By John Richardson
MOST of the world’s top ten chemicals producers reported lower sales for Q3 2015, but saw their profits improve on lower oil prices.
Sticking to the sector which I follow closely, which is polyolefins, this is down to a “lag effect”. The collapse of oil and so naphtha costs has not being fully reflected in polyethylene (PE) and polypropylene (PP) prices and margins. Instead, as the above chart shows, the spread between naphtha costs and just one grade of PE – low-density PE film grade – has expanded. This applies to most of the other grades of PE and PP.
This is of course not the whole picture for the top ten chemicals players by sales in 2014, as they don’t just make polyolefins. (Click here to download the latest ICIS analysis of both the top ten and top 100 chemicals companies by sales).
But the top ten companies include Sinopec, Dow Chemical, ExxonMobil Chemicals, SABIC, Lyondell Basell Industries and INEOS, which are all very big producers of polyolefins.
So why has this “lag effect” happened? In short, because globally, polyolefins markets have been tight.
In Asia, for instance, no less than 15% of the region’s cracker capacity was off-line in May of this year because of scheduled and unscheduled shutdowns. And in the case of PE, exceptionally tight spot ethylene markets have driven the spread between naphtha and PE to record highs. This in turn has boosted margins for integrated naphtha-based producers.
But the most important question you need to answer is obviously “What happens next?”
This is where, as usual, you must start with the macroeconomics to get to your answer. Here are three things that should now be firmly beyond questioning:
- There is no underlying, sustainable recovery taking place in the US and the rest of the West. Less babies has to mean less demand, until or unless policymakers wise-up. This is not a one or two year challenge. The lack of babies is instead a challenge that will last at least 20 years, in China as well as the West.
- China faces both an ageing population and vast oversupply in manufacturing, left over from the 2008-2013 economic stimulus package.
- This all adds up to major global deflationary headwinds, as too much supply is chasing too little demand. China, for instance, has just reported its 44th consecutive month of falling producer prices, with consumer-price inflation also weakening.
We all know from Japan that when deflation takes a firm grip, people delay non-essential purchases from today until tomorrow because prices will be cheaper tomorrow. Auto sales, electronics and housing sales therefore all suffer as you can usually, for instance, make your old car last a little longer.
As the value of money falls, the cost of servicing debt taken out when money was worth more increases. This discourages further lending and so is another drag on growth.
This is what we know. What we obviously don’t know is tomorrow’s oil price. All that is left for us to do therefore is to plan for a wide range of oil-price outcomes in today’s New Normal, whilst hoping that oil prices will actually stay at today’s levels.
Ideally, oil prices should go even lower. In a deflationary world, the last thing that the chemicals industry in general needs is higher oil prices.
Applying this to the polyolefins business, we know that China has greatly increased its PP capacities. Propylene will also stay historically very cheap. This will create a global opportunity for converters to switch from PE to cheaper PP.
You can easily see this affecting Asia, given that PP oversupply is centred on this region.
You can also make the case that because Asia has always been a highly cost conscious and very competitive polyolefins market, the deflationary headwinds in general will have the biggest effect on this region. This will drive polyolefins converters to aggressively search for other cost savings.
I therefore see both Asian PP and PE margins falling from this year’s highs, back to at their very least their historic averages over the next 12-18 months. There is also a significant chance that these margins will undershoot historic averages.
Today’s understanding tells us that Europe’s frequent outages have kept its polyoefins market tight. A weak Euro has also acted as an effective trade barrier.
You also have the perennial risk that if you ship polyolefins, say, from South Korea to Europe, the price might change two or three times before you take delivery.
A considerable portion of the European industry is owned by the Middle East, and so low-priced imports from the Middle East would end up being counter-productive.
This might add up to European polyolefins margins remaining very strong in 2015 and beyond.
We also already know that the US has enough of its own supply to meet local needs. And we also know that even if US converters wanted to import polyolefins, they face formidable extra logistics costs. Polymers in general are often shipped to the US in bags in containers. These bags have to be torn open and tipped into railcars or trucks so they can be transported to the storage silos favoured by US converters. The labour costs of emptying these bags can act as another effective trade barrier.
US producers also enjoy the shale gas advantage. So US margins are outstanding.
But today’s knowledge is only good enough for today in this increasingly volatile and uncertain world.
Here is a topic for further study and scenario planning: How much “deflationary leakage” will happen from Asia to Europe and the US over the next 12-18 months?
(Note that the post H2 2017 polyolefins world will be very different, as from then the US will start bringing on-stream vast new supplies of PE. I will return to this subject in later posts).
Returning to today’s theme, look at US shale-oil production for an example of what can happen in a deflationary world. This comes down to human nature.
Let’s think about the people who make up the polyolefins processing industry. They also, as I have just said, face big deflationary pressures.
This could well lead to innovation in supply chains and production processes that drive-down the resins costs for processors in the US and Europe – as well as Asia.
Beyond polyolefins, might similar forces be at play in other chemicals and polymers? This is again a subject I will focus on in later posts. In short here, though, here is your answer: Yes.