Shallow Discussions Versus Complex Oil Price, Economic Realities

China, Company Strategy, Economics, Europe

HDPE2

By John Richardson

IT has been a very good year so far for European and Asian naphtha cracker operators, as the chart above illustrates. As you can see, in the case of high-density polyethylene (HDPE), naphtha-based integrated margins in 2015 are turning out to be a better so  far this year than those in 2013 and 2014.

In detail:

  • European margins averaged $598/tonne in the first five months of this year compared with $455/tonne for the same period in 2014 and $550/tonne in 2013.
  • The improvement in Asia has been even more pronounced. So far this year, average margins have been $345/tonne. This compares with $133/tonne last year, and just $126/tonne in 2013.

Perhaps European and Asian producers owe this better performance to the “gold standard’ of commercial efficiency, which is described by McKinsey as follows:

Before [oil prices} reach an equilibrium, a chemical producer that has exceptional commercial and sourcing capabilities can expand margins in a falling oil-price environment. Conversely, in a rising oil-price environment, it can boost margins by raising prices faster than costs rise.

I take my proverbial hat off to any producer who has achieved this gold standard. Congratulations.

Unforeseen events – i.e. a big slice of luck – have, however, also played a role in this year’s improved performances by naphtha-cracker players. There is much talk of exceptional tightness in European and Asian ethylene and PE markets, as a result of both scheduled and unscheduled shutdowns.

A lot of this talk seems to be true, although one Asian ethylene and propylene buyer cautioned me last week to look at the data. “I don’t think production losses in Q1 of this year in Northeast Asia are that much greater than in the first quarter of 2015. But, of course, perceptions matter,” he said. I shall attempt to crunch the data over the next few weeks.

But to again give credit where credit is definitely due, on a recent visit to Europe I was hugely impressed with the brains I met inside one particular room of one particular naphtha-cracking company (they were far brighter than me). What really impressed me was their determination to constantly make operating improvements in an effort to recycle every kilojoule of energy produced by their steam crackers.

Perhaps I am easily impressed, but I was also impressed by their talk of greater feedstock flexibility. This reaffirmed my view that because of the ingenuity of the Europeans, and structural reasons relating to logistics and spare refining capacity, those who talk about closures of big volumes of European capacity are way, way, way, way off the mark.

And in general I believe, having worked in this space since 1997, that this is a very smart industry.

But here comes the caveat: I still worry  that senior executives are not sufficiently prepared for the potential volatility in oil markets in H2. This was the impression I gained, accurately or otherwise, during last week’s Asia Petrochemical Industry Conference (APIC) in Seoul, South Korea. McKinsey suggests that this might apply to some people chemicals industry in general.

I was also deeply saddened to hear shallow talk, during APIC, of “rising urbanisation” and the “growth of the middle classes in emerging” markets as guaranteeing a prosperous global economic future. There was insufficient depth to the discussions – for instance, there was no real debate about the implications of urbanisation peaking in China. A key recent statistic for me is that as little as 20% of China’s working population may now be left in the countryside. What does this mean for future chemicals demand growth?

This all links together. The global economic headwinds I’ve been warning about for several years help to explain why oil prices collapsed in the second half of 2015.

The other explanation is, of course, overinvestment in oil production. And as I have discussed over the last few days, oversupply via US shale oil is not going to disappear, but may instead get worse as the efficiency of the fracking process improves. Further support for my argument came with yesterday’s news that North Dakota oil production unexpectedly rose in March.

Of equal importance on the supply front is the role of OPEC. Hence, everyone should be worried about the latest International Energy Agency (IEA) Oil Market report, which was also released yesterday.

The report said that:

  • Supplies from Saudi Arabia, Kuwait and the United Arab Emirates remain near the highest level in three decades.
  • Total OPEC output is about 1.2 million barrels a day higher than the average of roughly 30 million barrels a day that will be required in the second half of this year.
  • Iran raised output by 90,000 barrels a day to 2.88 million barrels a day in April. This was the highest production level since sanctions on its oil exports took effect in July 2012. And, of course, a lot more Iranian oil could be exported after the end of June – the deadline or finalising the framework nuclear agreement with the West.
  • Global oil supply, therefore, rose by no less than 3.2 million barrels year-on-year in April.

And the IEA added in the same report:

Several large LTO [light tight oil or shale oil] producers have been boasting of achieving large reductions in production costs in recent weeks. At the same time, producer hedging has reportedly gone steeply up, as companies took advantage of the rally to lock in profits. 

It would thus be premature to suggest that OPEC has won the battle for market share. The battle, rather, has just started.

What goes up very quickly always has the potential to go down with equal speed. So might be the case with HDPE margins In H2 if oil prices weaken.

Why? Because PE end-users will also exercise their “exceptional commercial and sourcing capabilities” in order to expand their own margins in a falling oil-price environment. They have no choice in this matter because they are also, like their raw material suppliers, selling into a weakening global economy.

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