By John Richardson
THE US oil, gas and petrochemicals sectors are drowning in an excess of credit that has distorted rational analysis of long-term supply and demand fundamentals.
So, just as is the case with China manufacturing in general, these misguided investments are in danger of contributing to a prolonged period of global deflation.
Let’s look at US oil and gas first of all.
Some $1.2 trillion of money was borrowed by US shale oil and gas companies in the space of just five years. The logic for these investments was that the natural price for oil was $100 a barrel just about forever, but oil prices have, of course, now fallen well below this level.
This price collapse led to the mistaken belief that droves of US oil and gas producers would go bust. It was obvious from at least as early as last October that this analysis was based on people who don’t talk to enough people. What we have seen is nothing short of an explosion of innovation that has already driven US shale-oil production costs down by 15-25% over the last 12 months.
Even more “no strings attached” easy financing has poured into the US oil and gas sector over the last few months, from hedge funds, pension funds and private equity players. The logic behind these investments is that oil prices will soon rally, resulting in a recovery in the “undervalued” shares of US oil and gas companies.
But this new investments will instead be used to fund even more innovation whilst providing US companies with a financial cushion against lower oil prices. This will, of course, allow US producers to maintain high levels of production when oil prices once again decline.
In short, therefore, the US oil and gas sector will continue to play a significant role in global oversupply of energy. The problem is that is because of demographics, the demand in the West was simply never there to justify these oil and gas investments in the first place.
So this is how US energy companies will end up making the global deflationary crisis even worse.
Now let’s look at how easy credit has distorted the thinking of US petrochemicals companies.
Because of the overinvestment in US shale gas capacity, ethane prices have collapsed. This, along with the cheap financing that has also been made available to petrochemicals companies, made investments in new cracker and downstream capacities seem like “no brainers”. But there was never any real logic behind many of these investment because of, again, the fundamentals of demand.
First of all, given low demand growth in the US domestic polyethylene (PE) market (see the chart below), most of these new US projects will be heavily dependent on exports (the vast bulk of derivatives capacity downstream of all these new crackers is in PE).
And it has been clear for several years now that China’s economy would simply have to significantly slow down. China is the world’s biggest import market by far for PE. This is the kind of economic analysis should have been built into every project-feasibility study.
What has been equally clear for several years is that China wants to move as close as possible to self-sufficiency in basic commodity petrochemicals such as PE and polypropylene (PP).
So we could up end up with very little, if any, incremental demand growth in China’s PE imports over the next decade.
I also think that as the New Silk Road develops, funded by the China-led Asian Infrastructure investment Bank (AIIB), whatever petrochemicals China does decide to import will mainly come from its favoured economic partners. Because the US government has decided not to join the AIIB, this could put Europe, Southeast Asia and the Middle East in a stronger position than the US to supply these imports.
That leaves the rest of the emerging world as the place where the US can try and place its excess volumes of PE. I make no excuses for repeating the chart below, as it is so important.
It confirms what I said earlier about the scale of China’s imports compared with every other region in the world, both emerging and developed. So even if you assume that the economies of Latin America and Africa enjoy constantly fantastic GDP growth, and this is a big assumption, there is no way that they can approach China’s level of import demand for many, many years to come.
Another market that might offer great promise is India, but not if you try and export big volumes of basic petrochemicals to India. This simply isn’t going to work. The dominant source of supply for basic commodity petrochemicals will continue to come from local Indian companies. You instead need to come up with a strategy for India which is entirely different from building big overseas that are targeted at this market.
So, to repeat, easy capital has distorted thinking in the US oil, gas and petrochemicals sector. And why has credit been so easy? Because of badly misguided US Federal Reserve stimulus policies.
And one more issue that we need to think about here is this: What happens to US oil, gas and petrochemicals when US interest rates start going up? This will be the subject of later posts.