Cheap Oil Raises Naphtha Cracker Over Investment Risk

By John Richardson

THE ABOVE chart shows that from January 2015 up until November of this year, the Asian naphtha cracker industry has been making a great deal of money.

The orange bars are the premiums in percentage terms between feedstock costs and the prices of one grade of polyethylene (PE) – high-density PE injection grade – plus the prices of selected coproducts. This again underlines the huge value of our ICIS Pricing historical data.

It takes 3.3 tonnes of naphtha to make one tonne of ethylene, with around one tonne of ethylene making a tonne of PE.

Every time you crack 3.3 tonnes of cracker you not only end up with one tonne of ethylene. You also produce around 0.52 tonnes of propylene, 0.33 tonnes of C4 olefins and 0.75 tonnes of aromatics (benzene, toluene and xylenes).

Naphtha-to-PE producers add the money from the sale of propylene, C4 olefins and aromatics, which are referred to as coproduct credits, to help work out the integrated value of their PE production.

(Not included here is any money that producers with surplus ethylene might make from selling that ethylene into the merchant market. Also missing are additional coproduct credits from selling the fuel-oil type products and hydrogen that are produced in a steam cracker).

What is clear from the chart is that the naphtha cracking industry is largely beholden to the oil price, represented by the blue line:

  • Between 2007 and 2014, the PE premium over naphtha costs averaged 26%. This was when Brent crude prices averaged $92/bbl. Crude prices of course set the cost of naphtha.
  • But from January 2015 up until November this year, premiums have averaged 62% with Brent at just $50/bbl. In 2017,premiums reached 75% – the highest since at least 2000 – when Brent was at $44/bbl.

We all like to believe we are clever rather than lucky, but the reality in any business is that luck plays a big a role in success.

The naphtha cracker business is no exception. The US shale revolution, and up until late last year the Saudi Arabian decision to chase market share in global oil market rather try to shore up the price, was a lucky break. So was the Chinese decision to slow down credit growth in an effort to deal with its bad debt challenge. These three factors combined to crash the oil price from September 2014 onwards.

Meanwhile, PE demand growth has exceeded new supply, especially in China thanks to booming internet sales. This has meant that whilst oil prices and so naphtha feedstock costs have fallen very sharply, PE pricing hasn’t fallen anywhere near as much.

In addition, co-product credits have been strong as a result of tight supply. This has been especially the case in the main C4 olefin – butadiene.

A new wave of naphtha crackers

Naphtha cracking is, as a result, well and truly back in fashion. China is planning 17 new crackers, most of which will be fed by naphtha and other liquid feedstocks. Other naphtha crackers are on the drawing board in the rest of Asia and in the Middle East.

Some of the logic behind these projects is extrapolating the above chart years into the future.

As everyone knows, Brent prices have of late breached the $60/bbl level. But few forecasters expect crude to return to around $100/bbl over the long term.

Further, whilst  a big wave of new US ethane-based PE supply is due to hit Asian markets from next year, the consensus view is that the global economy will be strong enough to absorb this new capacity fairly comfortability. Profitability is expected to come down somewhat in 2018-2020, but few people expect a collapse in margins.

And because most of the new crackers starting up over the next three years are based on ethane feedstock, a case is being built for a shortage of propylene, C4 olefins and aromatics – as ethane crackers make only ethylene.

Here is another potential positive: The arrival of Peak Oil Demand could leave refiners with surplus naphtha to get rid of at advantageous prices.

Then think of rising US shale oil and gas production as the efficiency of the hydraulic fracturing process constantly improves. Underpinning the economics of many wells is natural gas liquids output (NGLs) – condensates, propane and butane. Ever-greater volumes of NGLs might find their way into export markets. This could further bolster the economics of naphtha/liquids cracking.

Challenging these assumptions

There is a risk of significantly higher oil prices over the next 12 months. Geopolitical risks and  Saudi Arabia‘s push for higher prices ahead of the 2018 Aramco IPO suggest that crude could go above $70/bbl, even if prices in the long term are significantly lower. As the chart above indicates, this would mean lower returns for naphtha-based PE producers.

And if Peak Oil Demand is approaching why not Peak Plastics Demand? The same forces that are already shaping legislation in favour of electric vehicles could well result in more and more restrictions on the use virgin plastics. Gasoline, diesel and plastics consumption will surely be seen as part of the same environmental problem.

A strong case can and should be made for the role that PE and other plastics play in meeting basic needs such as in sanitation, irrigation and food preservation. But what about the demand that could be lost as governments legislate for more and more recycling of plastics that go into single-use applications?

What about the global economy? Will all the new US PE due on-stream next year be smoothly absorbed? Perhaps not.

The history of petrochemicals contains many examples of periods of overbuilding. What are the odds that we are about to see history repeat itself through the construction of too many naphtha crackers?

From a country or region-specific perspective, overbuilding won’t matter as new naphtha crackers are as much about local economic development – i.e. jobs – as cost-per-tonne economics. These new projects make a lot of sense from this perspective.

Equally, from a Saudi Arabian perspective, building more refinery-to-petrochemical complexes is as much about dealing with Peak Oil Demand as it is about satisfying PE and other petrochemicals demand. Build these complexes and Saudi Arabia will avoid being forced to leave its more valuable asset – crude oil, of course – in the ground for good.

But for any PE producer, whether they are ethane or liquids based, without government support and with purely shareholders to answer to, the story is very different. They are very vulnerable to overbuilding of naphtha crackers.

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