Market outlook: The big crunch – oil rattles chems

The big decline in oil prices will have major implications for global petrochemicals, ranging from shifting levels of competitiveness to future investment

About 18 months ago, we singled out a disruption pattern that has finally arrived as the chemical industry is experiencing plummeting world oil prices, which means that changes to competitiveness, investment and trade patterns in chemicals are inevitable.

Low oil prices are likely to continue Copyright: Alamy

Industry observers will do well to watch out for reduced competitiveness of China coal-to-chemicals operations, increased competitiveness of cracking in Europe, expanded participation of oil companies in chemicals, escalated mergers and acquisitions (M&A) activity and other disruptions.

What’s happening with oil prices?
High crude oil prices over the past several years, coupled with low gas prices in North America caused oil producers to invest heavily in developing oil. Now oversupply is apparent. In order to ensure strong prices longer term, OPEC producers let oil prices drop by maintaining certain production levels, with the objective of forcing out the highest cost supplies.

So far, US production has continued unabated, though production is expected to decline later in the year (as unconventional wells drilled in 2014 ramp up, then slow down, since production tails off by two-thirds in the first year). Future increases will likely taper due to the drop in drilling rig count since September, when crude prices were heading below $80/bbl.

When will oil prices rebound?
While US shale oil is responsible for most new world production in recent years, most wells are estimated (by various analysts) to span somewhere in the middle of the global oil production cost curve, with higher cost oil being, for example in the Caspian, the deep waters in Latin America, in the Arctic and Canadian oil sands.

With Saudi Arabia’s $750bn in foreign exchange reserves (about 3.5 to 4 times their lost annual revenue from the 50% oil price decline) and low production costs, they have the fortitude to meet their objective. Low oil prices will likely continue until enough wells and projects are shut down. However, estimates of how long it will take to reverse the direction of crude oil prices range from a few months to a few years. So far, one independent producer has declared bankruptcy. Large international oil companies (IOCs) are expected to do better, as they scrutinise long-range plans under various oil price scenarios, even as low as $40/bbl.

However, the resilience and technology of the North American industry should not be underestimated. It is clear from data published by exploration and production (E&P) companies that unconventional well development costs continue to decline. At the same time, as drilling rig counts decline, talent and other inputs are becoming available, contributing to lower development costs.

How does this impact shale gas?
Low oil prices may slow adoption of natural gas in new end-markets, such as marine and land transportation. Also, there is a greater risk of liquefied natural gas (LNG) export customers switching to oil.

The first of 14 LNG export terminals are planned to start in 2015, with the industry hoping for a boost in gas prices from current very low levels of $2.93/MMBtu. One terminal, scheduled for 2018, has already been put on hold. Without an outlet for natural gas, prices may not recover for a long time. This would be good for North American petrochemicals in the short term. However, over the longer term, producers will be forced to reduce E&P, impacting future supply. This would also reduce the future availability of natural gas liquids (NGL) ethane, propane and butane, thereby increasing NGL costs for North American petrochemicals.

Impact ON GDP/chemicals demand
The drop in oil price can be seen as a shift in wealth. A drop of $60/bbl on world production of 90m bbl/day equates to about a $2 trillion shift from oil producers (companies and countries) to consumers/consuming countries. This is equivalent to 2.8% of GDP.

Economists are counting on a wealth multiplier effect from consumers to be better than that of oil companies when they spend and allocate capital. The theory is that lower energy prices increase consumers’ discretionary income via savings on gasoline, electricity and home heating.

Of course, North American consumers were benefiting from low natural gas prices already for several years and the reduced gasoline prices in November/December, have so far not translated into greater retail sales.

Consumers may be saving and working off debt. In addition, reduced energy industry spending has already had a large negative effect, amounting to thousands of layoffs in oilfield services, steel and other industries.

Naturally, economies dependent on oil exports (e.g., OPEC countries), will suffer from oil price declines and countries with net energy imports, such as China and Japan, will benefit greatly. However, the world economy is still suffering from high private and public debt, taxes, unemployment and poor fiscal policies, as headwinds. The lower oil price regime may not rescue the situation.

Impact on investment
This brings us to the chemical industry. The American Chemistry Council (ACC) refers to the relative competitiveness of gas cracking to naphtha cracking at an oil/gas ratio of 7. Based on natural gas prices of the past few months, oil would need to be in the $20-30/bbl range to make naphtha cracking more favourable.

However, low oil prices also have other global impacts. Chinese coal-to-chemicals plants depend on a high spread between coal and oil prices. Most plants are located inland China, where the cost of coal is low, due mainly to logistics constraints (“stranded coal”). Although economics vary among coal-to-chemicals plants, reports are that some become uncompetitive at oil prices below $70/bbl. While there is an oversupply of coal in the Chinese market (China has among the largest world reserves), the Chinese reserves to production ratio is only 31 years, indicating upward price pressure on coal longer term.

Low oil prices also impact ethylene economics in the Middle East, for crackers using liquids feedstock, which can have a discount of 25% to 30% off international condensate/naphtha prices. Naphtha prices fairly track crude oil. So a decrease in crude oil price of 50% erodes the level of the discount as well, shaving competitiveness against the world ethylene cost curve.

Another factor affecting chemical trade is the strength of the US dollar, which is making European cracking more competitive, causing the Middle East to shift more material, otherwise destined for Europe, to go to Asia.

Several other factors are causing the world ethylene cost curve to flatten. Some of this is occurring quickly; others are more long term.

Liquefied petroleum gas (LPG) can also be used as a cracker feedstock and to dehydrogenate to propylene. Increased supply of US LPG to Europe and Asia is reducing LPG prices globally. This is already improving cracking competitiveness in Europe.

Many analysts are projecting an excess of ethane in North America and increased ethane rejection (i.e., leaving it in natural gas), which has limits, encouraging innovation in ethane exporting schemes. Exporting ethane in larger volumes reduces its landed cost, especially as very large ethane carriers (VLECs) are built and logistical improvements are made. This way, US-sourced ethane will lower the feedstock cost to several European and India crackers.

Potential gas pipelines to the Americas west coast (possibly via Texas to Mexico) could reduce the cost of ethane, propane or natural gas exports to Asia. Railroad tank cars for natural gas are also in development.

Excess US condensates are being exported and this could improve overseas naphtha cracker competitiveness. New uses for gas and NGLs may aid gas price increases.

After the Big Crunch
In the past, when waves of investment occurred in the chemical industry to harness a particular advantage, the first movers where able to achieve the greatest value by securing a position early, being attentive to construction timing (faster paybacks) and locking up finance, equipment and talent before others.

A situation of delays and cancellations may happen in petrochemicals as cost curves flatten and demand weakens. Although North American gas cracking can still be at the low end of the cost curve, within time, margins may no longer justify large numbers of projects over short periods. Future plant additions may be more distributed, with perhaps some already announced projects pushed out.

Another disruption may occur in the short term – petrodollars being shifted to petrochemicals. This situation happened in past oil price declines. During low oil price times, petrochemical segment profits are more prominent in IOC portfolios and those segments become targets for capital allocation. This can bring about greater IOC market share in petrochemicals, making integration an increasingly important basis of competition.

Planning implications
With the many variables that will shape competitiveness in the next few years, some prudent actions include:

• Ensuring that plans adequately withstand the extremes of possible hydrocarbon, geographic, political and economic scenarios.
• Having a clear view of which customers and geographies to serve, including supply chain alternatives and anticipated product specifications and service levels.
• Building assets beyond the feedstock advantage, to include technology enhancements for reduced maintenance costs and downtime, on top of improved safety and environmental compliance.

Paul Bjacek is the research lead for Accenture Chemicals and Natural Resources. He has more than 20 years of experience in the process industries, including project activities in manufacturing, marketing and distribution. Prior to joining Accenture in 2004, Paul was affiliated with SRI ­(formerly Stanford Research Institute) and Chevron.