04 November 2011 15:58 [Source: ICB]
Producers will often cite negative or nonexistent profit margins. But it pays for buyers to look at the wider picture to see where the margins are
For chemical buyers, getting to the bottom of producer claims of negative variable margins is key to understanding the overall picture.
Just as singer Bret Michaels of glam-metal band Poison penned the words "Every rose has its thorn, just like every night has its dawn, just like every cowboy sings his sad, sad song" in the late 1980s US number-one hit - players in the chemical industry often have similar sad tales to tell.
Chemical buyers will outline the tale of soft demand, loosening markets and offers of low-ball priced imports. On the other side, chemical producers will lament rising costs, firming demand, and tightening markets exacerbated by future scheduled plant turnarounds.
The chemical producer also has additional artillery in its arsenal of why prices should rise: "My margins are nonexistent!" This raises another question of why a chemical producer would continue to produce a product if it is essentially paying you to take their material.
The ICIS Weekly Margin reports calculate a variable cash margin for a range of chemical processes and scenarios and for various geographic regions. A variable cash margin is the difference between the net price of an ex-works chemical product and the net price of the feedstock required; less the costs of utilities (e.g. steam, fuel and electricity) required to carry out the chemical process.
The definition of a net price is the price quoted in the marketplace, less any rebates, duties or logistical costs, etc. required to move that material into and out of the chemical facility. The variable cash margin is one of the more basic ways of measuring the profitability of producing a product.
It doesn't include the fixed costs of running a chemical facility (staff and maintenance costs or interest payments) nor any debt repayments or return on investment (ROI) to the stakeholders. The variable cash margin is also independent of the chemical facility's operating rate.
As with most industrial sectors, there are a range of variable operating costs that define what different market players can produce the next marginal unit of a product for. Low and high-cost producers are usually described as "leader" and "laggard" producers, respectively. Referring to the conceptual cost-curve shown, a laggard producer would sit on the right, while a leader producer would sit on the left of the middle blue-colored section (see chart below).
LEADER OR LAGGARD
An example of a laggard chemical producer would be a smaller-sized, stand-alone plant utilizing older facilities and process technology. If it produces polypropylene (PP) for example, it would be exposed to all of the price volatility in both propylene and PP markets.
In a tight market with high demand, a laggard is likely to have decent margins and be happy with business as usual.
Any lengthening of markets through lower demand or the arrival of competitively priced imports would most likely squeeze its margins or turn them negative. If market improvement isn't on the horizon, it could be forced to idle or close its facilities. It is likely that the level of demand and the cost structure of laggard producers will determine the price of a product in the marketplace.
An example of a leader producer would be that of a chemical producer that is using a world-scale, more modern plant and process technology, and is part of a highly integrated chemical facility.
The setting for the leader producer could be buying naphtha for a steam cracker and selling a range of polymers and downstream chemicals. Most likely the output of one chemical plant will be utilized internally as feed for another.
For example, ethylene and paraxylene (PX) from a steam cracker co-located with a refinery could be converted to monoethylene glycol (MEG) and terephthalic acid (PTA) to be later polymerized to polyester. A leader will most likely capture a significant portion of the "value add" within a supply chain, while a laggard producer may only capture the "value-add" over one or two chemical conversions.
As long as there is demand for the leader's product, it will most likely be able to capture an adequate variable cash margin that covers its fixed costs and provides ROI to its stakeholders. It is only the size of the ROI that changes over the business cycle.
A leader will also be able to offset a poor or even negative variable cash margin of a product or two, as it will be able to monetize product streams elsewhere that will offset the pain of a negative margin. Quite often a business segment will suffer for the greater good of the whole company.
An advantaged feedstock chemical producer will capture the entire margin of a leader producer and then some, depending on the size of its feedstock advantage. Margins of an advantaged producer are larger and more insulated throughout the business cycle as their feedstock costs have a looser linkage to oil prices.
NEGATIVE VARIABLE CASH MARGIN?
Quo vadis margin? laments the producer, or "where are my margins going?" In the never-ending battle of buyer versus seller, it is the seller's job to defend his margin with all effort or face an angry manager.
Is the negative variable cash margin fact or fiction? As with most things, in reality it is much more complicated than it first seems. The modern chemical industry is a complicated, intertwined sector - neither black nor white.
The following examples may help to clarify. The variable cash margin for a stand-alone PP producer in Northeast Asia that is mainly focused on exporting to China has been terrible - about minus $130/tonne and has been negative since the middle of the first quarter. The average variable margin for the first three quarters of 2011 was around -$80/tonne. A laggard stand-alone producer would truly be underwater.
However, if you consider that most modern PP plants are part of a more integrated chemical facility, most likely integrated back to a naphtha cracker, we begin to see a different story.
If we base this analysis on the production of one tonne of PP, we can calculate that for one tonne of PP we need approximately one tonne of propylene. To produce this much propylene, we need to crack about six tonnes of naphtha.
After cracking this much naphtha, we will produce more than 1.8 tonnes of ethylene, 2.2 tonnes of by-products (butadiene, aromatics, etc.) as well as a fuel export that can be utilized elsewhere in the chemical facility. The ethylene produced can be more effectively monetized by a downstream polyethylene (PE) plant as a feedstock stream. In this example, we will add a downstream high-density polyethylene (HDPE) plant to our integrated facility. If we now measure the profitability of this simplified chemical facility from naphtha to polymer, we get a combined PP variable cash margin of more than $450/tonne (1.0 tonnes of PP + 1.8 tonnes of co-product HDPE). Similarly, the average combined PP margin of the first three quarters of 2011 is about $470/tonne.
A similar story can be seen in the PP sector of Western Europe. The variable cash margin for a stand-alone PP plant is currently about zero, has been negative for most of the second quarter, and has averaged around €40/tonne ($56/tonne) for the first three quarters of 2011. The integrated contract HDPE margin in Western Europe was around €500/tonne at the beginning of October. If you have the same chemical facility as used in the Northeast Asian example, the current combined PP variable cash margin is €893/tonne and has averaged more than €1,000/tonne for the first three quarters of 2011.
MODEL, INTEGRATED CHEMICAL FACILITY
If we examine the profitability via a variable cash margin of a simple, model, integrated chemical facility we can get further insight into the profitability of chemical producers.
Our model facility will be situated in Northeast Asia and consist of an upstream naphtha cracker and several downstream plants, specifically a styrene monomer facility, an HDPE facility and a PP facility.
For most of the second quarter in Northeast Asia, standalone styrene monomer, HDPE and PP variable cash margins averaged -$59/tonne, -$46/tonne and -$70/tonne for the second quarter, respectively.
Nevertheless, if we base an analysis on cracking enough naphtha to produce one tonne of HDPE, and utilizing coproducts in the downstream facilities, we get a "chemical facility" variable cash margin of $261 for the yields tabulated. All of a sudden when all the components are evaluated, a new picture emerges.
There can be scenarios where a negative variable margin can exist, even after looking at the whole picture. But why would a chemical producer keep producing at a loss?
If the period of negative margins is viewed as temporary, either the result of lows in the business cycle, high feedstock or low product prices, the producer may continue to operate its facilities in order to honor customer contract commitments and to maintain market share.
There is also the issue that once the costs associated with shutting down a facility (costs of plant shutdown, staff layoffs and other asset retirement obligations, for example) have been factored in, losing a little money each month may be better than the large lump cost of calling it quits. Facilities may also operate with negative margins as the result of political or regional agendas where social benefits are realized elsewhere. Margins for chemical producers have fallen recently from the highs seen earlier in the year. Concerns about the sustainability of global growth and sovereign debt levels are taking their toll on chemical prices. However, upstream oil prices have remained at historically elevated levels.
Barring another financial crisis, chemical producer margins should revert to the mean. However, after you have heard a seller's sad song, step back armed with market intelligence and think about the bigger picture.
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