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Ukraine: Oil prices, lost petrochemicals demand, changing trade flows and the impact of the four megatrends

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By John Richardson on 04-Mar-2022

By John Richardson

IF WE ARE involved in a new protracted Cold War, this will change just about everything for the petrochemicals industry. Or, of course, we could go back to the Old Normal.

Corporate planners must therefore press on with drawing up short, medium and long-term scenarios and then apply these scenarios to tactics and strategies. But because of the pace at which events are moving, the scenarios will have to be constantly revised, probably every few days.

The most immediate work needs to take place on the impact of higher oil prices on petrochemicals demand.

Wednesday’s decision by OPEC+ to stick to its 2020 plan for unwinding pandemic-driven supply cuts sent crude even higher. They are maintaining their pre-invasion schedule of unwinding a further 2.6m bbl/day of production cuts by September of this year.

The OPEC+ and escalating conflict in Ukraine means scenarios already drawn up for lost demand resulting from higher oil prices will have to be revised.

Here is the latest analysis from Ajar Parmar, the ICIS Senior Oil Analyst:

The risk of a reduction in Russian oil exports is the primary reason behind the oil price spike in recent weeks. Russia exports ~4.5-5 million barrels per day of crude; with OECD oil inventories at a seven-year low, any loss of oil available to the market will heavily impact prices.

The recent comments from the US, suggesting Russia’s oil and gas exports could be sanctioned leads to the question of how effective the sanctions will be. Should the sanctions lead to a further substantial rise in oil prices, Russia could stand to gain overall.

Russia exports 2.5m bbl/day oil to non-European countries – much of this heads East to Asian buyers such as India, South Korea, Japan and China. Therefore, the manner in which the sanctions are designed will be critical to their success.

If Western sanctions on Russian oil exports only apply to Western crude buyers, Russia will feel some short-term pain, but will likely be able to still find willing buyers in Asia, as the oil market is especially tight at present.

However, if sanctions are supported by the West’s Eastern allies such as India, South Korea and Japan, the overall impact on Russia’s exports will be significant and the number of willing buyers of Russian crude will be extremely small.

One such buyer will of course be China, which will gladly take Russian crude at an $18.65/bbl discount to Dated BFOE, as recently reported by ICIS. But even then, the logistics of re-routing such significant volumes of oil trade will cause temporary pain for Russia. 

Aside from OPEC+ and the US gradually raising oil production over the coming months, the only major reprieve to these high oil prices is the prospect of a nuclear deal with Iran in the coming days, which could allow an additional 1.3m bbl/day of oil back on to the market.

It should be noted that it would take 3-6 months for Iran to fully reach this production level, but just the news of a completed nuclear deal itself, will help to quell prices from current levels. If this deal does not come to fruition, expect oil prices to remain elevated for the foreseeable future.

End End-use by end end-use analysis of lost demand is crucial

We will probably see more downward pressure on naphtha-based polyethylene (PE) margins, which, as the chart below illustrates, had already seen big declines up until the week ending 26 February. This was before oil prices reached an 11-year high.

As the slide illustrates – and as I’ve been highlighting since the middle of year – we are in a divided polyolefins world.

European and US margins have been at record highs due to stronger demand during the pandemic than before and reduced supply, mainly the result of the all the 2020 production problems in the US.

Meanwhile, China’s Common Prosperity policy shift is huge, huge, huge so please do not underestimate its significance.  This led to negative China PE demand growth last year, the first negative growth since 2000, according to my estimates.

China’s new home sales were down by 40% year- on -year in January. Robert Z. Aliber, professor of International Economics and Finance Emeritus at the University of Chicago, told Barron’s: “It’s worse than it seems. Fifty percent of Chinese developers will be bust a month from now.”

There was some misleading talk about improved Chinese purchasing managers’ indices in February pointing to an economic recovery.

But the biggest driver of China’s stellar petrochemicals demand growth since 2009 has been real estate. So, watch for any signs of China relaxing restrictions on the property sector that would boost short short-term growth.

In the long term, though, as I keep stressing, China must continue with real estate deleveraging and the other aspects of Common Prosperity which are all negative for petrochemicals growth.

This is the off the main point but still crucial for understanding today’s markets. Back to the main point. We must consider:

• The extent of lost PE demand in every region because of higher inflation if today’s high oil prices are sustained (they could go even higher),

• Because most PE demand goes into essential end-use applications, such as food packaging, it may be that consumption in the developed world will be largely undamaged.

• Not so in the developing countries (and remember, we can no longer classify China as a developing country). Further increases in inflation threaten to push more people in the developing world into extreme poverty, making them unable to afford even the most basic of modern-day goods wrapped in PE.

A crucial task for PE producers – and, also, polypropylene (PP) producers as we move onto next the slide below – is assessing demand growth prospects, end-use application by end-use application. This will help them decide what quantities of different grades to produce.

PP seems to be more vulnerable to higher inflation than PE as some 18% of global PP demand goes into white goods and 12% into autos. Spending on white goods and autos is often discretionary.

Demand into autos was already struggling before the invasion because of the semiconductor and shipping shortages.

Consumption by the autos sector could get even worse because of reduced discretionary spending –- along with the risk that more supply chain disruptions caused by the Russia invasion will cut vehicles supply.

But around 40% of global demand goes into rigid and flexible packaging, which, as with the majority of PE demand, could be less affected as people will still have to buy essentials.

NEA PP margins have been negative since mid-January this year on Common Prosperity and capacity increases.

As with PE margins, the ability of PE producers to pass on higher raw material costs will largely depend on what Beijing decides to do next.

 Disruptions to production and trade flows, however, offer opportunities

 Some 50% of Europe’s naphtha comes from Russia.

Around 2.79m tonnes of ethylene (11% of total European capacity) and 2.34m tonnes of propylene (12% of total European capacity) are reliant on refineries located along the Druzhba pipeline. While some alternative sources of crude oil could be sourced, it is unlikely normal levels of operations would be maintained.

Lost European PE and PP production could provide exporters with more opportunities, depending on what demand is like.

But this is unlikely to be an opportunity for Russian producers for sanctions and logistics reasons, as my ICIS colleague, Joe Chang, writes in this excellent Insight article.

The slide below shows my estimate of how US HDPE exports could increase in 2022 over last year, assuming there are no new major production problems.

In 2021, because of the production problems, US exports fell to just 30% of capacity. In terms of tonnes, they declined to 2.9m tonnes in 2021 from the previous year’s 3.9m tonnes, when exports were at 43% of capacity.

If you consider the new capacity that is coming onstream and assume that this year’s exports return to 43% of capacity, exports could surge to 4.5m tonnes. The top destination for US PE exports is Europe.

The slide below also shows the rise of Russian HDPE and PP imports since 2019 on new capacity. There are already reports of PP buyers looking for alternatives to Russian supply.

“Hold on, though,” I can again here you say, “won’t Russia just send more HDPE and PP to China given their close geopolitical relationship.?”

More than half of Russian’s 2021 HDPE exports went to China.

But how much of Russia’s polymer trade is by rail over the land border versus by sea container? Container routes to and from Russia have been cancelled.

Russia exporting more PE and PP to China may prove very difficult because of the unwillingness of banks to open letters of credit for Russian suppliers. Our ICIS Pricing editors are also reporting that in Asia, offers for Russian PE are being withdrawn because of buyer reluctance.

Maybe, though, the China appetite for Russian material will strengthen as its banks help finance trade.

But again, Russia’s ability to replace lost exports elsewhere by moving more material to China will hinge on this year’s pace of Common Prosperity reforms, as the following two slides remind us.

A lot will also depend on operating rate decisions China makes, which are always as much political as economic. Rates could be higher than is commonly expected because of supply security concerns.

The slides are also a reminder of the degree to which the global HDPE and PP businesses depend on China. In 2021, more than 60% of global net HDPE imports went to China and more than 40% if of global net PP imports.

Some initial thoughts on the bigger picture implications

In the long term, if we are indeed in a long-running new Cold War, boosting renewables electricity production makes every bit of sense – and, surely, this will happen.

Even if things do, hopefully go back to the Old Normal, this geopolitical shock underlines the risks of depending in imported energy and renewable electricity supply, from wind, solar and wave, is always local.

In either scenario, therefore, I see a further big push towards more renewable energy.

But in the short term at least, energy demand must be met through whatever means. So, expect a continued surge in demand for liquified natural gas and even for the bad old and very dirty coal.

If energy supply security fits with the sustainability transition, all well and good. But the immediate the priority will be keeping economies running by whatever means.

And while the long-term environmental pressures on petrochemicals seem likely to continue, what if polymer supplies were running out in some countries and regions because of shortages of energy supply, petrochemical plant closures and blocked container routes?

There would then be less pressure on producers and brand owners to push for more use of recycled resins. The priority would instead be making sure there was enough total supply of resins to maintain essential food-supply chains, regardless of the virgin and recycled mix.

Or, of course, the fall in demand might override production and supply chain disruptions, leaving plenty of polymers to go around and enabling the recycling push to continue.

We simply don’t know. But we must think through and plan for all the different outcomes.

Conclusion: The bigger picture becomes the smaller picture

When events are moving at their usual pace, the operational managers at petrochemicals companies don’t feel the need to pay much attention to the bigger picture.

But the bigger picture still creeps up on them and, suddenly, when reach tipping points are reached, hits them by surprise. Think here of China’s decision to move much closer to petrochemicals self-sufficiency in 2014 and how we are now at the point where China might soon become a net PP importer.

Now, though, the bigger picture is at front of mind for everyone because we are in the middle of perhaps the biggest geopolitical disruption since the beginning of the last Cold War in 1947.

Trade routes were completely redrawn as investment in manufacturing flowed largely within but not between the US and Soviet zones of influence. Economic growth patterns also diverged after the late 1960s from the 1970s onwards as the Soviet bloc struggled and the West boomed.

Analysis of the megatrend of geopolitics, even by a PE sales manager, has thus become essential because if they don’t understand the geopolitical effect on trade flows, they won’t be able to sell their PE.

Further, they need to understand demographics and its influence on China. China’s ageing population helps explain Common Prosperity.

The pace of sustainability is also critical to understand because of disruptions to energy and petrochemicals markets supply caused by geopolitics. In the short term, the pace of sustainability, for the reasons detailed above, may slow down.

And finally, we need to add an understanding how the pandemic continues to shape demand, supply and trade flows. In other words, the bigger picture of all four megatrends – geopolitics, demographics, sustainability and the pandemic or perhaps pandemics –- is the small picture.

Those who ignore the megatrends are destined to make every day tactical mistakes that will cost many millions of dollars.