Skating on thin ice?

15 April 2002 00:00  [Source: ACN]

Despite all the optimism over economic recovery, John Richardson reports that 2002 could still go either way for the US economy and the country's petrochemical industry, while the longer term competitive challenges for the US industry remain huge

The US economy and the country's petrochemical industry are skating on very thin ice. But at a macroeconomic level there are certainly plenty of reasons to be cheerful.

And much of the talk at last month's International Petrochemicals Conference (IPC) in San Antonio, Texas, US, sponsored by the National Petrochemical & Refiners Association (NPRA), was of the surge in demand from petrochemical customers.

To deal with the macroeconomy first, the ice does appear to be thickening as more evidence emerges of a recovery.

For instance, a report by the Institute for Supply Management said that its closely followed Purchasing Managers Index rose to a greater-than-expected 54.7% in February from 49.9% in January. Below 50% indicates a contraction in manufacturing, while above 50% represents expansion.

This follows persistently strong consumer indices that support the view that although corporate profits may take a while to recover, there currently seems to be no danger of consumer confidence collapsing, despite the erosion in personal wealth resulting from stock market declines.

However, in the midst of economic euphoria, it is very easy to forget that 11 September has changed the world for good.

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Reminder



Delegates at DeWitt's 27th annual World Petrochemical Review, which took place in Houston, Texas, US, the week before the IPC, were reminded of that fact by Dr George Friedman of the Stratfor group, a private US-based intelligence information company.

Friedman, an academic who lays claim to having advised senior US military commanders on defence matters, told the delegates that the US is preparing to strike at 60 countries harbouring Al-Qaeda networks because 'the president doesn't want to wake up one morning to the nightmare of finding several US cities destroyed by nuclear attacks.'

He pointed to the fact that the US recently made it clear that it does not rule out the option of itself using nuclear weapons in the war against terrorism.

And Friedman claimed that the Taliban and Al-Qaeda 'defeat' was in fact a tactical retreat from the cities, and that both are preparing for a spring offensive from the mountains.

A great deal of what Friedman said could turn out to be alarmist hog wash. Nevertheless, it did serve as a reminder that botched US military action or another major terrorist incident could derail the economic recovery.

And as this feature went to press, rising tension in the Middle East threatened the petrochemical price recovery.

Concerns over disruptions in oil supply from the Israeli-Palestinian conflict spreading beyond Israel's borders, pushed West Texas Intermediate crude to a six-month high of US$27.10/bbl, with the threat of a US military strike against Iraq remaining in the background.

The worry is that if events in the Middle East escalate into a global crisis, the economic recovery could be derailed.

As for all the talk at the IPC concerning the recovery in petrochemical demand and pricing in the US, much was about how the jury is still out over to what the extent the rebound is just down to inventory rebuilding by end-users.

One consultancy insists that the recovery in the average US cracker operating rate to 86% in March from 75% at end-2002 is far too great to indicate anything other than a substantial improvement in real demand. However, there is some dispute over the 86% with several industry players placing the March operating rate at slightly above 80%.

But whatever the actual number, Sergey Vasnetsov, chemicals analyst at Lehman Brothers, says that producers will not enjoy real pricing power unless the average C2 operating rate rises to the mid-90% range.

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'Once you get into the shortage concern zone, which is around 95%, you get a parabolic rise in cash margins. We are far away from that and while the demand growth we'll see this year will be helpful, it is too early to get excited about ethylene cash margin expansion,' says Vasnetsov.

On the other hand, all the current debate about what is real demand and what is just inventory rebuilding could turn out to be a red herring if Fred Peterson, president of New York-based consultancy Probe Economics is to be believed.

He says that the inventory reductions right down the chain were so great during 2001 that stock building alone will be sufficient to drive the cracker operating rate up into the crucial mid-90% range.

One consultant, supporting this view, says: 'Last year, you could have fitted a medium-sized home, a pick up truck and an RV (recreational vehicle) in most polymer silos.'

Feeble recovery



Yet another argument is that the focus on inventories is a distraction, and that what really matters is that this year will see only a feeble economic recovery.

'We expect restocking to be short-lived, given the prospects for a sub-par economic recovery,' says Merrill Lynch analyst Donald Carson.

Carson, therefore, concludes that there is no chance of the operating rate rising much above 85% in 2002.

And it must be remembered just how much ground the US industry has to make up. At the bottom point of a previous petrochemical cycle, in 1991, the operating rate was at 87.4%.

But still, despite the crucial cracker operating rate remaining well below the pricing power zone, some price rises have been achieved.

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For instance, US styrene producers managed to raise February contract prices by 0.5-1.5 cent/lb to approximately 30 cent/lb, with 1.5 cent/lb attempted for March and 5 cent/lb for April. PP producers achieved 3 cent out of the 5 cent/lb that they sought for April.

To introduce yet another note of caution, though, price rises are still a long way short of what producers need to make up for 2001, the worst year in terms of pricing in two decades.

The problem is that the recovery is very patchy. Rich Pisarczyk, ExxonMobil's global head of basic chemicals, says that for some polymer applications the demand rebound has been strong, while for others it has been much weaker.

Out of all these conflicting views emerges one consensus: it will take until late Q2 or early Q3 before it becomes clear whether the bulls or the bears are right.

If the bulls do prove to be right in 2002, the ice could still eventually crack under the skates of the US petrochemical industry because of long-term challenges to its competitiveness.

During the 2000 IPC, Dow Chemical's chief executive officer Michael Parker called for a national energy policy which would address the serious shortage of gas supply.

The US petrochemical industry was at that time still reeling from the rise in gas prices to US$10/mbtu in January 2001 from their 1994-99 average of US$2.50/mbtu.

Gas prices



Gas prices are crucial to the competitiveness to US petrochemical players because around 70% of US ethylene production is based on natural gas liquids from approximately 50% ethane, 15-20% propane and 3-4% butane feedstock.

The major contributor to the gas price surge was the over-reliance on natural gas as a feedstock for electricity generation.

The advantages of natural gas is that natural gas-driven electricity plants produce far less pollution than coal-fired facilities using conventional technologies.

Also, much smaller electricity plants can be built than is the case when coal is used, enabling operators to build facilities for actual demand rather than plants with surplus capacity that take far longer to repay their investment costs.

As a result, Parker pointed out that the US has become far too dependent on natural gas for power generation with far too little exploration to meet this demand.

A combination of these structural problems, a cold winter and the economic boom led to a steady rise in gas prices during Q4 2000 and into 2001 to the point where they reached US$10/mbtu.

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It is not only in winter that the strain on natural gas supplies drives up its alternative value as a feedstock for power generation. In the summer, too, the increasing use of air-conditioning units has created a second peak demand season.

Twelve months on, the odds are stacked in favour of a new and comprehensive energy policy emerging by the end of this year, believe senior industry executives.

Bob Slaughter, the newly installed president of the NPRA, said in a pre-IPC press conference that it is likely that a new energy bill will emerge from the US Congress this year, although its final form is far from certain.

Slaughter added that the energy bill, which has already been passed by the US House of Representatives, has several pluses for the chemicals industry. These pluses include provisions for increased development of oil and gas reserves in Alaska and the encouragement of the use of modern, clean coal-based technologies for power generation.

The bill also includes a provision for the construction of an Alaskan pipeline system to bring Alaskan gas to the US.

However, Slaughter pointed out that the Senate version of the bill is less supportive of the chemical industry's supply concerns. Nevertheless, he hopes that a reasonable bill will emerge from a conference committee that will bring the Senate and House versions together.

Concern



The industry is also concerned about elements in the Senate version that would prevent chemical producers co-generating electricity and selling surplus electricity to the power grid.

Another negative is that even if a reasonable bill does emerge by end-2002, it has to then become law and be effectively implemented.

This could take several years. Therefore, US chemical producers are likely to remain exposed to the danger of another gas price surge for some considerable time to come. Ironically, the strong, sustained economic recovery that everyone so much hopes for could be the trigger for another surge in natural gas prices to US$10/mbtu.

Public support is critical if a new energy policy that favours the chemicals industry is to ever be in place.

At least the trade unions are now on the side of the chemicals industry, though, said Eugene Allspach, president and chief operating officer of Equistar, the cracker joint venture between Lyondell, Millennium Chemicals and Oxychem.

'The unions have recognised how adequate gas supply is crucial to the competitiveness of our economy and therefore is crucial for jobs,' Allspach added, speaking at the same press conference.

Perception



However, the chemical industry is still widely perceived as a major polluter, which means that US producers face an uphill battle in convincing the wider public that they deserve a favourable energy policy.

And even if they win this argument, the US is likely to remain a highly litigious society where other attempts to improve competitiveness could succumb to what Duane Gilliam described as Nimbyism (not in my backyard).

Gilliam, executive vice president of US chemicals producer Ashland Marathon and the chairman of the NPRA, used the example of how hard it would be to create 1000 foot-wide rights of way linking Texan cities for the laying of gas pipelines.

The events of 11 September certainly haven't helped the chemicals industry in its uphill public perception battle.

Firstly, the terrorist attacks have understandably diverted public and government attention away from a new energy policy, slowing its passage through the legislature.

But much more crucially, the attacks have created public and political scrutiny of chemical processes that could ultimately lead to financially damaging legislation forcing changes in the processes.

New Jersey senator Jon Corzine wants his proposed Chemical Security Act to include a clause that would force companies to adopt safer technologies.

But Allspach argued: 'Congress should look at access to chemical plants and not the chemical processes themselves.' Corzine's Act in its current form also includes the creation of buffer zones around chemical plants.

Allspach added that even after 11 September, passenger jets are not viewed as primary weapons, but that's exactly what they were used for in the attacks on the World Trade Center and the Pentagon.

The emphasis since the terrorist attackshas been on access to aeroplanes - increased security - which is where Allspach believes the focus should remain for the chemical industry.

Another consequence of 11 September that could threaten short and even long-term competitiveness is insurance.

Producers are currently pooling resources to ensure adequate cover for plants and liabilities while urging the US government to help guarantee liability protection.

On the plus side for the industry is that a bill is currently going through the House that includes tort reform and other measures which would guarantee adequate cover for US chemical plants and their insurers.

So, if a new energy policy that favours the industry is put into effect and the lesser issue of insurance is dealt with, will this mean that US chemical producers will automatically find themselves on a very firm competitive footing? Far from it.

Like so many industries in other countries, the US industry is plagued by overcapacity.

And oversupply is getting worse.

Formosa Plastics USA and BASF/Atofina recently each brought onstream 820 000 tonne/year crackers which have added approximately 4.5% to North American ethylene capacity.

Additional capacity



In October of this year, BP is scheduled to add a further 225 000 tonne/year in Chocolate Bayou, Texas, with Shell Chemicals due to bring onstream an additional 545 000 tonne/ year of ethylene capacity at Deer Park, Texas, in July of next year.

The other problem is that as new world-scale and therefore more competitive capacities have been added, producers haven't shut down enough inefficient output.

The facilities which have recently been shut down, belonging to Chevron Phillips Chemical and Huntsman Corp, represent only about 3.1% of US capacity.

Producers have recently become more reluctant to shut capacity because of their belief that economic recovery has arrived, says Lehman Brothers' Vasnetsov.

If the economic rebound is sustained, Graham Copley, chemicals analyst with Sanford Bernstein, told the IPC delegates in a presentation that the US industry's marginal players would muddle through for a bit longer.

He added that the current rally in demand has already 'put an extra charge in the life support machine, but I think we will see more Chapter 11 filings.'

Copley said that it wasn't his intention to dampen the spirits of delegates, adding that he was eager to do anything he could to 'discourage these guys from building stuff.'

Bleak picture



The analyst painted a bleak picture of a US chemical industry confronting increased import competition.

He pointed to the indirect competition from overseas manufacturers of plastic bags who can beat the US hands down on labour costs.

He said that increasingly, US retailers are keeping their costs down by using cheap imports of goods such as plastic bags as leverage in price negotiations with domestic suppliers.

Copley described how one US home products supplier maintains a 'wall of shame' where it posts photographs of managers who have agreed to pay price increases from suppliers.

And then there is the direct competition.

Polymer imports have increased from Canada where the 'Alberta advantage', the very competitive gas prices in the province, give the producers there a major edge over their US counterparts.

There are some polymer imports from Asia, but a very effective non-tariff trade barrier remains in place which is likely to continue to severely limit shipments.

In the US, polymers are not moved by container but by rail car and are stored by end-users in the until recently almost empty silos.

But as Asia becomes increasingly self-sufficient, US exports to this region of some chemicals are steadily declining.

Also, even with the Alberta advantage, one producer there has had to recently severely curtail sales of PE to China because of an inability to compete with the Middle East.

So what's Copley's solution?

He suggests, like so many other analysts, that the US industry must innovate to survive.

Copley calls for R&D that leads to development of new products, not just R&D that results in more efficient processes for existing products.

A unique product enables a producer to more or less charge what it likes. However, in some cases, cheaper processes for commoditised products merely leads to more downward price pressure from end-users.

The analyst added that in 2001, the US chemical industry's average return on capital employed was just 4% against more than 5% for municipal bonds.

Copley also recommends more mergers, provided 'they find ways to shut the capacity that needs to be closed.'

All of this is, of course, a great deal easier said than done.

He painted such a grim picture that one might leap to the false conclusion that if you are a US producer, it's not worth getting out of bed on most mornings.

But perhaps the reality is that although the laggard producers might be at risk of Chapter 11, those which are reasonably competitive might just be able to muddle by through fully depreciated plants, non-tariff trade barriers and highly localised customer bases. Even in the US, globalisation will more than probably always remain limited.

Last but far from least is the ban on the use of MTBE in California.

Governor Gray Davis wants to delay the implementation of the ban from 1 January 2003 to 1 January 2004 because of air quality and gasoline supply reasons.

However, Republican senators are attempting to force California to stick to its original date.

Conclusion



So there you have it, the US in less than 3000 words.

From an outsider's perspective, it seems that for all the US talk about the Asian petrochemical industry's lack of competitiveness, some parts of the US industry don't appear to be a great deal better.

And as is the case with Asia, more mergers and plant closures are needed, plus in the case of the US more favourable legislation.

But from over here looking over there, what really counts is that the US economy keeps on recovering.

At the moment it is not just the US but the whole world that is skating on thin ice.

Additional reporting by Joe Chang of Chemical Market Reporter and the Houston Chemical News & Intelligence team - Joe Kamalick, Gary Taylor and Mike Sheridan





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