Commentary: A transitory downdraft in petrochemicals?

The downdraft across global chemical markets coincides with the continuing weakness in crude oil. And with seasonal destocking expected towards the end of the year, the big question is: How long could it last?

The Chemicals Volume Proxy – developed as a leading indicator by Canaccord Genuity analyst Paul Satchell using spot pricing data from ICIS – has been flashing warning signs. Since mid-October, the weekly readings have been negative for the US, Europe and Asia – a string of six consecutive negative readings in each region, which has not appeared all year.

“The prevailing bearish environment for oil prices is likely to be a major factor in the destocking which we believe is being reflected in our index. Given the traditional trading weakness of December, the fourth quarter of 2014 appears increasingly likely to disappoint,” said Satchell.

It should be no surprise that the Volume Proxy readings have been negative with the plunge in crude oil prices since September 2014. The r-squared value measuring significance of correlation between Brent crude oil prices and US petrochemical prices – as measured by the US ICIS Petrochemical Index (IPEX) – since 2000 is 86.4%.

US petrochemical prices clearly move with global crude oil prices, even as much of the feedstock is based on natural gas. The r-squared value between the US IPEX and Henry Hub natural gas is just 2.0%, showing essentially no correlation.

However, an interesting analysis based on an emerging debate in the US about the impact of oil prices on polyethylene (PE) has yielded a different result. Since 2000, the r-squared value between Brent crude oil and US contract high density PE (HDPE) prices is just 63.0% – not quite significant using the widely cited 75% threshold.

In a mid-November meeting hosted by Wells Fargo, Westlake Chemical CEO Albert Chao pointed out that since 2010, the correlation between oil and PE prices is only 32.0%, said Wells fargo analyst Frank Mitsch.

An ICIS analysis for the same timeframe between Brent crude and US contract HDPE yielded an r-squared value of 19.0%. The value using WTI crude was 40.0% – both not meaningful correlations.

Yet most investment analysts, including Mitsch, believe “lower oil will eventually translate into lower ethylene and PE prices”. But that does not mean US producers cannot maintain fat margins – they may just be somewhat leaner.

“With feedstock costs remaining low, we think the resulting narrower spreads still translate into high profitability for domestic producers, and remain attractive enough to further support investments exploiting the US shale advantage,” Mitsch said.

Getting back to the Volume Proxy as a leading indicator, could a further global petrochemical downdraft be in the works, or will the current weakness prove transitory?

It is worth looking at another leading indicator – the manufacturing Purchasing Managers’ Index (PMI) – to see if there is confirmation on the weakness from the overall manufacturing sector.

The latest US reading in November was a strong 59.0, while the eurozone came in at 50.6 and China at 50.4 (HSBC Markit data).

Any reading above 50 indicates expansion in activity, while under 50 indicates contraction. The relative weakness in the eurozone and China bears watching but so far, the alarm bells are not ringing.