INSIGHT: As overcapacities build, look to value creation in China markets

By John Richardson

PERTH (ICIS)–You always knew that no matter what chemicals and polymers you made, China would buy most of the surpluses you were left over with when you had satisfied the needs of your domestic customers and other export markets.

This golden age of doing business in China – when doing business in China was so easy that just about anybody could make a decent profit – is over. And it is quite likely over for good.

The first reason for this relates to demand, as we have discussed in a previous Insight, and so we won’t go over old ground here.

China is attempting the boldest, most risky set of economic reforms for at least the past 20 years. In the short term, all the evidence suggests that this has to mean much-lower economic growth. And in the longer term, there is no guarantee that these reforms will be successful.

The supply side of the story nothing short of takes your breath away. The thing is, though, that it is not as if any of the data we are about to present is entirely new. It has been sitting in the ICIS Supply & Demand database for several years now, telling a very clear story about impending chronic oversupply in many chemicals and polymers in China. This is thanks to very aggressive capacity additions in China itself.

What has changed is that there is no longer anything impending about oversupply in products such as purified terephthalic acid (PTA) and polyvinyl chloride (PVC). Very long markets are already with us.

In the case of PTA, we estimate that capacity was around 11m tonnes/year in 2008. By 2015, this had risen to 52m tonnes/year. Meanwhile, consumption had only increased from 15m tonnes to 32m tonnes.

The PVC story in the same. Capacity in 2008 was 15m tonnes/year, which by 2015 had risen to no less than 32m tonnes/year. Consumption increased from 9m tonnes to 16m tonnes.

If oversupply on this scale affected any purely market-driven economy, capacity rationalisation would be very rapid as companies frantically restructured in an effort to keep investors happy.

But China is different, as are other countries such as Iran. A separate story to be pursued later is how aggressively Iran will expand its petrochemical exports, now that sanctions have been lifted.

Countries such as China and Iran don’t always only think of the immediate bottom line – ie how much an individual plant, or a whole industry, is losing or making on the basis of revenues versus costs-per-tonne measures of production. Payback is instead also measured in terms of longer-term contributions to the wider economy.

So what will China do with its petrochemicals overcapacity?

As we discuss in detail in our new Scenario Study – raising petrochemicals exports, through maximising operating rates, would be a way of compensating for slower domestic growth.

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, according to a 22 February Reuters’ article.

China’s diesel producers are able to export very aggressively because a floor has been set for domestic diesel prices, said Reuters.

Looking only at PVC, many of China’s coal-based plants are in western China so that they are near coal mines. 

Demand for coal in general will fall as the environmental push intensifies. But a 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.

So why not keep these coal-based PVC plants open in order to reduce the number of job losses in coal mines?

Why not, also, expand the coal-to-chemicals industry through, say, many more coal-to-olefins projects? This, too, would not only preserve jobs in coal mines, but also create new jobs elsewhere.

PTA and PVC might even be viewed as strategic products by China as it pursues its New Silk Road initiative – also known as One Belt, One Road.

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 could happen: As labour costs continue to rise in eastern China, China will increasingly outsource plastic processing – which is labour intensive – to neighbouring countries such as Burma (Myanmar) and Laos.

China will supply the PVC resin to run these plastic processing plants and will then re-import the finished plastic pipes etc.

And China might also keep all of its PTA capacity open in order to make lots more polyester fibre. This polyester fibre could be moved to Burma where it might again be cheaper, because of lower labour costs, to make fabric and finally clothes, carpets, sheets and pillowcases etc.

But even if you ignore these wider economic benefits, economies of scale are another reason to believe that major capacity closures may not happen in products such as PTA.

Much of the overcapacity in China’s chemicals and polymers industries in general is the result of a building frenzy which took place in 2008-2013.

As an aside, this was when China was in the midst of a huge economic stimulus programme. All that really mattered was the immediate economic benefit delivered by building new plants across a wide range of industrial sectors.

But crucially here, many of China’s new chemicals plants are world-scale because they were constructed so recently.

In the same new study, we think through what all of this might mean for operating rates and thus imports versus exports for a wide range of chemicals and polymers.

Taking PTA as an example, our base case is that China will run its PTA plants at an average operating rate of around 60% in 2016. This would still leave room for approximately 500,000 tonnes of imports.

But if operating rates were instead just three percentage points higher – at 63% – this would leave space for approximately 1m tonnes of exports.

The hard reality that exporters need to confront is that some of China’s deficits might well have disappeared for good.

And might China eventually move much closer to self-sufficiency in polypropylene (PP) – and even in polyethylene (PE) where deficits remain nothing short of huge? 

A scenario where it aggressively adds a great deal more polyolefins capacity cannot be entirely dismissed.

So, if one golden era is over, how do overseas chemicals companies create a new golden era of profitability in the China market?

Many of the opportunities will be around services rather than just products – for example, providing the expertise needed to clean up China’s polluted water and food.

And where China still needs to import products, they are more likely to be higher value in nature – eg high quality water-treatment chemicals and sophisticated polymers for food packaging.

But higher value will not necessarily mean higher margins because of affordability pressures. China, when you ignore the short term distortions of the 2008-2013 economic stimulus package, remains a developing economy.

This new approach will require some companies to completely re-assemble their strategies.

Once these new strategies have been built, implementation will obviously be the challenge. Mind sets will have to be completely changed from the most senior levels down to the most junior staff.

It is, therefore, going to be fascinating to observe what chemical company CEOs say and do over the next 12-18 months. They need to take the lead in this critical area.