Global petrochemical cycle to turn down in 2008 and beyond

The coming slowdown

26 March 2008 16:14  [Source: ICB]

By Andrew Swanson/Nexant

Consultant's Corner

The global petrochemical cycle will turn modestly down in 2008 and beyond, as US demand suffers and Middle East capacity comes online

"RESILIENT" IS the word to best characterize the global petrochemical industry. The sector had a solid 2007 despite major headwinds, but the down cycle will start to manifest itself in 2008 and beyond.

In the US, sales by major chemical firms, as reported by the American Chemical Society (ACS) were about $176bn (€113bn), up by 9.9% over 2006. Earnings of nearly $15bn were up by 12%.

Nexant's cash margin index for US petrochemicals and polymers held steady through 2007 at about 70 and in Europe at 180 (1984 = 100).

Indeed, the indices have been at these levels since the industry recovery from the last recession, at the beginning of the decade.

The industry's performance has been noteworthy at a time of unprecedented and inexorable feedstock cost increases, especially those related to crude oil, such as naphtha.

Crude oil prices averaged just $66/bbl in 2006. Prices paused briefly in early 2007 as winter demand eased, and then increased to close out the year in triple-digit territory.

The 2007 average is a breathtaking $73/bbl. That the industry could maintain profitability throughout 2007 in the face of these price movements is a testament to its importance to customers and its skills in passing through cost increases.

Profitability in the critically important olefins and aromatics areas was strong. Cash cost margins for ethylene from natural gas liquids (NGL) in the US held up very well in 2007, yielding pretax returns on investment in the range 25-35% - well into reinvestment territory if companies were so minded.

By contrast, ethylene margins from naphtha in the US, Europe and Asia were one third of NGL-based margins, reflecting the comparative cost advantage that US ethane and propane have had over globally priced oil-based naphtha.

In aromatics, benzene continues to present problems, with prices that depressed extraction returns.

In polyethylene (PE), low density polyethylene (LDPE) and linear low density polyethylene (LLDPE) performed well, although there were worrying downward margin trends in Europe.

VINYLS HIT HARD

Not all segments of the industry performed so consistently. Unsurprisingly, the US vinyl chain suffered most, hit hard by the decline in housing construction.

"Decline" is too soft a word for an industry that saw a 42% reduction in housing starts, from a peak of 1.75m in September 2006, to 1.01m in January 2008. Steady declines in demand and steady growth in feedstock costs are a toxic combination.

Pipe-grade vinyl cash margins for the nonintegrated producer are negative. Even the integrated vinyl producer is seeing pipe-grade cash margins close to zero - a level not seen since 2003. The margin compression is less apparent in Europe and Asia.

Average margins in 2007 do not tell the whole story. What may be an early warning of looming, market-wide problems can be found in the global industry's performance in the fourth quarter.

Generally, fourth-quarter cash margins were lower than third-quarter profits. Nexant's US cash cost margin index fell from 75 to 50 in the fourth quarter of 2007, despite operating rates staying at about 87%. In Europe, the index fell from 200 to 140.

Clearly, price increases have not been able to recover cost increases. Add to that a softening in domestic markets, partially offset by booming export markets, and the chances of a strong 2008 look increasingly unlikely.

Some months ago, it was possible to forecast a continuation of strong profitability from 2007 into 2008, and, in certain circumstances to foresee a margin fly-up if demand remained strong, operating rates high, and market psychology shifted to fears of scarcity. This latter possibility now is looking remote in the face of a potential US recession.

PROSPECTS

What then does the future hold? Will the recession in the US housing market and the credit squeeze extend to the broader global economy and begin to lower margins in even the most profitable segments?

The US Federal Reserve has an increasingly constrained outlook for the growth of the overall economy. The Fed recently adjusted its forecast downward for GDP growth in 2008 from 1.6% to 1.3%, and for 2009 from 2.7% to 2.1%. At the same time, it expects the economy to underperform its "normal" growth rate of 3%/year as far out as 2012. The combination of a housing slump and a credit crisis will take significant time to work out of the system.

The petrochemical and polymer industry's demand growth leverage to US GDP is close to, but less than, 1 times GDP the days of growth premiums to GDP are long gone.

Moreover, an increasing share of US polymer resin demand growth is being met by imports of bags, film and rollstock. Nexant estimates that import volumes were about 500,000 tonnes in 2007.

These fundamentals are not helped by downstream market problems, not only in housing, but in autos as well, where some observers forecast a fall in US production by up to 1m units, or 6%, compared with 2007.

But, additional US exports are possible, and indeed the competitive advantage of ethane at just over $1/gal relative to naphtha at over $2/gal can justify this.

Such sales are made into highly competitive spot markets and yield reduced netbacks after transportation costs. Nevertheless, they are highly valued incremental sales and go far to support many US companies' international - especially Latin American and Asian - commercial strategies.

In Asia, China's important role as a growth engine in manufacturing, and hence in demand for petrochemical and polymer inputs, looks set to continue. Domestic GDP growth, just over 11% in 2007, is forecast at a still robust 9.5% in 2008. Commodity polymer (PE, polypropylene [PP], polystyrene [PS] and polyvinyl chloride [PVC]) imports are at a rate of over 11m tonnes/year.

In trade terms, there is evidence of a slow shift in GDP growth away from the net export component to the domestic demand component. In 2005, an increase in net exports accounted for one-third of GDP growth. By 2007, this share had fallen to one-quarter, with the additional growth coming from domestic demand.

On the supply side, China continues to develop its petrochemical industry, although its investment program is meeting domestic demand growth and not leading to import substitution.

In the next two years, China will bring online about 1.5m tonnes/year of new ethylene capacity, an increase of 15%.

Over the same time frame, Middle East capacity is projected to grow by 8.2m tonnes/year - an astonishing 60%. New capacity in Iran, Saudi Arabia and other countries will therefore be entering Asian and European markets. Other potential markets will undoubtedly be targeted.

With moderating US GDP growth, Nexant forecasts global ethylene demand growth at 4.2% in 2007-2008 but then at a more constrained 3.7% in 2008-2009.

As a consequence, we forecast global ethylene operating rates to ease from 92% in both 2007 and 2008, to 89% in 2009, with some consequent reduction in margins. We project a continuation of the slowdown already apparent in the last months of 2007.

Andrew Swanson is a vice president at Nexant and is responsible for chemicals consulting in the Americas and Asia. He has performed a wide range of consulting assignments, including strategic planning, feasibility studies, competitive analysis, and market and commercial analyses for a diverse client base. Before joining Nexant, Swanson worked for ICI and Nalco Chemical.

For more information, visit www.nexant.com

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