Further collapse in China auto sales underlines radical change in petrochemicals business model

Business, China, Company Strategy, Economics, Middle East, Naphtha & other feedstocks, Oil & Gas, Olefins, Polyolefins, Sustainability, US

By John Richardson

HAVE FEEDSTOCK will build has been the route to success for many years in the petrochemicals business.

If you have never experienced anything else then a change in the paradigm is very hard to come to terms with. What often instead happens is that a new paradigm is simply rejected in favour of the idea that the future will soon return to the comfortable and familiar past. Recent changes in markets that suggest different outcomes are dismissed as temporary statistical blips.

But it is becoming more and more evident that the entire business model upon which the petrochemicals industry has been built has been completely and permanently upended. This is the result of changes in demand patterns caused by structural changes in the Chinese economy resulting from excessive levels of debt and an ageing population. Too much debt and ageing population, along with sustainability pressures, are reshaping global demand.

Focusing just on China and on the polypropylene (PP) business in this post, one of the dangers for those who don’t accept the new paradigm is that their outdated views are being reinforced by availability of lots of cheap propane feedstock.

In the US, propane has become cheaper even than ethane over the last 12 months, according to our margin analysis. This reflects abundant supply of propane because of the shale gas revolution and temporary limits on the mid-stream fractionation capacity needed to process sufficient ethane. A further factor behind higher ethane prices has been the start-up of a large number of US ethane-based crackers.

Adding to the temptation to press ahead with new PP investments is global oversupply of propane – again the result of the shale gas revolution. Steam cracker feedstock is becoming increasingly weighted towards propane because of the abundance. A large number of new propane hydrogenation-to-PP facilities are being planned in the US and elsewhere.

Barring more geopolitical chaos resulting from further disruptions to the region’s oil supply following last week’s attack on Saudi oil and gas facilities, the long term direction of oil prices is down.

This is the result of declining demand for gasoline and diesel as electric vehicle sales rise and fuel efficiency in conventional car engines improves. Diesel is facing additional pressure from the Dieselgate scandal. It has very quickly gone from being the fuel of choice for improving fuel efficiency to an air-pollution scourge for the public and legislators.

This  has already led to under-utilisation of refineries. Refineries could be shut down, but environmental clean-up costs can be prohibitively big.  Conventional fuels demand is not going to disappear overnight. This is a long process. Refineries will thus need to be kept open to maintain local supplies of fuel, with their economics boosted by providing advantaged feedstock to nearby petrochemicals plants.

This provides another reason to draw the wrong conclusion. Lots of cheap naphtha from refineries is adding to the momentum for new PP capacities.

What’s even worse is that the oil majors are building new refinery capacity heavily targeted towards providing petrochemicals feedstock. The logic here is that, “We have cheap oil, and we cannot risk leaving it in the ground as fuels demand declines, so let’s make it into lots more petrochemicals”.

Because the oil majors are moving heavily into petrochemicals as a result of their access to cheap oil, this is again reinforcing the old paradigm of “Have feedstock will build”.

The China autos market as a case study

Events in China’s PP business and the local autos market should have been sounding warning bells about demand for many years:

  • In the ten years between 1999 and 2008, China’s PP consumption grew by a total of 6.5m tonnes.
  • But as China’s economy was turbocharged by the biggest economic stimulus package in the history of the world, China’s PP demand rose by an astonishing 14.4m tonnes in the decade from 2009 until 2018. Meanwhile, as the ripple effects of China stimulus spread across the rest of the world, Asia & Pacific PP consumption increased by 5.7m tonnes – more than double its rate of increase during the previous ten years.
  • This extraordinary growth in PP was a product of the effect of stimulus on finished- goods consumption.
  • China’s auto sales saw huge increases. This is of great importance to PP as the autos sector is the polymer’s single-biggest off-taker. China’s average annual new vehicles sales growth was 906,000 in the pre-stimulus years of 2001-2008. This jumped to 2.17m in 2009-2017.

The sustainability of new auto sales growth averaging 2.17m should have raised lots of questions surrounding debt and affordability levels. It was obvious as soon as the boom began that hundreds of millions of Chinese could only afford new cars because of the credit boom, as their per capita income levels remained much lower than in the West.

Cheap lending was used to both buy autos directly and inflate the property bubble, which provided further support for the sales of new cars. Gains in household wealth resulting from rising real estate prices increased the ability to buy a wide range of big ticket, or expensive, consumer durables, including autos.

Air pollution became a lot worse as auto ownership soared. It was already bad enough before the stimulus programme because China was the low cost manufacturing workshop of the world. Questions should have been asked about when the government would have to act to reduce air pollution.

But questions were not asked, and, I am afraid, are still not being asked by enough people. They instead see the decline in China’s autos sales in 2018 and 2019 as a temporary problem, a brief interruption in progress towards the dream of “a billion plus middle class” Chinese consumers.

This analysis doesn’t’ just ignore debt and environmental issues. It also ignores the rapid of ageing of China’s population. When you are retired you have less money because you are living on a pension, especially in China where there are major pension shortfalls. You are not working and don’t need to take the kids to school and back. So, even if you own a car, you drive less miles when you retire.

This one dimensional thinking also overlooks the relatively small size of China’s second-hand car market compared with auto markets in the West. We are now seeing the China second-hand car market take off.

There are no logical reasons why China second-hand car sales will not reach 2-3 times those of new cars sales, typical of Western markets, from today’s 50%. The second-hand car market in China might become even bigger than in the West for affordability reasons. Now that the debt tide is retreating, what’s left behind is much lower average capita income levels than in the US, Europe and the rest of the developed world.

The latest data from China’s autos market confirms that the new paradigm is gathering pace.

If you projected full-year 2019 new car sales from the January-July sales data this implied a 13.4% decline in sales. January-July pointed towards negative sales growth of 1.8m new vehicles in 2018-2019. But in the January-August data from the China Association of Automobile Manufacturers (CAAM) indicates a 14.1% fall in 2019 sales and 2018-2019 negative sales growth of 2.38m vehicles. The CAAM earlier predicted a strong rebound in 2019 sales, but now expects low or negative sales growth for the next three years.

Please be very careful about new PP investments to serve China given that:

  • Whilst our base case predicts China PP demand growth of around 14m tonnes in the ten years between 2019 and 2028, not much down from the previous decade, you need other scenarios.
  • My personal view is that growth is more likely to be close to half of this – some 7m tonnes. This would lead annual average percentage demand growth at 2.5% rather than our base case of 4.6%. 2.5% wouldn’t be disastrous. It would instead indicate that China had become a more normal economy, with growth at that level following historic patterns of decline as its PP market matured.
  • We have to think of the global implications of 2.5% growth because of the close links between China and the rest of the global economy. Under this scenario, I estimate total global PP consumption in 2019-2028 would be 81.5m tonnes smaller than our base case.

Conclusion: The new service-based model

This isn’t doom and gloom provided the petrochemicals industry moves away always building capacity when cheap feedstock is available. What this business instead needs to do is become more of a service provider.

Sticking with China autos and PP, China will still need affordable mobility in big volumes in the future. Transportation must also have a lower environmental footprint.

PP producers should work with auto manufacturers to supply solutions that increase the life of vehicles, thereby supporting the growth of the second hand market. They should seek to become the preferred supplier of PP to electric vehicles manufacturers. And a ride sharing grows in China, they need to again work with the auto makers and the ride sharing providers to help design vehicles that can stay on the road 24/7 with a lower risk of wear and tear and breakdowns.

We are all capitalists aren’t we? None of the above should be provided free of charge. PP companies can charge for these and other service opportunities that will arise as the new paradigm continues to develop.

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