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China Polyethylene: Increased Local Naphtha Supply Threaten Imports And Margins

Business, China, Economics, Naphtha & other feedstocks, Oil & Gas, Olefins, Polyolefins
By John Richardson on 06-Feb-2017


By John Richardson

CHINA’S polyethylene (PE) demand grew from around 22m tonnes in 2914 to approximately 25m tonnes in 2016 – an increase of 12.16% based on the exact numbers, according to ICIS Consulting.

Even better news for the global PE industry is that this strength in Chinese demand has occurred during a period when there have been very few capacity additions taking place – including in China itself, relative to its robust demand growth.

You have thus ended up with the above chart, which shows continued strong growth in imports of virgin, or non-recycled, PE and a margins boom. Here I have just looked at margins for just one grade of PE and one region, but this surge in profitability applies across all grades and all regions.

What explains this great success story despite a slowdown in the overall Chinese economy in 2014 and 2015 as economic reforms gathered pace?

There has been a lot of talk of China’s PE demand growth decoupling from GDP – i.e. growing much faster as a multiple over GDP than has typically been the case for an economy at China’s stage of economic development. Two main reasons have been given for this:

  1. Rising food-safety concerns have resulted in booming demand for modern-day packaged food, which of course is wrapped in PE. Further, as more and more people climb out of poverty in China, they are consuming pre-packaged food for the first time. Despite the economic slowdown, heavy government spending in rural areas has continued apace in an effort to close the big income gap between poor inland China and the much-wealthier coastal provinces.
  2. The internet sales explosion is also said to be behind surprisingly strong demand growth for PE. Everyone accepts that the old heavy industry-based economy slowed down in 2014 and 2015 as steel mills, coal mines and cement factories etc. were shuttered in order to tackle overcapacity. However, it is believed that this was more than compensated for by the growth of the mobile internet economy. As more and more people buy goods on line, via companies such as Alibaba, these goods require bigger and bigger quantities of packaging material – including, of course, PE.

Next came the 2016 reversion to the tried and trusted  – but I believe fundamentally flawed – short-term stimulus approach to boosting the Chinese economy.

Lending took off again, primarily to the real-estate sector, resulting in soaring house prices. China’s debts that were already a source of major concern before 2016 went up even further. But any product manager eager to export PE to China very probably wasn’t bothered about this, as this reflation of the economy further PE demand growth.

But what if this demand success story isn’t just about a decoupling of China’s PE growth from GDP and last year’s return to old-style stimulus policies? What if the strong profitability and resiliently strong imports are mainly about something altogether different?

The Role of Recycled PE and Naphtha Availability in Shaping  Today’s Market
Operation Green Fence was launched by the government in 2013, but didn’t start to have a major impact until 2015. This is designed to better protect the health of workers handling this often contaminated imported scrap material.

These new restrictions were thought to be partly behind a sharp fall in imports of scrap PE from 2015 onwards, which might help to explain some of the rise demand for virgin PE in China – and the rise in virgin PE imports. Another factor was of course the collapse in oil prices and so PE prices that made virgin PE much more affordable.

Imports of scrap PE fell from around 4.4m tonnes in the full-year 2014 to approximately 2.3m tonnes in January-November 2016, based on the latest China Customs data I have available. This is some 50% lower.

PE producers will, however, quite rightly argue that imported scrap PE largely serves very low value end-use applications. Scrap PE imports have thus perhaps been mainly replaced by low-end virgin resin production from China’s new coal-to-PE plants.

Meanwhile, the persistent strength in imports is said to be mainly about demand for higher-value grades of PE – such as hexene and octene-grade linear low-density PE and pipe-grade HDPE. You could never use recycled PE for these end-use applications, it is argued.

But here is the thing – and watch this space for further analysis in this area: During 2016, I believe that China’s domestic PE production was constrained by a reduction in the availability of local naphtha.

The “teapot”, or independent, refineries in China were given licenses by the government to import high-quality crude, rather just fuel oil, for the first time in 2016. The aim here was to preserve jobs at and around these refineries by preventing their closure as the economy was restructured.

Another other motive was to increase competition in refined products market, and in so doing boost the efficiency of the much bigger, and more technologically sophisticated, state-owned refineries.

Granting these licenses to the teapots fulfilled these objectives as it led to a surge in exports of refined products and more competition in the local market.

The teapots are not configured to produce naphtha unlike their state-owned competitors. But as margins for the state-owned refiners were squeezed by more competition from the teapots in gasoline, diesel and kerosene etc., the state-owned players had to cut their overall refinery runs.

This led to less availability of local naphtha and thus lower domestic PE operating rates. Sinopec’s Q3 2016 results statement shows that the state-owned refining-petrochemicals major’s ethylene production fell by 1.9% in January-September 2016 over the same period last year.

 Outlook For the Rest of This Year

Operation Green Fence  looks set to continue as a result of the environmental concerns surrounding imports of scrap PE. This may offer some further support to imports of lower-value PE. But this is of course unless oil prices, and so the PE prices, go through the roof.

But China’s teapot refineries will not receive any further quotas to import crude oil in 2017, according to this December 2016 Reuters story. This would obviously reduce their ability to compete in refined products’ markets.

One reason given for the change of policy is a squeeze in domestic diesel margins to the point where too many refiners are losing too much money. Another explanation are reports that some teapots have sold-on these licenses to third parties at a profit rather than using them to import crude.

It thus seems as if local naphtha output might well rise as the refining profitability squeeze on Sinopec and PetrocChina –   the state-owned refiners and petrochemical players – is reduced. This will in turn boost domestic PE production.

This year marks the addition of large amounts of new capacity in the US and the Middle East at a time when the global economy might well be in recession because of the Trump factor.

Slower growth in China’s virgin PE imports therefore seems likely because of a weaker local economy and higher local operation rates. This would result in a contraction in global PE margins.