By John Richardson
FOUR years ago it seemed like an absolute “no brainer”.
Just about everyone thought that China’s economy was going to expand at double digit annual rates, virtually forever.
You also had the surge in ethane availability in the US, thanks to the shale gas revolution, oil prices which most people thought had reached their “natural long term level” of $100/bb and banks that were falling over themselves to lend money to US petrochemicals projects because of record-low interest rates.
Many boards of directors have thus, as we all know, sanctioned new US ethane-based steam cracker capacity and a great deal of downstream polyethylene (PE) on the assumption that the extra PE volumes will produce strong margins gains, whilst also being easily absorbed by global markets. China’s ability to absorb most of these excess volumes was critical to this argument. This is because the size of its markets, the rate at which its market has grown and the scale of its deficit in PE will for a very long time dwarf every other country and region.
Consensus thinking maintains that the new US PE volumes will still be very easily absorbed, and that all US producers will return excellent profits, despite a very different-than-expected macroeconomic background.
Who cares you if are right for the wrong reasons as long as you still end up being right? Here is why the majority of people still think everything will be fine in the post-2017 PE world, after new US PE capacity has arrived in global markets:
- Yes, China’s economy is clearly undergoing profound adjustments that the majority of people entirely missed. But whilst the investment-led part of its economy has surprised most people with its weakness, equally surprising is the strength of consumption-led growth. This has led to widespread claims of a positive decoupling of PE demand growth from lower growth in China’s overall GDP.
- Sure, oil prices are going to be lower for longer than just about anybody had expected. But ethane will still be so abundant in supply that whilst ethane-based cracker margins might be a bit lower than been expected versus naphtha crackers, ethane-based margins will still be excellent.
- Not all the new US projects will come on-stream as scheduled. For technical and market reasons there will instead be a very delayed start-up schedule, enabling markets to very easily absorb all of this extra PE.
But please, please be careful out there.
Starting with Point 1, economic reforms have only just begun in China as the battle between the reformists and anti-reformists is only now reaching its conclusion. President Xi Jinping, who is leading the reformers, has consolidated his power base through pushing ahead with his popular anti-corruption campaign – and through taking away some of the power of the ministries that have traditionally managed economic policy.
Xi is thus in a position to push ahead with the most painful and difficult phase of economic reforms that will challenge the notion of decoupling. I will look at how Xi has consolidated his power base, and what this means for China’s economy, in detail on Wednesday.
As for Point 2, this article in the UK’s Daily Telegraph underlines some of the arguments that we have been making about oil markets for nearly the last two years.
Shale oil production costs continue to fall to the point where pre-production costs in the Permean Basin in Texas could be as low at $2.25/bbl. This shouldn’t surprise anyone. The economic imperative to push the envelope on US shale oil technology has been there for a long time, as shale oil technology is one of the few genuine bright spots in the US economy.
We also know that Saudi Arabia has never really thought it could get rid of shale oil production. It has always known that this is impossible. Its market share policy is actually been driven by this: Recognition that demand growth for oil has gone beyond its peaked, and so it cannot afford the run the risk of being forced to leave its most valuable national asset in the ground, for good. Saudi Arabia will, as a result, maintain high levels of production over the long term.
The weakness in oil prices over the last two years also reflects deep-seated problems with the global economy, resulting from the long term implications of the end of the Economic Supercycle. Demand for oil, and all the things made from oil, is the core issue here.
Oil could therefore very easily average less than $30/bbl in today’s money over the long term. What would that mean for the revised margin forecasts of US PE producers?
Granted, new US supply may turn out to be more staggered than had previously been imagined. But you still have to question whether even these more staggered volumes can be sold for the following three reasons:
- Why shut down an old, fully depreciated naphtha cracker in Europe? Even if the maintenance costs for this cracker are high, oil at less than $30/bbl makes the economics of such a cracker look entirely different, especially when you add the co-product credits from benzene and butadiene etc. which of course you don’t get from ethane cracking.
- Cheap oil and abundant local supplies of naphtha could well result in naphtha cracker expansions in some regions.
- The rise of populist politics in the US could lead to more trade barriers between the US and other countries, depending on the result of this November’s presidential elections. This could place new US-based PE capacity at a disadvantage versus new plants elsewhere.
Some US producers will perhaps do better than others. For example, those who have focused on higher-value grades might end up being in a better position. Growth in grades such as C6 and C8 linear low-density PE is likely to remain strong in China even if the overall economy continues to slow down. This would fit with China’s attempt to escape its “middle income trap”.
Any US producer who can win domestic market share from competitors through, for example, cheaper logistics – and by so doing minimise their exposure to exports – might also do well. This could well be the model that works better at the commodity end of the US PE business.
At the very least, what seems clear is that generalisations about the US PE industry are not going to work in today’s highly complex and uncertain world. This is an important message for investors as widespread talk builds of an even more sustained ethylene, and so PE, upcycle. Not all US PE producers are likely to do well.