Building commodity chemicals in China becomes more risky

Bear in a China shop

15 May 2008 00:00  [Source: ICB]

With concerns over the environment, water shortages, a US economic slowdown and global overcapacity, how long will China's economic miracle last?

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John Richardson/Singapore

THE RISKY business of investing in new commodity chemical capacity has suddenly become even riskier, because of increased doubts surrounding China.

Will there continue to be a steady progression of rising per capita incomes from East to West, or could China's industrial revolution be derailed by the environment?

And assuming that China's great economic miracle continues, to what extent will the country serve its own petrochemical needs?

GROWTH MIGHT NOT ALWAYS BE LINEAR

The simple way for a company to assess future demand growth is to look at history and exclude what economists call externalities - a positive or negative impact on any party not involved in a particular economic transaction.

It is impossible to measure how pollution billowing out of an export-processing zone and being breathed in by nearby inhabitants might affect the expansion of the economy.

Similarly, there are no metrics available to calculate whether China will run out of sufficient water to maintain its commitment to spreading wealth from east to west.

Growth isn't always linear and doesn't always follow historical patterns. For example, one of the major reasons why the industry enjoyed such fantastic profitability in 2004-2007 was because no one accurately anticipated the tremendous boom in the China market.

Everyone knew that World Trade Organization membership would deliver benefits, but no one foresaw the voracious rise in consumption that led to double-digit growth for most chemicals.

But could air pollution force the government to moderate growth to keep a check on social unrest?

And might the chronic water shortages in Northern and Western China lead to the rate of urbanization slowing down? Further expansion of towns and cities would spread prosperity more evenly across the country.

Scientists are warning us that climate change doesn't necessarily progress in a straight line. Tipping points could soon be reached beyond which damage accelerates beyond our control.

William Laurance, a biologist with the Smithsonian Tropical Research Institute in Panama, warns of one possible tipping point in the April 12 issue of New Scientist.

Rising corn-based ethanol production in the US has led to less planting of soybeans, thereby driving up soybean prices. This has resulted in an increase in the rate of deforestation of the Amazon as farmers race to take advantage of high prices.

Deforestation of the Amazon might result in the world's most important consumer of carbon dioxide descending into "a rage of droughts and forest fires."

Chemical companies make the case for the environmental benefits of their products. Good examples are polymer-based filtration systems to purify water, and plastic pipes that can help to reduce water waste. In Shanghai, 45% of water is wasted because of poor collection, storage and distribution systems, according to Abu Dhabi-based Borouge.

But could it be that the very nature of growth is itself the real problem?

BUSINESS AS USUAL

The length and depth of the looming down cycle are also pressing concerns.

Optimists believe that global markets will absorb the flood of new capacity by 2011-2012, while one pessimistic consultant warns there is a chance that ethylene will remain in surplus until 2020.

The arguments for and against a prolonged downcycle could fill several magazines, not just these two pages, and would include different takes on crude oil prices, inflation and the global food crisis.

But the chemical industry consensus is that it's a question of when rather than whether China will inspire a new era of prosperity. Things such as runaway climate change are not being discussed - at least in public.

This was the case at the plastics trade show Chinaplas 2008 in Shanghai last month.

"The mood was optimistic. Oversupply is going to be a worldwide problem for a few years, but the show illustrated the tremendous opportunities for further strong growth, and not only in basic commodity polymers," said a source with a Middle East producer during the event. "The sophistication of the Chinese processing machinery on display indicated how far up the value chain the country is moving."

His views were echoed by Jim Harris, senior vice-president for polymers at global producer ExxonMobil Chemical.

"We see improving demand for value-added polymers in China, although commodity polymers will also still do well," he said. "We are increasingly focusing on products which will have greater strength and recyclability, such as our metallocene grades of polyethylene [PE]."

Japan's Sumitomo Chemical, which with Saudi Aramco is due to start up a new mega complex in Saudi Arabia at the end of this year, was equally bullish.

"We are quite optimistic about demand picking up after this summer's Beijing Olympics because of the Shanghai Expo in 2010," said George Yang, Sumitomo's business development manager in China.

"Demand growth for polypropylene [PP] will be [in] double digits this year, and PE will track GDP. Some sectors are doing extremely well, such as automotive applications for polypropylene homopolymer grades. We expect growth of 20% this year."

The automotive sector is identified as one of the big areas of yet-to-be-tapped potential. China has 100 cars/1,000 people, compared with 800 cars/1,000 people in the US.

Overseas polymer producers are emphasizing their value-added grades and application know-how because the Chinese economy is undergoing so many major structural changes.

The government cut export-tax rebates for manufacturers who import raw materials and reexport finished goods on a wide range of products last July.

More cuts might happen in an effort to shut down low-value, high-energy-consuming manufacturers in Southern and Eastern China.

China's central government wants industry in the developed parts of the country to become more sophisticated while encouraging lower-value production to move inland.

The export-tax credit cuts - along with a stronger yuan, high inflation, rising labor costs and the US economic slowdown - are creating what one Southeast Asian polymer producer says is a "dislocation effect."

It will take a while for industry in Eastern and Southern China to adjust to the tougher cost environment, he says. "But once this adjustment has occurred, the sky's the limit."

As for basic commodities, Western China represents huge unexploited potential. Infrastructure is being built ahead of demand in provinces such as Yunnan in the Southwest.

"There are four-lane highways with hardly any traffic," says a source at the industry association Petroleum Institute of Thailand (PTIT), who conducted a recent fact-finding trip to Yunnan. Thai producers are planning to truck polymers to Southwest China via a new road being built from Thailand, through Laos, and across the border into China.

"I cannot see China ever having sufficient capacity to meet most of its domestic needs," the source adds.

SELF-SUFFICIENCY DRIVE

But UK-based Shell Chemicals estimates that 20m tonnes/year of yet-to-be-announced ethylene capacity could be added post-2012 - much of which might be based on coal.

The debate about the environmental impact and economics of coal-based-chemicals is a long way from being resolved.

If the Chinese government, however, decides something should be done, it nearly always gets done. Coal-to-chemicals is seen by officials as a crucial part of the drive towards overall energy self-sufficiency.

The problem in assessing the strength of import demand will, as a result, hinge on estimating exactly how much of this 20m tonnes/year of capacity will get built.

Innovation in the East and South will also not stop at finished goods. Chinese petrochemical producers Sinopec and PetroChina want to produce their own higher-value polymers using locally developed technologies.

Chemical firms are eager to emphasize that it's not just about China. They point to rapid expansion in markets such as Vietnam and India. But because China's consumption of chemicals is greater than India's, growth rates in China matter more to global balances.

There is no escaping the fact that a weak China means a weak global chemical industry. History doesn't always repeat itself and growth might not follow comfortable, easy-to-forecast linear trajectories. Too much investment has probably been based on the flimsy assumption that sustainability and rapid economic growth are compatible.

The biggest worry about the environment, to paraphrase Donald Rumsfeld, is the unknown unknowns.