Global petrochemical cycle at a crossroads between the economy and energy prices

Chemical crossroads

26 March 2008 15:37  [Source: ICB]

With an impending US economic recession, high energy prices and the coming wave of new Middle East capacity, the ethylene cycle is poised to trough in 2009-2011

Consultant's corner
Sergey Vasnetsov/Lehman Brothers

THE CHEMICAL industry stands at the intersection between two major dynamics - the economy and energy prices.

The pace of economic growth deter-mines the extent of chemical demand, while energy prices are the dominant cost in production of all chemicals, in particular for commodities.

Before discussing our outlook for the US chemical industry, we should start with a set of economic assumptions, which are the product of our own research and the opinions of several experts in their fields.

KEY ASSUMPTIONS

The US economy is likely to enter a recession phase in 2008-2009 due to the impact of the bursting housing bubble and credit crunch, initially on US consumer demand, and then on US industrial production.

While quarterly GDP is too volatile to forecast, an extended recession phase to us means annual GDP growth of around 1% for two years.

The cheaper dollar should help US exporters, but will also lead to inflation in dollar-denominated commodity prices. Western Europe and developed Asian economies are expected to slow down, but avoid recession in the absence of their own housing bubbles and credit crunches, while developing countries are expected to continue their rapid economic growth.

Highly volatile energy prices have continually frustrated many industry experts and energy consumers. Both experts and the NYMEX futures market have forecast steady or declining oil prices for every six to 12-month period since 2003.

But the upward trend in crude oil prices has consistently defied those expectations, and we have had to adapt. While short-term swings are indeed confusing, we have noticed a clear longer-term trend, shown below.

Certainly, this is a very simplistic view, but it seems to have worked better than most other far more sophisticated models. While we are not in the business of oil price predictions, it will be interesting to see if such a trend will continue in the environment of slower global economic growth, both in the US and globally.

DISSECTING THE DIFFERENT CYCLES

As the coming wave of capacity expansions for many commodity chemicals is well known, the industry has been preparing for a trough.

Companies have taken many preparative steps, such as streamlining operational efficiency to improve profitability, enhancing vertical integration to reduce volatility, reducing capacity to decrease oversupply and realigning their portfolios to focus on core businesses.

While the competitive landscape for each commodity chemical and strategy of each company may vary, we believe the changes will improve the position of the US ­chemical ­industry during the expected global ­chemical trough.

ETHYLENE TROUGH IN 2009-2011

For ethylene and polyethylene (PE), 2008 will be a transition year toward the expected trough of 2009-2011.

The Middle East Gulf countries (notably Saudi Arabia, Iran and Qatar) have been rapidly building new ethylene and related capacity in recent years, thanks to large and cheap resources of ethane. This wave of new capacity should materialize in 2009-2011.

However, given the much more limited availability of ethane to new, as-yet-unannounced projects, starting up in 2012 and beyond, we expect most new ethylene plants will be built on naphtha (many ­integrated with refineries, notably in China), which is a more expensive ­feedstock. In addition, naphtha-based ­complexes tend to be more costly than ­ethane-based plants.

Therefore, we expect a significantly slower pace of new capacity additions in 2012-2014, thus helping the global cycle to recover toward the next peak.

Since ethylene is the "mother of all chemicals," the above forecast is applicable to other large ethylene-chain derivatives such as PE, ethylene glycol (EG), propylene and polypropylene (PP).

MIDDLE EAST EXPORTS: WHERE WILL THEY GO?

The large polymer capacity expansions in the Middle East will likely be directed toward Asia. These two regions are set to dominate commodity chemical capacity growth in 2008-2012, accounting for over 80% of new global ethylene and 66% of propylene capacity.

We expect the global ethylene and propylene derivatives trade to grow considerably as a result, due to a large mismatch of location for demand growth, in Asia, and capacity growth in the Middle East.

NORTH AMERICA'S EXPORT WINDOW TO CLOSE

After experiencing a decline in net exports earlier this decade, North America has seen a resurgence in ethylene equivalent exports up to 13% of total US production in 2007 and so far in 2008, due to a higher ratio of oil/natural gas prices and a weak US dollar.

However, we expect that opportunities for US commodity plastics exports will decline significantly in 2009-2011, as large volumes of highly cost-advantaged Middle East capacity displaces other exporters into China, notably US, Korean and Japanese producers.

A reduction in global operating rates and a redirection of global trading patterns will be needed to accommodate the "Middle Eastern wave." Propylene net trade will follow a similar pattern as ethylene, with the Middle East becoming the major exporter and Asia the major importer, although North America is still expected to retain a small net export position in propylene derivatives.

We expect that North America, a traditional chemical exporter, will be joining Western Europe by 2009 as a balanced region of commodity chemical production and consumption, and then gradually growing as a net importer of commodity chemicals and plastics.

PET, PVC AND PS TROUGHING

Other plastics, such as polyethylene terephthalate (PET), polyvinyl chloride (PVC) and polystyrene (PS) have been plagued by slower demand growth and overcapacity, which is unlikely to change over the next couple of years.

The weak US housing market and oversupply in Asia continue to pressure PVC. The PET cycle went into a heavily oversupplied period in 2007, as overall capacity jumped by 25% in North America from the first quarter of 2006 to the second quarter of 2007.

Although the PET market still enjoys a steady demand growth rate of about 6-7%/year, the new capacity has overwhelmed the market.

In addition, since the cost curve for PET is flat, it is hard for PET producers to materially differentiate themselves. This encourages new entrants and has led to aggressive competition and poor returns.

The US styrene/PS industry is finally taking proactive measures to improve profitability, after years of battling weak operating rates and high raw material costs.

The recent plant shutdown by US petrochemical producer Sterling Chemicals in Texas City has removed 11% of North American styrene capacity from the oversupplied market, which has provided some relief. But it is not enough for a steady recovery in styrenics.

CHLOR-ALKALI SOFT LANDING THROUGH 2010

The outlook for the chlor-alkali chain is quite different from that of olefins. Operating rates and cash profit margins in North America have been quite strong over the past few years, due to a 13% capacity reduction and improved market concentration since the last trough of 2001-2002.

Continued capacity expansion in China (15% growth in 2008, followed by 10% growth in 2009) are likely to reduce operating rates and profitability in the Asian chlor-alkali market over the next few years.

The US cycle will be driven down by chlorine (because of housing-related PVC weakness) and later by caustic (as a result of a general decline in industrial production).

US PVC producer Shintech is also bringing on major chlor-alkali capacity in Iberville, Lousiana, this spring.

However, we believe market concentration, with the top four US producers controlling 76% of total capacity, and some planned reductions in capacity could help the US industry at the bottom of the cycle.

STABILITY IN ACETIC ACID, ACRYLIC ACID AND TiO₂

These niche products are not part of the Middle East petrochemical boom, and hence should have relatively more stable supply/demand balances through 2010.

High producer concentration, limited capacity growth and steep cost advantages have reduced cyclicality and have improved profitability. Even so, capacity growth in other regions, mainly Asia, is expected to weigh on profitability towards the end of the decade.

Among the three, TiO₂ remains the most difficult market. Acrylics are doing better, while the acetyls chain is in very good shape.

PAINTS AND COATINGS: A SIMILAR PICTURE

The severe downward correction in the US housing market is expected to continue to pressure architectural paints and some industrial coatings in 2008.

However, the recent industry consolidation is reshaping the competitive landscape, improving the concentration and global reach of the top producers. The increased regional diversification should help offset weak US conditions for the large paint producers and raw material and overhead synergies should help improve the profitability of the larger entities.

GASES GOING STRONG

The industrial gas industry continues to diversify, expanding into new regions and developing within three secular growth areas: those of energy, the environment and emerging economies.

Consolidation has resulted in four global producers, each with its own regional strategy or market niche. As the majority of industrial gas contracts contain "energy pass-through" clauses, this allows producers to maintain their operating profits, despite sudden spikes in energy costs.

While industrial gas earnings are partially reliant on healthy global industrial, electronics and steel industries, long-term "take-or-pay" contracts and energy cost protection help to reduce the impact of a global slowdown, as shown by continued sales growth in 2000-2003.

Sergey Vasnetsov leads a chemical research team at Lehman Brothers responsible for coverage of 19 major US chemical companies. He has 11 years of chemical research experience, both in academic and applied industrial areas, and 12 years of Wall Street experience. He has been ranked by Institutional Investor magazine in the top group of US chemical analysts in each of the 1999-2007 annual surveys. He has an MBA in Finance, from Rutgers University, in New Jersey, US, and an MSc in Chemistry from Novosibirsk University, Russia.

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