Deflation Threatens Asia’s Ethylene-Polyethylene Link

ethylenenaphthaHDPE

By John Richardson

AS you can see from the above chart, ever since April 1997, when we first started providing price quotes for spot Northeast Asian (NEA) high-density polyethylene (HDPE) film grade, it has been spot ethylene rather than spot naphtha prices that have driven HDPE prices. You can find the same pattern for any other grade of PE in both North and Southeast Asia.

Back in 1997, when I had recently started working in this industry, this made a little more sense as at that stage there were more entirely non-integrated Asian PE producers – i.e. they didn’t operate their own crackers, or were not connected to domestic ethylene supplies by pipeline. They were more producers around who had to engage in the very expensive business of shipping spot ethylene long distance.

But these days, more than 95% of Asian PE producers either have their own crackers or have most, if not all, of their ethylene needs covered by domestic pipeline supplies.

In the case of the cracker operators, this means that their PE units never pay the equivalent of the prevailing spot ethylene price. Instead, ethylene is priced on transfer cost mechanisms that vary from company to company.

Those who buy ethylene locally by pipeline also don’t pay the prevailing spot price. Their cost of feedstock is instead based on varying formulas of different regional spot prices, minus substantial discounts for the freight costs for freezing and shipping ethylene that are of course not incurred.

In some cases, there are also dedicated pipelines between one cracker operator and one downstream customer. This means that these cracker operators often provide even heftier discounts off prevailing spot prices because the international spot ethylene market in Asia is very thinly traded. Even if these cracker operators wanted to sell ethylene to someone else, they would struggle to find enough regular customers.

Asian spot ethylene markets have been exceptionally tight this year. This helps explain why, despite the 2015 fall in naphtha costs and lower crude oil, Asian PE margins have actually expanded. For example:

  • HDPE injection grade CFR NEA naphtha-based integrate variable cost margins averaged $513/tonne for 2015 up until 4 December, according to ICIS Consulting. This compared with $245/tonne for the whole of 2014 and $130/tonne for 2013.
  • Average NEA low-density PE film grade  naphtha-based integrate variable cost margins were at $581/tonne, again up until 4 December. This was against $323/tonne for last year and $211/tonne for 2013.

To help explain the role of cheap naphtha versus expensive ethylene in driving PE margins higher, analysing spreads between naphtha and PE is very useful. In again the case of HDPE injection grade, the 2009-2014 average spread between naphtha and HDPE was $475/tonne. From January to October of this year, it increased to no less than $692/tonne.

What about next year? As my colleague Yeow Pei Lin writes, in an excellent article on the Asian ethylene market, supply looks set to remain pretty tight in 2016 on permanent cracker closures in Japan, slowing exports from South Korea and the Middle East, and new non-integrated downstream expansions in China and Taiwan.

Will this therefore equal a repeat of this year’s PE margins? I don’t think so. Here are my three reasons why:

  1. We are in a deflationary world, mainly as a result of China. The cost of all the finished goods made from PE will thus continue to come down. So there will be a push up the value chain by hard-pressed retailers and their manufacturing suppliers to find raw-material cost savings. The illogical link between Asian spot ethylene and spot PE price will thus be challenged. I don’t believe it will necessarily be broken, but it will certainly be challenged, reducing the correlation.
  2. Spot propylene is going to be very cheap next year relative to ethylene. As propylene also drives the Asian polypropylene (PP) price, we will see PP gaining more market share from PE. The hard-pressed retailers and manufacturers will of course be behind this push as they try to save on costs.
  3. Substantial new PE supply is due on-stream in the Middle East and Asia next year.

“But hold on, isn’t cheaper oil fantastic news?” some people will continue to say. These people will interpret OPEC’s decision to maintain oil production, which was announced last Friday, as a big positive for the global economy.

This  is the wrong reading of events. Barring geopolitics, the oil price could now fall below $30 a barrel because of vast oversupply in crude – and also in other commodities – that has been built up on totally false assumptions of demand growth. This was why OPEC felt it had no choice but to keep production at high levels. The alternative was to cut output, only to see prices still fall along with OPEC’s market share.

The OPEC decision underlines the extent of the global deflationary pressures we face – hence, the intensification of efforts to save on manufacturing costs. PE producers will therefore struggle to hold on to existing margins, and will very likely face a sharp correction in profitability.

All doom and gloom? Not at all. As I shall explore on Wednesday, petrochemicals producers in general can take advantage of deflation, and also of the drive for greater sustainability. But they have to approach markets in a very different way.

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