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China’s Export Strategy: The Realistic Scenario

Business, China, Company Strategy, Economics
By John Richardson on 24-Feb-2016


By John Richardson

THE analyst was giving me hard time. “You see, the problem is you are not a chemicals engineer, and haven’t crunched the supply and demand data and cost curve data. What you are talking about is all fuzzy and intangible and so just plain wrong”.

The conversation I was having with this analyst was in 1998, when I was just a year into my experience in the petrochemicals business. We were debating South Korea and whether or not it would shut down substantial amounts of its capacity in response to the Asian Financial Crisis.

His argument for major closures rested on the fact that, of course, South Korea had – and still has – no hydrocarbons to call its own. So it has to import all of its oil or naphtha to feed refinery-petrochemicals business.

This had left their variable costs per tonne of production at a severe disadvantage over producers elsewhere – particularly over those in the Middle East, where a major new wave of capacity expansion was being planned, he said.

And because of the Asian Financial Crisis, South Korea’s petrochemicals companies were struggling with heavy losses as a result of the collapse of the Won – the local currency – versus the US dollar, he added.

I argued, though, that I had read in the newspaper the previous day that South Koreans were queuing up to hand over their jewellery to the government so that the government could replenish its foreign currency reserves. That suggested to me an incredibly strong national will to get through the crisis.

And I told him that I had also read in South Korean newspapers, and had heard from my South Korean contacts, that the government was determined to rescue the petrochemicals business through a series of Big Deals. Ownership structure might change, I said, but plants wouldn’t shut down.

I didn’t go far enough in my predictions. Rather than plants being shut down, capacity was actually expanded very aggressively over the next ten years to serve the booming China market, This followed a successful government-led realignment of ownership after several years of negotiations.

Wind the clock forward today and exactly the same kind of linear thinking will get you into an awful lot of trouble again, if you apply this thinking to what will happen to China’s excess supplies of some petrochemicals.

Let’s take polyvinyl chloride (PVC) as one example – and I will look at other products in future posts.

Between 2005 and 2015, China’s PVC capacity was increased from around 9m tonnes/year to 32m tonnes/year. If you look at the exact data, that’s an increase of no less than 261%, according  to ICIS Consulting

This was of course the result of the 2008-2013 economic stimulus package, when the priority was to build capacity across many industries for the sake of building capacity only. Investments were all about delivering instant short term kicks to GDP growth and had little to do with supply and demand balances.

Meanwhile, consumption jumped by 100% from 8m tonnes to 16m tonnes – a very strong increase that was  the result of the real estate and infrastructure frenzy that was another product of the stimulus programme. But 100% is obviously a lot less than 261%.

Based on the 1998 type of thinking I quoted above, you might well think that major PVC capacity closures are inevitable as of course local PVC companies simply must be losing money.

You can layer on top of this 1998 thinking some of the wider context that was so badly missed by some people when they studied South Korea during the Asian Financial Crisis.

In the wider context, the Chinese government is pressing ahead with major economic reforms that involve closing down excess capacity in industries such as steel. So you might believe that PVC will also see major rationalisation of capacity.

And of course as economic reforms slow down, the economy is slowing down. So we are unlikely to see anything close to the doubling in PVC demand over the next ten years that we saw in 2005-2015. This provides a further reason for closing PVC plants down.

There is also the environment to think about. Some 80% of China’s PVC capacity is coal based and coal is one of the major causes of China’s air pollution crisis. As part of its reform programme, Beijing is without doubt firmly committed to dealing with this challenge. So why not shut down lots of PVC plants, along with the steel plants and power plants that also consume coal?

If you all of this together, you end up with what seems like reasonable scenario of major PVC capacity closures in China.

But we don’t see this scenario being realised – both in PVC and petrochemicals in general. We discuss this in great depth in our new Study – 5 critical questions to answer to survive in today’s chaotic petrochemicals markets. We then tell you what to do next to still make money in China.

Here, in summary, are five factors to consider about PVC:

  1. Exports are a way of compensating for a weaker domestic economy. Diesel exports serve as a good example of how this is already working. China’s diesel exports were up by 80% last year and have helped drive Asian refinery margins to six-year lows.  China’s diesel producers are able to export very aggressively because a floor has been set for domestic diesel prices. Similar support for the PVC industry cannot be ruled out.
  2. Many of these coal-based PVC plants are in western China in order to be near coal mines. Shut them down and you destroy jobs at a time when Beijing is trying to close the economic gap between its poorer western provinces and its much-richer eastern seaboard.
  3. True, demand for coal in general will fall as the environmental push intensifies. But I believe that the bigger gain in terms of tackling pollution can be made from shutting down vast oversupply in steel and reducing dependence on coal for electricity generation, as these two industries generate far more pollution from coal than PVC and other coal-to-chemicals plants. Coal mines also need to be kept open in the western provinces to again preserve jobs. So the coal-to-chemicals industry in general will remain in favour. This will also involve an aggressive expansion of coal-to-olefins capacities.
  4. PVC will be a strategic polymer for China as it pursues its New Silk Road – also known as the One Belt One Road – initiative.  Look at  the map at the start of this blog post. Major improvements in road and rail links between China and its poorer neighbouring countries, which are part of the One Belt One Road initiative, make it much more viable to move goods between China and these countries. So here is what will happen: As labour costs rise in eastern China, it will increasingly outsource plastic processing, which is labour intensive, to countries such as Burma (Myanmar) and even Laos. China will supply the PVC resin to run these plastic processing plants and will then re-import the finished plastic pipes etc.

Then look at the chart at the beginning of this blog post for two scenarios on China’s PVC exports:

  • Scenario 1 is our base case for total exports in 2016-2026, based on an average operating rate of 65% – three percentage points higher than the average operating rate in 2005-2015. This would leave  a total of 22m tonnes available for China to export in 2016-2026.
  • In Scenario 2, I have kept to our assumptions on capacity. Note that we don’t envisage major rationalisation of capacity – in fact, we expect it to continue to grow, albeit at a slower pace. I also haven’t adjusted our base case assumptions on demand growth. I instead have only increased the average operating rate to 71%, which felt to me to be a fairly conservative increase. The end result is 45m tonnes available for export.

This is an example of the detailed data on different scenarios – across many different petrochemicals value chains – which we provide in our new Study.