By John Richardson
TAKE a look at the above chart and ask yourself this question, “Why is it that the spreads between high-density polyethylene (HDPE) injection grade and naphtha have been so good so far this year?”
The same has therefore, of course, applied to margins for integrated PE producers.
Let’s first of all look at the data in the above chart in detail before I give you my answers to the above question:
- The average spread between naphtha and HDPE from January 2009 until the end of last year was $453/tonne.
- So far this year this year, the average has been $676/tonne.
- We can also look at this in terms of multiples of the HDPE price over naphtha. The average multiple in 2009-2014 was 1.60. In January-July 2015, it was 2.30.
It is the same story in low-density PE (LDPE) film which again must prompt the question of “Why?” Between 2009 and 2014 spreads averaged $580/tonne, whereas so far in 2015 they have soared to an average of $765/tonne. Multiples have increased from 2009-2014 average of 1.7 to 2.4 so far this year.
Here are my five reasons why I think this has happened in both HDPE and LDPE:
- Up until late February, oil prices were in bear territory. From that point up until June, the mood in oil was mainly bullish and so converters in Asia, most importantly in China, “bought ahead” of their immediate resin needs in order to hedge against future PE price rises.
- This created the impression of stronger demand at a time when PE markets felt as if they were tight, even if this was only an impression.
- The Asian merchant ethylene market was, however, very tight indeed. This was the result of both scheduled and unscheduled shutdowns.
- Spot merchant ethylene is always a very thinly traded market in Asia, as it represents only about 5% of the total ethylene sold (the rest is either sold on contract, usually by pipeline, or there is just a “transfer” cost or price incurred from moving ethylene from a cracker to a PE unit belonging to the same company). So it takes only a relatively small amount of lost production to send the Asian ethylene price skyrocketing. On 30 January, it reached a low point so far this year of a spot price $1,080/tonne CFR Northeast Asia (NEA). But then as production losses increased, it rose to a 2015 year-to-date high of $1,430/tonne CFR NEA on 8 May.
- Even though the vast majority of Asian, and also Middle East, PE producers are integrated through to ethylene, it is the ethylene spot price that drives Asian PE prices. This is because the Asian converter industry is very fragmented and so processors are either unable to change the status quo, or lack the market knowledge to challenge this status quo. Perhaps it is a combination of both of these things.
Demand was at best OK throughout the bull-run for oil, ethylene and PE prices and in some cases was described as weak in different parts of Asia. At the same time, whilst agree that there isn’t that much new PE capacity due on-stream this year and next, I don’t think that the real, sustainable growth that I can see have been enough to create really tight markets (more on this theme in later posts).
Now, of course, markets are moving in the opposite direction. Oil is in deep bear-market territory, ethylene had fallen to $1,290 CFR NEA on 31 July and PE prices had also declined.
At the same time, demand is weakening in China as economic rebalancing continues. Southeast Asia (SEA) is obviously suffering because of China, one of the symptoms of which is weaker currencies. On Monday, for example, the Malaysian Ringgit fell to a 16-year-low against the US dollar, which is making PE imports much-less affordable.
So the final two questions you need to ask yourself “Will spreads, and so margins, begin to return to their historic averages?” and, if your answer is yes, “How quickly will this happen?”
I believe that spreads and margins have, over the long term only one direction to go – and that’s down. There is nothing to suggest to me that the economic fundamental, not only in China, but also globally, can do anything but get worse. Equally, oil has really only one way to go as it returns to its historic average price of $30 a barrel.
There is also a chance that spreads will go below their long-term average as the New Normal further develops.
How quickly will this happen? I really hope I am proved wrong, but I think there is every possibility of a very rapid, and so very disruptive, fall over the rest of this year and into early 2016.
This is all well and good for the future if you are doing the right thing with your “windfall profits”. Investors will look at your company favourably as the New Normal continues.
But if you have told your shareholders that the rest of this year and 2016 will be the same as January-July 2015 because of a PE mini supercycle, and so there is no need to do anything differently, I think you might well face some major problems.