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Re-evaluating Investments In A Lower Margin World

Business, China, Company Strategy, Economics
By John Richardson on 02-Dec-2015


By John Richardson

BACK in January 2008, just about nobody thought that the shale-gas revolution would transform the economics of the US petrochemicals business.

Then from around 2011 onwards came the new set-in-stone view: That this was an industry which virtually had a licence to print money for another 10-20 years.

What do people now think? Well, most people I speak to take the view that oil prices will “normalise” around $60-80 a barrel in 2-3 years’ time (it used to be 1-2 years, but recent events have led to a little more bearishness about the medium-term prospects for crude prices).

The crucial thing for the US petrochemicals business is of course with oil prices back at $60-80 a barrel, this would re-establish the wide gap between US natural gas and oil prices. This would boost ethane-based cracker margins versus those of the naphtha cracker players, and so fully justify the many billions of dollars spent on new US ethylene and derivatives capacity (you can see from the above chart how the gap between oil and natural gas has recently narrowed).

The failure of this kind of thinking is that it is too “supply” focused, both in the way it looks at crude oil, and the demand for commodities in general – and of course connected to both of these things the way people view the global economy.

There are two critical factors here which tell us, barring geopolitics, that oil prices could well fall below their long-term average price of $30 a barrel over the 2-3 years – and beyond. These factors are:

  1. China is no longer interested in heavy manufacturing investment-led growth, which means a long term slowdown in its crude-oil demand growth. For environmental reasons, China will also wherever possible move away from using oil. Daniel Yergin, the author of the one book that is essential reading about the oil industry – The Prize – agrees with my view. This is a view I have been putting forward for the past three years.
  2. All the evidence shows that as you get older, you drive less and in general consume fewer things made from oil. The impact of ageing populations in the West means that one billion people are moving into the low-earning, low-spending 55+ age group.

So, returning, to the US petrochemicals business, what happens next? The gap between oil, and so naphtha prices, and US natural-gas prices will continue to narrow. This will make the returns on US cracker and derivatives projects lower than both the companies and their investors had budgeted for.

But the problem will of course not be just margins, It will also be selling the large volumes of production, mainly polyethylene (PE), that will emerge out of these new complexes.

China will be a lot closer to PE self-sufficiency than many people think by 2020, with other developing markets such as Africa and Latin America both too small and too complex to offer an adequate replacement for sales to China that are bound to disappoint.

And with oil prices set to remain cheap, this will give Europe – the other big target for US PE exports – the opportunity to very competitively price their PE to keep US producers out.

Returning to the subject of margins, US producers can either:

  • Give large volumes of PE exports to traders, who will be delighted to take the material off their hands. The traders will find a home for some of this material in fragmented and difficult markets such as Africa, but at a cost of course.
  • Alternatively, US producers can invest in their own people on the ground to avoid handing over too much money to traders. But this will obviously incur a substantial cost as well.

Either way, profitability will be further squeezed by the extra expenses of selling into overseas markets.

You can take the view that all of this is, in fact, good for the supply side of the story. The chart below shows our estimates of ethylene capacity expansions versus consumption in the US up until 2025. Beyond 2020, when most if not all of the already sanctioned investment should on-stream, we might see delays or even cancellations of some of the capacity that at the moment we assume will happen.


But here is thing: What if the China PE market ends up going the same way as polypropylene? I see no logical reason why this won’t happen. Even the existing, already funded, US projects would then struggle to place their volumes – especially if of course the global economy in general continues to struggle. And, of course, as I said these approved projects will have lower margins than many people had anticipated.

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