Four serious challenges are on the horizon for the global petrochemical industry as I describe in my latest analysis for ICIS Chemical Business and in a podcast interview with Will Beacham of ICIS.
The first is the growing risk of recession, with key markets such as autos, electronics and housing all showing signs of major weakness. Central banks are already talking up the potential for further stimulus, less than a year after they had tried to claim victory for their post-Crisis policies.
Second is oil market volatility, where prices raced up in the first half of last year, only to then collapse from $85/bbl to $50/bbl by Christmas, before rallying again this year. The issue is that major structural change is now underway, with US and Russian production increasing at Saudi Arabia’s expense.
Third, there is the unsettling impact of geo-politics and trade wars. The US-China trade war has set alarm bells ringing around the world, whilst the Brexit arguments between the UK and European Union are another sign that the age of globalisation is behind us, with potentially major implications for today’s supply chains.
And then there is the industry’s own, very specific challenge, shown in the chart. Based on innovative trade data analysis by Trade Data Monitor, it highlights the dramatic impact of the new US shale gas-based cracker investments on global trade in petrochemicals.
The idea is to capture the full effect of the new ethylene production across the key derivatives – polyethylene, PVC, styrene, EDC, vinyl acetate, ethyl benzene, ethylene glycol – based on their ethylene content. Even with next year’s planned new US ethylene terminal, the derivatives will still be the cheapest and easiest way to export the new ethylene molecules.
The cracker start-ups were inevitably delayed by the hurricanes in 2017. But if one compares 2018 with 2016 (to avoid the distortions these caused), there was still a net increase of 1.7 million tonnes in US ethylene-equivalent trade flows.
This was more than 40% of the total production increase over the period, as reported by the American Chemistry Council. And 2019 will see further major increases in volume with 4.25 million tonnes of new ethylene capacity due to start-up, alongside full-year output from last year’s start-ups.
The problem is two-fold. As discussed here in 2014 (ICB, US boom is a dangerous game, 24-30 March), it was never likely that central bank stimulus policies could actually return demand growth to the levels seen in the Boomer-led SuperCycle from 1983-2000:
“Shale gas thus provides a high-profile example of how today’s unprecedented demographic changes are creating major changes in business models. Low-cost supply is no longer a guarantee of future profitability.”
This was not a popular message at the time, when oil was still riding high at over $100/bbl and the economic impact of globally ageing populations and collapsing fertility rates were still not widely understood. But it has borne the test of time, and sums up the challenge now facing the industry.
Please click to download the full analysis and my podcast interview with Will Beacham.
US ethylene spot prices are tumbling as the major new shale gas expansions come on line, as the chart based on ICIS pricing data confirms:
- They began the year at $617/t, but have since more than halved to $270/t on Friday
- They are only around 10% higher than their all-time low of $240/t in September 1998
- WTI crude oil was then $15/bbl and ethane was $0.15c/gal
- On Friday, WTI closed at $70.5/bbl and ethane was $0.25c/gal
The collapse in margin has been sudden, but is hardly unexpected. It is, of course, true that downstream polyethylene plants associated with the crackers were delayed by the hurricanes. So ethylene prices may recover a little once they come online. But unfortunately, that is likely to simply transfer the problem downstream to the polymer markets.
The issue is shown in the second chart, based on Trade Data Monitor data:
- It shows annual US net exports of polyethylene since 2006
- They peaked in 2009 at 2.6 million tonnes as China’s stimulus programme began
- China’s import demand doubled that year to 1 million tonnes, but then fell back again
- Net exports have actually fallen since 2016 to 1.9 million tonnes last year
The problem, of course, was that companies and investors were fooled by the central bank stimulus programmes. They told everyone that demographics didn’t matter, and that they could always create demand via a mix of money-printing and tax cuts. But this was all wishful thinking, as we described here in the major 2016 Study, ‘Demand – the New Direction for Profit‘, and in articles dating back to March 2014.
Unfortunately, the problems have multiplied since then. President Trump’s seeming desire to launch a trade war with China has led to the threat of retaliation via a 25% tariff on US PE imports. And growing global concern over the damage caused by waste plastics means that recycled plastic is likely to become the growth feedstock for the future.
In addition, of course, today’s high oil price is almost certainly now causing demand destruction down the value chains – just as it has always done before at current price levels. People only have so much money to spend. If gasoline and heating costs rise, they have less to spend on the more discretionary items that drive polymer demand.
COMPANIES HAVE TO REPOSITION FAST TO BECOME WINNERS IN THIS NEW LANDSCAPE As I suggested with the above slide at last month’s ICIS World Polymers Conference, today’s growing over-capacity and political uncertainty will create Winners and Losers:
- Ethylene consumers are already gaining from today’s lower prices
- Middle East producers will gain at the US’s expense due to their close links with China
- Chinese producers will also do well due to the Belt & Road Initiative (BRI)
As John Richardson has discussed, China is in the middle of major new investment which will likely make it a net exporter of many polymers within a few years. And it has a ready market for these exports via the BRI, which has the potential to become the largest free trade area in the world. As a senior Chinese official confirmed to me recently:
“China’s aim in the C2/C3 value chains is to run a balanced to long position. And where China has a long position, the aim will be to export from the West along the Belt & Road links to converters / intermediate processors.”
The Losers will likely be the non-integrated producers who cannot roll-through margins from the well-head or refinery. They need to quickly find a new basis for competition.
Luckily for them, one does exist – namely the opportunity to develop a more service-led business model and work with the brand owners by switching to use recycled plastics as a feedstock. As I noted in March:
“Producers and consumers who want to embrace a more service-based business model therefore have a great opportunity to take a lead in creating the necessary infrastructure, in conjunction with regulators and the brand owners who actually sell the product to the end-consumer.”
Time, however, is not on their side. As US ethylene prices confirm, the market is already reacting to the reality of over-capacity. H2 will likely be difficult under almost any circumstances.
The industry made excellent profits in recent years. It is now time for forward thinking producers – integrated and non-integrated – to reinvest these, and quickly reinvent the business to build new revenue and profit streams for the future.
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It is almost a year since Donald Trump became President. And whilst he has not followed through on many of his promises, he has indeed introduced the major policy changes that I began to discuss in September 2015, when I first suggested he could win the election and that the Republicans could control Congress:
“In the USA, the establishment candidacies of Hillary Clinton for the Democrats and Jeb Bush for the Republicans are being upstaged by the two populist candidates – Bernie Sanders and Donald Trump….Companies and investors have had little experience of how such debates can impact them in recent decades. They now need to move quickly up the learning curve. Political risk is becoming a major issue, as it was before the 1990s.”
Many people have therefore had to go up a steep learning curve over the past year, given that their starting point was essentially disbelief, as one commentator noted when my analysis first appeared:
“I have a very, very, very difficult time imagining that populist movements could have significant traction in the U.S. Congress in passing legislation that would seriously affect companies and investors.”
Yet this, of course, is exactly what has happened.
It is true that many of the promises in candidate Trump’s Contract with America have been ignored:
- Of his 174 promises, 13 have been achieved, 18 are in process, 37 have been broken, 3 have been partially achieved and 103 have not started
- His top priority of a Constitutional amendment on term limits for members of Congress has not moved forward
Yet on areas that impact companies and investors, such as trade and corporate tax, the President has moved forward:
- On trade, he has not (yet?) labelled China a currency manipulator or moved forward to fix water and environmental infrastructure
- But he has announced the renegotiation of NAFTA, the withdrawal from the Trans-Pacific Partnership, his intention to withdraw from the UN Climate Change programme and lifted restrictions on fossil fuel production
These are complete game-changers in terms of America’s position in the world and its trading relationships.
Over the decades following World War 2, Republican and Democrat Presidents alike saw trade as the key to avoiding further wars by building global prosperity. Presidents Reagan, Bush and Clinton all actively supported the growth of global trade and the creation of the World Trade Organisation (WTO).
The US also led the world in environmental protection following publication of Rachel Carson’s ‘Silent Spring‘ in 1962, with its attack on the over-use of pesticides.
Clearly, today, these priorities no longer matter to President Trump. And already, US companies are starting to lose out as politics, rather than economics, once again begins to dominate global trade. We are returning to the trading models that operated before WTO:
- Until the 1990s, trade largely took place within trading blocs rather than globally – in Europe, for example, the West was organised in the Common Market and the East operated within the Soviet Union
- It is therefore very significant that one of the President’s first attacks has been on the WTO, where he has disrupted its work by blocking the appointment of new judges
Trump’s policy is instead based on the idea of bilateral trade agreements with individual countries, with the US dominating the relationship. Understandably, many countries dislike this prospect and are instead preferring to work with China’s Belt & Road Initiative (BRI, formerly known as One Belt, One Road).
US POLYETHYLENE PRODUCERS WILL BE A CASE STUDY FOR THE IMPACT OF THE NEW POLICIES
US polyethylene (PE) producers are likely to provide a case study of the problems created by the new policies.
They are now bringing online around 6 million tonnes of new shale gas-based production. It had been assumed a large part of this volume could be exported to China. But the chart above suggests this now looks unlikely:
- China’s PE market has indeed seen major growth since 2015, up 18% on a January – November basis. Part of this is one-off demand growth, as China moved to ban imports of scrap product in 2017. Its own production has also grown in line with total demand at 17%
- But at the same time, its net imports rose by 1.8 million tonnes, 19%, with the main surge in 2017. This was a perfect opportunity for US producers to increase their exports as their new capacity began to come online
- Yet, actual US exports only rose 194kt – within NAFTA, Mexico actually outperformed with its exports up 197kt
- The big winner was the Middle East, a key part of the BRI, which saw its volume jump 29% by 1.36 million tonnes
Sadly, it seems likely that 2018 will see further development of such trading blocs:
- The President’s comments last week, when he reportedly called Africa and Haiti “shitholes” will clearly make it more difficult to build long-term relationships based on trust with these countries
- They also caused anguish in traditionally pro-American countries such as the UK – adding to concerns that he has lost his early interest in the promised post-Brexit “very big and exciting” trade deal.
US companies were already facing an uphill task in selling all their new shale gas-based PE output. The President’s new trade policies will make this task even more difficult, given that most of it will have to be exported.
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The Financial Times kindly prints my letter this morning on pricing policies for polyethylene.
Sir, Conspiracy theories are always good fun, and Robert Bateman’s views on the polyethylene market are no exception (Letters, December 29). But there is a much more prosaic explanation for the pricing structures he describes.
The key issue is that until recently, lowest unit cost was the key driver for industry profitability. Soaring demand from the baby boomers rewarded business models based on the theme of “If you build it, they will come”, as highlighted in Field of Dreams, the blockbuster baseball movie of the late 1980s. In turn, this led companies to build ever-larger plants, and to develop a shrewd appreciation of the difference between full and variable costs. Local customers paid full price, to reward the investment made. Foreign customers were then supplied with anything left over on the basis of marginal cost economics. Not for nothing were these markets often known as “Rest of World”. It was this dynamic, rather than any conspiracy, which led prices in far-off emerging markets such as Asia to be much lower than in the home markets of the major producers.
Today, however, this business model is long past its sell-by date, as concepts of sustainability and the circular economy come to the fore. Asian countries are also rapidly becoming self-sufficient and no longer depend on low-cost imports from the west. Yet old habits die hard. The excitement over shale gas economics has blinded many North American producers to the outlook for future demand growth and encouraged them to sanction major capacity expansions. Mr Bateman and his fellow manufacturers can therefore look forward to receiving increasingly attractive prices as 2017 progresses, without any need to lobby for new antitrust legislation.
Paul Hodges, Chairman, International eChem
It could be a very difficult H2 for anyone involved in the Asian oil and polymer markets. And given the global importance of these markets, everyone around the world will also feel the impact. The issue is that most business strategies have been based on 2 increasingly unlikely assumptions:
Companies all assumed that oil prices would stay at $100/bbl or higher forever
They also assumed that China’s economy would grow at double digit rates forever
It would have been hard enough if just one assumption had been wrong.
If oil prices had remained high, then companies based on natural gas might still have hoped to do well. If China’s demand had remained strong, then at least it would have been able to buy some of the planned new production. But as both assumptions seem likely to be wrong, companies have few places to hide:
China’s slowdown means that its gasoline and diesel exports are soaring. Gasoline exports rose 75% in H1 to 4.45 million tonnes, whilst diesel exports more than trebled to 6.6 million tonnes
The collapse of oil prices means that US polymer producers no longer have a major cost advantage versus oil-based producers in Asia and Europe
The end result of these two developments is likely to be chaos in oil and polymer markets.
Profits are already collapsing in Asian refining markets – they are down 83% since the start of the year and were just $2.21/bbl this week. And China is not the only country boosting its exports – India’s gasoline exports are up by nearly a quarter this year, whilst Saudi Arabia’s exports were up 76% between January – May.
Similar changes are taking place in China’s polymer markets, as the charts show. China’s polyethylene imports rose just 2% in H1 versus 2 years ago. Its polypropylene imports actually fell by nearly a quarter over the same period, as it ramped up new capacity based on very cheap imported propane.
And the underlying problems of too much supply chasing too little demand are likely to get worse, much worse, as we head into 2017, when all the new N American PE capacity will start to come online. Where will it all be sold is the big question? Can it all be sold?
Of course, the position might turn around if central banks do a mega-stimulus programme involving ‘helicopter money‘.
But the nightmare scenario for these producers is that the collapse of gasoline and diesel margins will now cause refiners to cut back production. In turn, this will further pressure oil markets – which are already struggling to cope with record high global inventories – and cause prices to return to parity with natural gas prices.
None of these concerns are new. I first raised them in a detailed analysis in March 2014, titled US boom is a dangerous game, when I warned:
“Shale gas thus provides a high-profile example of how today’s unprecedented demographic changes are creating major changes in business models. Low-cost supply is no longer a guarantee of future profitability. Any company sanctioning new investment without a firm guarantee of future offtake therefore risks finding itself landed with an expensive white elephant for the future.”
Unfortunately, however, consensus thinking preferred the analysis first described by Voltaire’s Candide – “that everything was for the best, in this best of all possible worlds“. Refiners and polymer producers could now find themselves in a very difficult situation as a result.
I spent most of last week in New York and Boston, meeting with major investors. One key topic on all their agendas was the major downturn underway in the global mining industry. The connection with my visit was that some have already begun to worry that the planned US ethylene expansions may lead to a similar outcome.
The reason is that mining companies were a few years ahead of the US in rushing to boost their capacity by record amounts. They were convinced that China’s growth would be sustained at double-digit levels forever. Now they are paying the price. As the Financial Times reports:
“Commodity prices roared up during the past decade because of voracious demand from China, which single-handedly transformed the mining industry. But prices have come down virtually across the board as China’s economic growth has slowed, and the country moved away from a multi-year construction boom.”
Equally sobering is the assessment of Mark Cutifani, chief executive of leading company, Anglo American,
“It is a pretty tough market. The news from China hasn’t been good . . . It has deteriorated more than we expected and we think it is going to be tougher in the next six months“.
Investors are now worrying they may have encouraged US ethylene producers to make the same mistake:
- They are currently helping to fund a 40+% increase in US ethylene capacity, at an estimated cost of $145bn
- Yet as the chart above shows, the US has been unable to raise its demand above the levels of 10 years ago
- Ethylene, PVC, styrene and ethylene glycol output peaked in 2004, and polyethylene output peaked in 2007
Equally worrying is that net exports of ethylene’s major derivative, polyethylene, have been in decline since 2009, as the second chart based on data from Global Trade Information Services confirms,
Investors are also worried that many of these investments are apparently proceeding without the security of signed off-take contracts, backed by major bank guarantees. This also mirrors developments in the mining industry, where euphoria over the outlook for China was the key driver.
These concerns are now being brought into sharp focus by the renewed weakness in crude oil prices since the Iran nuclear deal was finalised. Investors are now concerned that if this decline continues, a return to lower oil prices could remove today’s US cost advantage versus other regions. China’s stock market collapse adds to their concern.
These developments highlight the way that investors’ rose-tinted glasses led to them falling in love with the shale gas story, just as they had with mining. They had encouraged both industries to expand by bidding up share prices for the companies involved, and rushing to provide the necessary finance. Now they are realising, too late, that different Scenarios were also possible.
There is, of course, no easy escape from the current commitments, given the up-front costs that have already been incurred. But the example of the mining industry suggests cancellation may well end up being the lowest cost option in the long run.