After the storm…

19 September 2005 00:01  [Source: ICB]

In the wake of Hurricane Katrina, tight petrochemicals supply will, just as in 1973-74, enable producers to push through price increases, reports Joseph Chang

Following a major inventory correction in the second quarter of 2005, profitability in the North American petrochemicals and plastics industry appears to be back on track, marching towards the peak of the cycle by 2006 to 2007. While the impact of Hurricane Katrina will take a toll on third quarter profits, the long-term outlook is bright as supply-demand fundamentals were already tightening on the back of healthy demand growth and a dearth of capital investment.

‘The near-term impact of Katrina is negative, as producers’ volume will suffer in the third quarter. Logistics issues, specifically rail outages and delays, will make it difficult for producers to resume normal operations,’ says Fulcrum Global Partners analyst Frank Mitsch. ‘However, the long-term impact is positive as the reduction in production capacity will further tighten the supply-demand balance and help producers push through price increases.’

Companies poised to benefit include Lyondell, Nova Chemicals, PPG Industries and Eastman Chemical, according to the analyst.

ENERGY COSTS

While energy costs have soared in the wake of Hurricane Katrina, with crude oil surging past $70/bbl before retreating to around $64/bbl and natural gas still above $11/m Btu, commodity chemical companies may easily be able to maintain or even increase margins in the long run.

Gleaning lessons from the Arab oil embargo of 1973-74, the US petrochemicals and plastics industry is poised to boost margins in the face of elevated oil and natural gas prices, according to CS First Boston analyst William Young. Back in October 1973, as oil quickly jumped from $3/bbl to over $5/bbl before climbing to $11.65/bbl (about $45/bbl in today’s dollars) in January 1974, buyers of commodity chemicals started ordering aggressively to secure material.

‘Put yourself in the position of a purchasing agent whose job it was to buy petrochemicals and plastics. The first job is get the material. The second job is get the best price,’ says Young. ‘Once the embargo started, 99% of the effort went into the first task. After all, if you couldn’t obtain materials, it didn’t matter what you paid for them. That is, industrial purchasing agents did the same thing as ordinary customers – they topped off their tanks.’

OPERATING RATES

Operating rates surged past 90%. ‘The basic chemical companies were able to raise prices significantly, more than covering the elevated cost of feedstocks,’ notes Young. ‘The buyers were predominantly interested in getting the material, almost regardless of the price.’

As a result, operating income for the major chemical companies jumped 40% in 1973 and slightly over 30% in 2004, despite the huge increase in raw material costs. The best profits were enjoyed by commodity players such as Dow Chemical, Monsanto and Union Carbide, while speciality firms such as DuPont, Hercules and Rohm and Haas fared the worst.

‘It is certainly no coincidence that a similar phenomenon occurred in 2004 in the face of higher oil and gas tabs,’ Young asserts. ‘As raw material costs surged, it was the commodity-oriented firms that enjoyed margin improvement while value-added companies had a much tougher time raising prices to bolster margins.’

So what happened after the oil embargo? When the embargo ended on 18 March 1974, a broad recession ensued in 1974 and 1975, leading to a massive inventory correction. Operating rates for major chemical companies fell from 90% in 1973 to 85% in 1974 and to 76% in 1975.

However, something out of the ordinary unfolded during this correction, recalls Young. Customers were convinced that the basic chemical companies would have to build meaningful new capacity to supply their needs in the coming years. After all, the chemical industry was growing about 50% faster than GDP in the early 1970s. Basic chemical suppliers were quick to point out that they needed to maintain strong pricing – even during the inventory correction – in order to justify investing the large amounts of capital to add capacity.’

As a result, even as unit shipments fell about 7%, pricing continued to increase. Operating income in the middle of the recession fell less than 10%. However, eventually the industry overbuilt and earnings took a dive, failing to recover to 1973-74 levels until 1988.

The scenario is likely to play out very differently in the years ahead. ‘Unlike the post-1973-74 period, we do not expect a new burst of capital expenditures to lead to oversupply problems in 2006 to 2007,’ says Young. ‘In the OECD countries, virtually no ethylene expansions are in the works. The bulk of new capacity in basic petrochemicals and plastics is being built in the Middle East. With healthy global economic growth, these expansions should not be a problem until well into 2007.’

The implications are very positive for commodity chemical stocks. ‘Once it becomes apparent that cost increases will be passed on to customers, investor fears are typically allayed,’ he notes. Dow Chemical significantly outperformed the market in 1974 as well as in 2004. Young favours Dow, Eastman, Georgia Gulf, Huntsman, Lyondell and Nova, all of which he rates ‘outperform’.

If recent history is a guide, extraordinary events could accelerate the march to peak conditions. ‘Back in 1994, the beginning of the tightness in the industry that led to the peak in 1995 was caused by a drought in Japan where they didn’t have enough water to run some of the plants there, as well as fires at some Gulf Coast plants,’ says Greenwich Consultants analyst Michael Judd. ‘That peak was supposed to occur in 1997, but happened in 1995 because of these unexpected outages. The question is: is Katrina the catalyst?’-

… ETHYLENE BEARS THE BRUNT

Robert Brown assesses the impact of Hurricane Katrina on the US ethylene/polyethylene market

Hurricane Katrina and its aftermath have sent fourth quarter forecasts for ethylene out the window. But at least two factors that were driving predictions prior to the storm are still in place: raw material costs and demand. Spot ethylene prices, already on a healthy run after bottoming out at 24 cent/lb during the second quarter, reached a record high of more than 50 cent/lb following Katrina.

‘Domestic spot ethylene prices reached 51.25 cent/lb, surpassing the roughly 47 cent/lb level reached in December 2004 and setting the stage for further increases in ethylene contract prices,’ notes Don Carson, analyst with Merrill Lynch. ‘With August ethylene contract prices at 41 cent/lb and a 5 cent/lb increase for September a certainty, producers have nominated a further 5 cent/lb increase for October, which they will need to implement in order to regain some of the margin lost in recent weeks.’

While ethylene price increases look like a certainty for producers, even more certain will be raw material price increases. ‘The ethylene/polyethylene market faces significant raw material headwinds,’ says Carson. ‘Ethane-integrated high-density polyethylene (hdPE) costs have increased around 7.5 cent/lb in August and are expected to rise another roughly 7 cent/lb to nearly 50 cent/lb in September.’

‘Most of the pricing activity probably will be driven by costs and will be achievable because the market is tight,’ says Earl Armstrong, managing director at DeWitt & Co. ‘The question is how much cost is needed and where is the energy environment going to be? An awful lot of crude oil pricing has been speculative and driven by paper transactions and those numbers could ultimately be anywhere from $50/bbl to $70/bbl.’

‘The [raw material] costs we are looking at are historically high,’ notes Mark Eramo, vice president of olefins for CMAI. ‘Whether you are cracking heavy or light, we are talking about 35 to 40 cent/lb to manufacture ethylene,’ he adds. ‘That is one of the reasons spot prices are so high. The cost for the incremental pound of ethylene, depending on what you are cracking, is extremely high. Part of the reason behind 50 cent/lb spot ethylene is a response to higher costs and part is in anticipation of shortages.’

‘The biggest problem right now is getting feedstock in, mainly for olefins,’ notes Dan Feller, vice president of base chemicals for Total Petrochemicals. ‘Pipe delivery is the thing that is driving everyone’s concerns.’

PE producers have responded with a series of increases to stave off raw material costs; however, their success remains to be seen. ‘With the second 6 cent/lb increase bringing benchmark hdPE prices to 67 cent/lb in September, the market has turned its focus to the next round of increases,’ says Carson. Producers have nominated a 7 cent/lb increase effective 15 September and yet another increase for October of 10 cent/lb. ‘With several PE producers already on sales allocation prior to the hurricane, we believe that market conditions are tight enough to allow producers to pass along sharply higher raw material costs, although it is unlikely that they will implement both nominations – barring a further spike in energy prices.’

Hurricane Katrina has only served to constrict an already tight PE market. ‘Katrina has taken out 3.7% of North American PE capacity and [added] $12/m Btu natural gas, so there is a tremendous amount of upward pressure on the system,’ says David Begleiter, analyst with Deutsche Bank.

While Katrina’s initial impact may be detrimental to third quarter earnings, longer term, there should be some positive effects as well. ‘Even before Katrina we were expecting a tight ethylene market post Labor Day (5 September) due to a heavy turnaround season in September and October,’ says Begleiter. He anticipated 7.6% of North American ethylene capacity to be offline in September and 8.3% in October.

Dow Chemical had been planning a turnaround at its Taft, Louisiana, facility and Formosa was set to a big turnaround in Point Comfort, Texas. But having a larger impact on pricing than any of the shutdowns in Louisiana is the Innovene outage at Chocolate Bayou, Texas. The unit is reportedly on a 45% allocation following an explosion at its olefins 2 cracker in August.

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