China used to be the manufacturing capital of the world. It would buy raw materials, and sell finished products to the West. But these volumes are now in decline. The West’s ageing populations already own most of what they need, and their incomes are reducing as they enter retirement.
So China’s business model is changing. It can’t afford to lose jobs, because that would lead to social unrest. So its exports are still booming. But today, these are exports of basic products such as diesel, gasoline and polymers. And they are gaining market share by cutting prices, at the expense of other Asia producers. Thus gasoline margins in Singapore, the Asian pricing benchmark, have halved to just $7/bbl since the start of the year:
- China’s diesel exports trebled in March to 1.25 million tonnes as the economy slowed
- Gasoline exports were also up 8% to 670kt
- Gasoline stocks in Singapore are now close to all-time highs at 15MT
Polymers are seeing the same effect, as the chart shows for polypropylene (PP) in Q1:
- China’s production has risen by a third since 2014, causing imports to also fall by a third
- Middle Eastern exporters have been badly hit, losing nearly half of their volume
- Exports are also starting to rise, from a small base, following the diesel and gasoline model
- And China’s polyethylene (PE) capacity is also rising – it is up 13% versus 2014
PP is therefore following the path set last year by PVC, where China now seems set to become a net exporter. PP will take longer to reach this position, but net imports are already seeing a major decline, down to just 640kt in Q1, versus 1 million tonnes in Q1 2014. So the direction of travel is clear.
One other fact is critical, of course, as we discuss in our new Study, ‘Demand – the New Direction for Profit’. This is that PP can often substitute for polymers such as PE, PVC, PET, ABS and others in certain applications. So today’s downturn hitting the C3 chain – and European propylene prices are now trading at just 69% of ethylene prices – has wider implications. It will make it even harder for the new US PE and PP capacity to find a home.
“The reality is the US from a chemical standpoint is a very mature market. We have some demand growth domestically in the US but it’s a % or two – it’s not strong demand growth,” Pryor said, adding that polyethylene hardly grew in the US in a decade. “That is not going to change.
“The domestic market is what is it and therefore, part of these products, I would argue, most of these products will have to be exported,”
That was the view of Stephen Pryor, then President of ExxonMobil Chemical, just 2 years ago. Latest data for US ethylene production in 2015 confirms his analysis, as the chart shows:
- It has finally reached a new high, 11 years after the previous high in 2004 – but only by 2.9%
- PE also reached a new high, versus the previous high in 2007, by 7.2%
- But the other derivatives – PVC, styrene and ethylene glycol – were still below their 2004 highs
- PVC was 11.3% lower, styrene was 14.8% lower, and MEG lower by 42.1%
Now, of course, things are about to change quite dramatically, as the massive US expansions come online and start to export their product. The competition they provide will likely be extremely tough, as we discuss in our new Study with ICIS, Demand – the New Direction for Profit,
Everyone knows what happens to margins when a major battle for market share takes place. It is almost certain, for example, that the US will need to start selling some or all of its new capacity on the basis of roll-through margins back to the well-head.
And at the same time, polymer producers will also face increasing inter-polymer competition from polypropylene. Propylene’s recent price collapse is just a warning sign of what is to come, as China moves towards its target of achieving 93% self-sufficiency in the C3 value chain.
We are therefore heading towards a world where there will be Winners and Losers.
Companies urgently need to develop new outlets for their product, as we describe in the Demand Study. Such outlets do exist, in potentially large volumes in the water and food industries. But “potentially” means just that – the volume of new demand required means companies now have little time left to plan and implement the business development activity now urgently required.
Our aim in the Study is to help you go up the learning curve as quickly as possible,. If you don’t start to develop new markets today, it may well be too late tomorrow.
Everyone wants to assume that markets will soon be back to “normal”. Consensus thinking now accepts that China will be a bit slower than before – but it argues that 6.5% GDP growth is still pretty good, even if it isn’t double digit. And it suggests that persistence, and “staying the course” is vital for success.
But what happens if the future isn’t simply a slower version of previous growth? What happens if it really was a one-off BabyBoomer-led economic SuperCycle? And even worse, if central bank stimulus simply created short-term demand – and left us with major debt problems for the future?
That is what the data seems to be trying to tell us, when we look at leading indicators such as the polyester market, and now propylene, as the chart above highlights:
- It shows the ratio of propylene prices to ethylene since 1978, when price histories begin
- And it provides the answer to the question I raised in 2012, when new propylene capacity was first discussed
- Very clearly, propylene is going back to selling at a major discount to ethylene
- It has already moved from near-parity to 69% of ethylene values so far this year, and will no doubt fall further
The key to the change is the new capacity now coming online. As we note in Demand – the New Direction for Profit, major increases have been taking place in China’s capacity. China is already using more propylene than ethylene, and its output has been increasing from refineries, olefin crackers, on-purpose plants and from coal. In the main derivative polypropylene, for example, volume has already surged 34% on a year-to-date basis between February 2014 and February 2016, and there is a lot more capacity to come.
Abundant supplies of propylene and its main derivatives also have a second-order impact, as they encourage product substitution with other value chains. As ICIS pricing reported in November:
“China’s PE spot import prices dropped in the week, especially for HDPE injection grade. Local traders lamented that some garbage and tray factories replaced HDPE injection resins with PP copolymer resins due to lower feedstock costs. Hence, the HDPE injection grade prices dropped by about $50/tonne from the previous week.”
Of course, not every application can be substituted. But it can impact 10% – 25% of polyethylene, PVC, PET, polystyrene, ABS and even polycarbonate. So the potential for major pricing upsets is large. And there is no reason to believe that China will act as a “responsible” Western producer, cutting back output to balance demand:
- Its aim is to maintain employment and act as a reliable supplier of critical raw materials to downstream factories
- The Communist Party stays in power by continuing to improve people’s living standards
- Shutting down plants, particularly the new plants built under the stimulus programme, is not on its agenda
What happens next? Worryingly, there seems only one likely outcome – a battle for market share, in which prices for all the affected products eventually end up being set on a roll-through basis to their ultimate feedstock. Cheap propane, oil and coal support lower prices for the propylene chain, whilst cheap natural gas and ethane support lower prices for the ethylene chain.
Developments in the paraxylene chain have already provided a clear warning of what is to come, as I discussed last week. Developments in the propylene chain suggest it is only a matter of time before similar pricing pressures hit the other major value chains.
Companies therefore need to find alternative outlets very quickly indeed, as we discuss in the Demand Study. Doing nothing, and hoping for the best, could prove a very risky strategy indeed.
Everyone is now beginning to notice the change in economic policy in China. And concern is rising about the outlook for all those new petchem investments about to come online, whose rationale has been the need to supply ever-increasing growth in Chinese demand. The chart above highlights the reality behind this wishful thinking:
- Everyone “knew” that China would never go ahead with its PDH and coal-to-chemicals expansions
- But in fact, production data from Chemease shows output is now up 25% in 2015 (red column) versus 2013 (blue)
- As a result, China’s PP imports are up just 1% over the period, and are down 8% versus last year (green)
- Similarly, its exports are on the rise, up 9% versus 2013 and up 42% versus last year
- As a result, imports from NE Asia are down 12% versus 2013 and even Middle East imports are up just 4%
The problem was that commentators chose to ignore the potential impact of China’s New Normal policies. They failed to recognise that China simply couldn’t go on with its failed stimulus programmes, which had created major problems across the country with pollution and corruption.
This threatened the whole basis of Communist Party rule, which has since Deng Xiaoping’s time been focused on increasing living standards to maintain social order. And in addition, there is the sheer waste of resources involved – $6.8tn over the past 4 years, according to the government’s own National Development and Reform Commission. There was just no way that the previous policy could continue.
Equally important, however, in the quest for social stability, is China’s need for jobs. This was made clear at the critical 3rd Plenum in November 2013, which adopted what has now become known as the New Normal economic programme. Jobs are rapidly disappearing in traditional, high-polluting industries such as steel, as an excellent analysis by the Wall Street Journal confirms. But something has to take their place.
Petrochemicals and polymers are an obvious choice, as they support jobs down the value chain in compounding, as well as in end-user industries such as autos, food packaging. Unlike steel, these jobs are not heavily polluting – and they are also relatively high margin. This is important, as it will allow domestic incomes to increase – and so help to support social stability. The growth of coal-to-chemicals production also provides a replacement outlet for coal no longer needed for steel production – thus helping to preserve jobs in the mining industry.
Polypropylene thus highlights the level of change taking place in China. Its pace is now increasing, as President Xi must take most of the pain over the next 18 months, before all eyes turn to the next National Congress in November 2017, when he is due for reappointment. It would make no sense at all for him to turn up for this with a job half-done.
When the Congress meets, he instead needs to be able to look forward, and point to the opportunities ahead from the Belt & Road initiative and the Asian Infrastructure Investment Bank. The next 18 months will be a tough wake-up call for those companies and investors who still want to believe that stimulus is just around the corner.
Polypropylene (PP) is one of the world’s major plastics – used in areas as diverse as car bumpers and food packaging. And in recent years, consumption has soared due to China’s seemingly insatiable demand, as it became the manufacturing capital of the world.
But now, all that is changing. As we warned in chapter 2 of ‘Boom, Gloom and the New Normal’, China has hit the turning point of the Lewis Curve. Thus the front page headline of yesterday’s Financial Times warned:
“China’s migrant miracle grinds to halt as rural labour supply runs dry. 278m workers moved to cities since 1978. Ageing population to bring slower growth”
Nobel Prize winner Arthur Lewis’ key insight was that countries had a ‘free ride’ in the early years of industrialisation, as rural populations moved to the towns. Their contribution to economic growth had been limited in the countryside, focused on the planting and harvest seasons. But in the cities, they could work 12 hours a day, 7 days a week.
China followed this model from 1978, when Deng’s reforms began to open up the country to the outside world. Under World Bank guidance, China’s GDP maintained double-digit levels of economic growth as 278m peasants began the biggest urban migration in history.
Today, however, the ‘free ride’ has come to an end. And we can see the impact in the latest data for China’s PP market in Q1, based on data from Global Trade Information Services, as the chart above shows:
- China is the world’s largest market for PP, and used to be the largest importer
- Its market is still growing, up 13% versus last year, but the basis of its demand has changed
- Imports were down 8%, and instead exports were starting to grow – up 8%
- This pattern is set to accelerate as domestic production increases – it was up an astonishing 19%
The reason is simple. China’s new leadership fully understand the demographic challenge they face. They know they can no longer be the ‘manufacturing capital of the world’, as they no longer have constant supplies of cheap labour from the rural areas.
The chart above from KKR highlights the dramatic nature of the change now underway:
- In January 2002 (as China joined the World Trade Organisation), lower margin re-exports were 56% of its total exports (yellow line)
- They were still at 49% as recently as 2010 – but by January this year, re-exports had fallen to just 38%
- Over the same period, higher margin trade has risen from 44% to 51% of the total (blue0
- Both trends are also clearly accelerating
Thus the government is now happy to allow low-margin activities such as plastic film processing to move offshore to countries such as Bangladesh, Vietnam and Cambodia. Their aim is now to export higher-margin products, such as PP, that will instead enable China’s domestic incomes to grow.
Hopefully, more front page stories in the world’s financial media will help to get this message into the boardrooms of companies and investors around the world. Otherwise, they will continue to promote out-of-date strategies aimed at supplying China’s disappearing re-export trade.
More and more commentators are beginning to recognise that deflation is becoming inevitable in many major economies:
- China’s producer prices fell -4.3% last month, and its consumer prices rose just 0.8%
- Eurozone consumer prices fell in December to -0.2%, and are likely to have fallen further in January
- US prices rose just 0.8% in December and are also likely to have fallen further in January
- Japan’s prices have already fallen by a third from their 3.7% peak in May, after last year’s VAT increase to 8%
This is hardly a surprise to anyone but the central banks. The world has an ageing population, and there is a growing shortage of people in the peak spending age range of 25 – 54 years, due to the halving of global fertility rates to just 2.5 babies/woman since 1950.
My concern is not about deflation. It is about the enormous debt created by the central banks since 2007, in their vain attempt to compensate for the lack of babies by printing money.
They had assumed that they could create a ‘wealth effect’ by boosting stock prices. But fewer people own stocks than houses. So the US subprime housing bubble should have been a warning that they were doomed to fail.
And as McKinsey’s report highlighted yesterday, they have instead only succeeded in raising global debt to 3x GDP.
Debt, of course, becomes more expensive with deflation. So unfortunately, the central banks have done exactly the wrong thing by adding debt. Major defaults are now becoming almost inevitable, as we move through the Cycle of Deflation.
CHINA’S CHANGING MARKET FOR PLASTICS HIGHLIGHTS KEY ISSUES
As so often, developments in chemical markets are a leading indicator of what lies ahead. The chart shows the changes taking place in China’s demand for the 3 main plastics – polyethylene (PE), polypropylene (PP) and PVC between 2012 – 2014:
- All 3 markets show demand growth slowing, whilst China’s own production increases at the expense of imports
- The reason is the adoption by the new government of its New Normal policies which reverse previous stimulus
- It had realised the stimulus had “wasted $6.8tn” – around the size of its own economy
- PVC shows this development very clearly, as its growth was based on the development of the property bubble
- The new policies means China is now a net exporter, when it had been the world’s largest importer in 2012
Of course, this reverse-course is creating major problems for countries which had built vast new complexes to supply ever-increasing amounts of plastic to China. Instead, these producers find themselves in an over-supplied market.
They are thus forced to cut prices to gain orders, creating yet more deflation. As the charts also show:
- The big losers are NE Asia (NEA) and North America (NAFTA), whose exports have fallen sharply
- NAFTA has done particularly badly, despite its temporary cost advantage with shale gas versus oil
- China clearly prefers to buy its limited import needs from the Middle East (ME) and SE Asia (SEA)
And so the plastics market highlights how deflation is set to continue, particularly as oil prices return to more normal levels below $50/bbl.
As China has discovered, central banks are essentially pushing on the proverbial piece of string. Adding more stimulus only creates more over-capacity.