DM,' he points out. 'This means that for the same operating rate, like 1984/85 and 1993, we have the same margin in current dollars. So the real margins decline with inflation. Our good old experience curve model predicts this.'

Furthermore, the correlation improves when dividing by the current naphtha price. This Clinkspoor explains by reference to the supply curve model.

As naphtha has to do with variable cost, he plots two variable cost supply curves - one for Q1 1993 and the second using 1980 prices (see diagram). The difference in variable cost of the laggard is more than $100/tonne, he points out. Remember that in weak markets, prices and margins are set by the laggard.

'In 1985, the margin was about DM750. Experience curve learnings suggest we should still expect DM750/tonne in 1993, or $440/tonne,' he says. 'However, pre-1986 naphtha was much more expensive and we lost some $100/tonne margin through a less steep supply curve. This gives a margin expectation $100/tonne below $440/tonne, or $340/tonne. That's where we are today.'

By: Mary Heathcote, Asian Chemical News
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