02 September 2011 16:53 [Source: ICB]
Significant social and economic forces are reshaping chemical markets, creating new opportunities via portfolio and product innovation. We foresee these developments leading to a chemical renaissance that will benefit global players and, especially, assets centered on North America, prompting continued restructuring and consolidation of the chemical industry.
Many factors are driving this transformation, including new energy and feedstock sources, continued shifts in market demand, the industrialization, maturation and further development of world economies, and megatrends related to the world's population and its resource, environmental and energy requirements. We examine each of them below.
NORTH AMERICA'S SHALE ADVANTAGE
We see North American shale gas as a major advantage, a low-cost energy source and feedstock that should enhance profit potential of the North American chemical asset base, including specialty assets.
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During the past two years, the price of North American natural gas has averaged about 60% below its BTU parity with crude. North America gas prices are second only to the advantaged regions with "stranded" gas. Globally unique, the scale of North America's shale gas reserves and natural gas infrastructure are particularly suitable for leveraging in the chemicals domain.
Shale gas investment is driven primarily by energy supply economics. It requires substantial scale and the support of a sizeable market and resource base. The scale of investment and infrastructure allows access to natural gas liquids as a co-product in quantities sufficient to make co-located ethylene production possible. We doubt the same potential to access wet gas exists outside North America, Mexico and perhaps China.
In this regard, North America appears to present considerable promise for an advantaged light feedstock that should be available in sufficient quantities and low enough prices to support continued olefins investment. This is made possible by industry commitment to invest and develop the infrastructure for an efficient supply chain that can enable monetizing wet gas reserves. On the petrochemical end of the value chain, six cracker investments have been announced. They may not all go forward but enough will to increase the North American export share and capture much of the available global trade share through 2020.
CHANGING FEEDSTOCK DYNAMICS
Because of the significant availability of favorable light feedstock, North America is clearly second only to the Middle East in the economics of olefins assets, and we expect the global industry cost curve in olefins to keep evolving. Middle East facilities will remain low-cost players but, moving forward, low-cost ethane will be scarce in the region, and the combination of liquid feed and higher capital costs will impact the cost base of producers, prompting new approaches.
Increasingly, Middle Eastern players will look for creative ways to sustain chemicals growth, including an acceleration of more downstream integration and specialization to add additional value to higher-cost upstream petrochemicals, as well as alternative investment, including chemical refinery concepts that capture value through scale and novel integration approaches. Globally, the shift in light feedstock use in North America continues to affect key co-product markets in C3 and C4, making these products scarcer and raising their value which has, in turn, sustained producers cracking liquids.
DEVELOPMENT AND THE SHIFT EAST
The popular notion of a "super cycle" - in which demand rapidly outpaces supply - seems only modestly optimistic given the continued downward revision of global GDP growth forecasts. For many petrochemicals products, particularly polyethylene (PE), China is the largest consumer and most significant driver of growth. A scenario of growth driven by China and India as income and consumption develops suggests a more stable demand outlook. The Asian growth outlook, coupling continued infrastructure demand and rising disposable income, remains robust. We continue to wait for Western companies to exhibit the typical business cycle recovery we believe will be forthcoming.
The Asian chemical sector will continue to grow, although not as quickly as many expect. Industry growth and development are hindered by limited access to technology and intellectual property, the absence of specialized markets, and business execution models that will continue to rely on cross-border merger and acquisition to fuel development.
CONSOLIDATION: THE PATH IS UPON US
M&A activity in the chemical sector began the year at a good pace. Strategic buyers have maintained a strong presence in the market place, which has seen a range of sizeable and watershed deals. Certain investment themes have emerged, such as cross-border and geography-driven investments. For example, Solvay acquired Rhodia in large part to gain its Asian business position, while Dow continues to build key positions in the value chain of advantaged regions that will target Asian market growth, such as the Middle East.
Another theme has been portfolio diversification, such as Ecolab's acquisition of Nalco to gain greater access to the promising oil and gas sector, a growth market for water management and environmental services.
Other examples include the purchase of ISP by Ashland, Cognis by BASF, and Arch Chemicals by Lonza. Financial investors are still pursuing cash flow and valuation. For example, Berkshire Hathaway bought Lubrizol, and Carl Icahn is bidding for Clorox.
Overall, consolidation is proceeding quickly, particularly in the specialty sector. With the overall market correcting and near-term pressure on chemicals and other GDP-sensitive sectors, strategic buyers with good cashflow, strong balance sheets and diversified portfolios will benefit from attractive valuations as acquisition ensues.
We also expect an increasing number of cross-border deals in developing regions as players pursue diversification, intellectual property and technology that can be leveraged for investment.
INCREASING PORTFOLIO SCALE
These shifts in industry structure have numerous strategic implications. We believe the prospect for consolidation is significant, which suggests increasing scale requirements that will make it more difficult for small regional players to thrive.
Changing energy and feedstock scenarios arising from North America's natural gas advantage will propel investment by larger energy and petrochemical players in the olefins value chain. Refineries will also present incremental feedstock opportunities. With the gasoline market displaying challenging fundamentals in North America, refineries can be reconfigured to produce incremental ethylene, given the abundance of low-cost dry gas.
Beyond petrochemicals, at macro level, the natural gas advantage will support higher earnings potential for commodity, diversified and specialty chemical assets in North America, revitalizing the region's chemical industry, perhaps at the expense of European assets and moderating growth in the Middle East.
These shifts in position should also provide impetus for restructuring in Asia and prompt the further evolution of Asian majors, such as PTT Chemical and China Bluestar, capable of acquiring and developing geographically balanced portfolios as a foundation for competitive advantage. Ultimately, creating value is all about driving sustainable growth through strong portfolios and innovation. Changes in key industry fundamentals such as energy and feedstock provide a solid foundation to pursue these objectives.
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