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US Petchems: Victim Of A Black Swan? What Black Swan?

Business, China, Company Strategy, Oil & Gas, Polyolefins, US
By John Richardson on 31-Mar-2015




By John Richardson

JIM Gallogly, the former CEO of LyondellBasell, has advised US petrochemicals companies to “think very, very hard” about new investments.

“Some of you simply are going to be too late. And you need to recognise where you are at,” he told delegates that this week’s 40th American Fuel & Petrochemical Manufacturers (AFPM) International Petrochemical Conference (IPC) in San Antonia, Texas.

This is wise advice, indeed, and behind the scenes, some of the 17 polyethylene (PE) projects planned for the US – which in theory would add 8.1 million tonnes/year of additional capacity – might  have already been shelved.

The good news is that the shelving of these projects will save companies billions of wasted investment dollars. But the bad news is that some money has already been spent on feasibility studies etc.

So what went wrong and what lesson can be learnt for the future?

It is very tempting to reply, “Well, nothing, really, because nobody saw the collapse of oil prices coming. It was one of those ‘Black Swan’ events”.

As a reminder, cheaper oil, which Gallogly  suggests could prevail for “many, many years”, erodes the cost advantage that US PE producers enjoy over most of their overseas competitors.

US PE producers predominantly make their ethylene feedstock from the natural gas ethane, whereas most overseas producers manufacture ethylene from naphtha, which is made via oil.

Recently, ethane supply has been abundant in the US thanks to the shale oil and gas revolutions – and so very cheap.

And the cost advantage enjoyed by the States widened even further when oil was in the region of $100 a barrel. This obviously made naphtha even more expensive in comparison to ethane.

Now, though, you have the longer term prospect of reduced ethane supply in the US as shale oil production is cut back on lower oil prices (the less shale oil you make, the less ethane is produced, as ethane is produced as a by-product of shale-oil production).

More immediately, though, the collapse in oil prices has by itself made naphtha-based PE production a lot more economically attractive.

This is real 101 stuff for anyone in the petrochemicals business, but this type of discussion tends to become very dominant at times like this. I saw this during the 1997-1998 Asian Financial Crisis, when everyone kept going on and on about higher local currency debt-servicing costs resulting from a stronger US dollar. People were very good at talking about the main effect of the crisis, and not so good at discussing its causes.

Perhaps this is because is it comforting to fall back on what is known, what is clearly understood, amidst all the discomfort  of a “Black Swan” event.

But the collapse of oil prices could and should have been be foreseen by the US PE industry, and by everyone else, because:

  • $100 a barrel oil was never a “natural” price level. Historically, in fact, $30 a barrel, inflation adjusted, has been the average price of oil for the last 150 years.
  • This should have prompted the question: “Why have oil prices been so high of late?”
  • The answer? In just three words: Central bank stimulus.
  • In more detail, this  stimulus generated all the cheap finance that enabled speculators to raise the price of oil way beyond its long term trend. And to maintain the price in the region of $100 a barrel, the speculators needed a convincing story about demand.  “Booming China” pretty much served this purpose.
  • Now,, though, US Fed stimulus is being withdrawn  as China’s economy slows down. This has exposed real demand levels for crude, during a period when the supply oil has been vastly increased on false assumptions of what was real demand.

But even if oil prices had stayed at around $100 a barrel, the market would never have been there for all of this additional US PE production.

Why? Because we knew a long time ago that growth in US demand could never have been strong-enough to absorb most of this new capacity. The US has long been a mature market for PE, which has resulted in low rates of growth (see the first of the two charts at the beginning of this post).

This meant that 75% of all of this extra PE production would have to have been exported. To where? To mainly China (see the second chart above).

Would China have been willing to take most of these extra volumes? No. A study of economic reforms in China should have told you this.

So, what’s the lesson for the future? In just two words, it is this: Decent analysis.