Commodity Chemicals – Building In the US, an Adventure or an Investment

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

graham@/lipinski@sector-sovereign.com

October 9th, 2012

Commodity Chemicals – Building In the US, an Adventure or an Investment

  • Planned ethylene expansion in the US relies on a significant price discount for US natural gas versus global crude oil for more than the next 10 years as well as a robust export market for ethylene derivatives. We test these two assumptions and find possible fault with both.
  • Better returns on capital may be available through acquisition today; resulting in consolidation that would help an industry with a very negative slope to gross margins and returns on capital. Higher oil prices stifle demand growth globally and capacity additions add to oversupply, losing money if the US natural gas/oil gap closes.
  • We would favor companies without a major expansion plan, as timing of completion is too far in the future to offer much certainty about the cost advantage. Alternately, US producers should find creative ways to encourage plastics converters to locate or relocate consuming capacity in the US. This would take away some of the two way trade in plastics and derivatives and increase domestic consumption of the planned ethylene.
  • The analysis favors companies like WLK, GGC and LYB who see the benefits now and do not have significant capital plans. WLK and LYB have growing mountains of free cash and will be challenged to deploy this in a way best for shareholders, although WLK have some shorter-term expansions, which should have good returns.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

Commodity Chemicals has a very poor return on capital trend (Exhibit 1), which underscores the fungible nature of the products produced and the importance of continual moves to consolidate the industry and thereby create economies of scale. Historically we have maintained that any R&D expenditure, resulting in product enhancement, has been competed away quickly, and that R&D is incremental and necessary to keep up rather than something that increases value. Both the gross margin and return on capital trajectory completely supports this view.

So scale is everything and fewer producers would be better than more producers. We have too much product and we have too many producers. New producers have emerged out of a combination of nationalistic desire to have a local industry and the idea that there are feedstock advantages to be exploited.

We are at a point of inflection in the industry once again, as the “promise” of low cost feedstocks in the US (US natural gas versus global crude oil) looks like it will spur a capacity drive similar to the one we saw in the Middle East in the last 20 years (the Middle East added 25 million tons of capacity from 1990 to 2011- the region now has 17% of global capacity).

Concerns are many fold and in no specific order include:

  • The renewed cost advantage in the US and the likely expansions do not really change the market structure. The US is the marginal supplier of ethylene derivatives to the world today and will remain so after any expansion – US production will not displace lower cost “export” supply from the Middle East and may struggle to shutdown higher cost regional producers with captive local markets.
  • Demand growth – it is probably being overestimated meaningfully such that any new US capacity will enter a market already more oversupplied than anticipated.
  • Lowering export ethylene derivative prices to push lower cost US product into international markets will inevitably have a negative impact on domestic US prices, which might be good for longer-term US demand growth, but bad for medium-term results.
  • The gas advantage may not be sustained, either because expected shale based availability is overestimated today or because oil prices come down from their politically rather than fundamentally driven highs. Oil supply is also increasing. As oil prices fall, the pricing required to force the closure of higher costs units also falls, reducing U.S. export profitability.
  • Shutdown expenses in higher cost regions (specifically Europe) may be too high and may force producers to keep operating at economics that do not appear to make sense and which lower global pricing.
  • Shale gas is not unique to the US.

We discuss each of the issues below in more detail, and suggest some alternatives, such as buying, rather than building capacity and finding creative ways to attract conversion capacity to the US to minimize the exports.

We are more interested in companies that are in a position to exploit the natural gas advantage in the medium term than the longer-term as we have more certainty in the 5 year forecast than the 10 year forecast – this list would include WLK, GGC, DOW and LYB, but would be more cautious on DOW than the other three because of the large capital outlay that DOW is planning.

Still The Marginal Supplier

If we go back to the 1970s and 1980s, the US was a major supplier of plastics and other basic derivative chemicals to the world. Prior to that period, Europe also had a major role, but after the rise in oil prices in the 70s the clear cost advantage that accrued to the US natural gas based producers effectively squeezed Europe out of the picture and ever since, European exports to the global market have been opportunistic. This is particularly true for ethylene derivatives, less so for propylene derivatives where the competitive landscape has been more even.

Rolling forward, the US has maintained its position as the incremental supplier to the world – US operating rates are only tight, and we only see prices fly up well above marginal costs in the US when the global market is tight and US export pricing is higher than US domestic pricing. What has changed is that the US is not the low cost supplier to the world anymore – that role sits with any producer exploiting what is effectively stranded natural gas liquids supply (i.e. where there is a limited local market for natural gas). As capacity has been added, mainly in the Middle East, to exploit this cheap raw material, the US has seen its share of a growing “international” market fall, but remains the supplier at the margin. We showed the cost curve in Exhibit 2 in our initial work on this subject back in May.

Exhibit 2

Source: IHS and SSR Analysis

There are some interesting observations that derive from this analysis:

  • First: the current price of polyethylene in Asia is below the theoretical break point on the curve. This is because the price is being set by suppliers that sit on the bottom end of the curve. You have to add both polyethylene conversion costs to the cost in the chart and shipping costs to market. The break-even ethylene price that is back calculated from polyethylene at $1,300 per ton delivered to Hong Kong, Shanghai of Singapore is probably closer to $1,000 per metric ton, rather than the $1,250 suggested in the chart.
  • Second: this is possible (and sustainable) because the ethylene plants operating in that cost range from $1,000 to $1,250 per metric ton are generally supplying markets where they have a delivery cost advantage because they are local. In addition, they are for the most part making specific grades of polymer or other ethylene derivatives for specific local end-uses that are not as easily substituted by imported product from the Middle East and the US. This dynamic will not change when the US has much more export capacity.
  • Third, the US is not going to displace any of the capacity below and to the left of it on the curve. Even some of the less cost competitive facilities in the Middle East are closer to the main import markets and have a shipping advantage.

The second point is critically important, as these are the companies that the US producers are seeking to displace as they add new capacity with their sights on the export market. Things will be OK if we see robust demand growth over the next few years, but if we have a significant overcapacity in 2017 and 2018, as we expect, pricing could get much more ugly than exhibit 2 would suggest. And on that subject…

Demand Growth

It is probably important to think about the demand environment for basic chemicals, specifically ethylene, as we contemplate expansions in the US and Canada over the next 5 years. In its most recent estimate, IHS shows global consumption of ethylene in 2011 of 125.6 million metric tons, against a capacity to produce of 147.4 million metric tons – and an operating rate of 85%. While this is an improvement over the operating rate dip in 2008 of 83%, prior to this you have to go back to 1982 to find a rate that low – Exhibit 3.

IHS expects an additional 24.6 million tons of capacity to be added by 2016, but only around 10% of this in North America. The shale gas deluge comes after, in 2017 and 2018, and could be as much as an additional 10 million tons. The world could add 35 million tons of new capacity – 23% – within 6 years. But this is only 3.5% compound growth, so is it a big deal? It is if you believe the basic premise under which the planned US capacity will move forward, which is high absolute crude oil prices leading to high prices relative to cheap US natural gas.

Exhibit 3

Source: IHS and SSR Analysis

High priced crude is a demand growth killer for this industry and rising crude prices are at least as bad as high crude prices – Exhibits 4 and 5. High oil prices are bad for two reasons, they stifle overall economic growth and they raise the absolute price of basic plastics which encourages users to find ways to use less and to look for alternates – the higher the price the greater the incentive. Rising and volatile crude oil prices create uncertainty and consequently slow down investment that might consume additional chemicals and plastics.

Exhibit 4

Source: IHS and SSR Analysis

Exhibit 5

Source: IHS and SSR Analysis

Regardless of the price of crude oil, ethylene demand growth has a steady downward slope globally – Exhibit 6, and a much more pronounced slope for the US – Exhibit 7.

Exhibit 6

Source: IHS and SSR Analysis

Exhibit 7

Source: IHS and SSR Analysis

Prolonged low global operating rates will result in break-even pricing for marginal producers and ultimately put a lid on US domestic prices that may still generate a very high margin and return on capital, if the oil/natural gas delta remains high, but at lower margins than we see today and lower than what is implied in consensus estimates.

Pricing

Exhibit 8 shows pricing for polyethylene in the U.S. since early 2001. The solid line is the contract price for High Density Polyethylene as reported by IHS in its monthly monomers report. The dotted line is the Far East spot price carried by Bloomberg and the shorter dashed line is the NYMEX spot price as carried by Capital IQ.

Exhibit 8

Source: IHS, Capital IQ, Bloomberg and SSR Analysis

The reported U.S. contract price is well above the international “clearing” price and the gap has widened meaningfully over the last 4 years. Large buyers of polymer do not pay this list price; they pay something much lower with discounts determined by size of purchase as well as other factors. However, the list price is used as a reference for polymer derivative pricing and it is part of many pricing formulae.

Even with the discount, the average U.S. buyer is paying a lot more than his opposite number in Hong Kong, Shanghai and South East Asia. This is why we continue to see the export of basic polymers from the U.S. and the return of fairly low value derivatives from Asia. Today, not much US polyethylene is exported to Asia and so the volumes that move at these lower prices are a small proportion of overall US production. In total, North America is expected to export around 2.5 million tons of polyethylene this year, around 14% of overall production in North America, with less than half of this moving to the very competitive Asia market.

Post (the shale wave) expansion we would expect to see as much as 7.5 million tons of polyethylene exports (assuming half of the planned ethylene capacity is converted to polyethylene). This would then be 33% of production – Exhibit 9. The assumption in the exhibit is that there is no domestic growth in polyethylene consumption in the US from 2012 to 2018. Obviously, if the US can encourage polymer converters to increase capacity domestically these higher export volumes can be reduced – see later section.

Exhibit 9

Source: IHS and SSR Analysis

If this change in trade volumes were to knock 10 cents per pound off realized US domestic polyethylene pricing, the US industry would lose $1.1-1.5 billion of revenue and gross margin.

Sustainability of the Gas Advantage

All of the capacity we are expecting in the US is driven by the idea that natural gas prices are going to remain cheap relative to oil for many years, and that the gas available in the US will be sufficiently “wet” to keep the ethane market oversupplied even once the new ethylene capacity is completed. Given that the facilities will come on stream in 2017 and 2018 and at a minimum will be expecting a payback period of 5 years – there is an expectation that gas remains cheap versus oil for at least the next 11 years and probably more like 15.

This is a long period to forecast.

  • I started my career at BP in 1983. In the previous year the company had done barely better than break-even its chemical business (because of the very high price of oil) and the expectation was that this would continue for the foreseeable future. Four years later the industry went into its strongest ever up-cycle following an oil price collapse.
  • As a consultant in 1989 and 1990, I had several clients who had major capital projects around the world, with the basic planning premise that the high margins the industry was experiencing would be sustained for the foreseeable future – three years later we were at cyclical lows.
  • In the early 2000s we saw natural gas prices spike in the US. The expectations were that prices would remain high for the long-term. In 2002/2003, then at Sanford Bernstein, I co-wrote an early and definitive piece underscoring the problems of high priced natural gas and predicting the demise of the US chemical industry. This was widely accepted as conventional wisdom by early 2003 and there were many plant closures. By 2010 we were again awash with natural gas and prices have been low ever since.

The purpose of the last three bullet points is to illustrate how wrong we can be when we forecast out beyond a few years. When prices of any product are high producers find ways to make, or find, more of it and consumers find ways to use less of it. When prices are low, consumers find ways to use more as a replacement for more expensive products and investment in production slows down. So how could this happen here?

  • We have already talked about slower demand growth for petrochemical products because of higher prices for plastics, but the same dynamic can and will apply to oil and gas.
  • There appears to be plenty of shale or tight oil around the World and with the high price of oil there is plenty of encouragement to find it and bring it to market. Equally important; do not buy into the argument that it costs $50-70 per barrel and that will set a floor price. North Sea crude was supposed to set a floor in the high $20s in the 1980s, but was being produced profitably at $12 per barrel by the end of that decade. Learning curves and logistic investments will greatly reduce the cost of finding and development for all of the unconventional supplies of crude around the world. If we were to make a bet, the economics of the US ethylene investment plan will be upset by a decline in the price of oil and consequently a loss of competitive edge for the U.S.
  • But gas could be the problem also. These shale based wells require constant drilling as the well decline rates are very steep. Low gas prices will encourage increased consumption, in some cases at the expense of oil:
    • LNG trucks – filling stations are being constructed and are planned across the country.
    • Incremental power stations will be built based on natural gas, as they were through the 1990s. Recent prices for natural gas make it unlikely that we will see significant advancement in projects for wind or solar power in the U.S.
    • Export terminals are under construction for LNG in the US and Canada and there are plans to export propane also.
    • The US methanol industry is restarting.
  • Lastly, shale gas is not limited to the U.S. and there is a lot of investment in discovery and production in Europe, Latin America and Asia. It is early days with these programs and it is not clear how much gas there is and how high the NGL content might be. Opportunities to build low cost ethylene may materialize in other parts of the world.
  • There is no guarantee that there will be abundant supplies of U.S. natural gas in 10 years time, nor that oil prices will remain at such a premium to natural gas.

If the sustainability of the competitive advantage is not there, the US is building a lot of capacity to export to a number of markets that do not need the product, and will not have the economics to force the outcome.

Shutdowns in Other Regions

One of the assumptions behind the expected wave of investment in the US is that it will result in the shutdown of facilities in other countries, thereby making more permanent room for the additional product from the US.

We should not underestimate the social and environmental costs of closing ethylene and derivative facilities in many countries. Companies have operated facilities for years at below what would be considered normal break-even economics because the costs of closure are higher than the costs to keep the facilities running. This is particularly true today in Europe, where much of the high cost capacity is located. Very high unemployment rates and very strict labor laws make redundancies both financially and politically difficult in Europe.

Moreover, there is often significant government pressure to keep facilities in a working state, even when shutdown, so that there is an easy restart should economic conditions change. The downside of this for US producers would be that, in the event that there is a swing in oil prices relative to natural gas such that European capacity became competitive again, plants would restart and the overcapacity would be greater.

From a planning perspective, we should probably assume that pricing needs to fall 10-15% below breakeven in the higher costs regions, and stay there for a while (12-18 months) before we get any permanent or semi permanent closures.

Take a look at the economics we proposed in the initial work that we did on this subject back in April of this year – Exhibit 10. As a reminder, in this analysis we set the price of polyethylene as the break-even economics of production from naphtha, and we compared this with the cost of production of polyethylene from ethane, assuming ethane at break-even extraction economics from natural gas. Since we did the analysis in April, the forward curves have moved and the gap has closed, though not by much. We have also raised our capital cost assumption, based on what companies are suggesting it will cost to build these new facilities. Returns still look good if you could lock in the pricing today.

Exhibit 10

Source: Bloomberg, IHS and SSR Analysis

  • (1) The price of naphtha in c/gallon is 2.5x the price of Brent crude in $/bbl. This is slightly below the 40 year average, which has been fairly stable.
  • (2) The co-products on the Naphtha plant are valued at about 80% of the cost of Naphtha, which is above the historic average and well above the average in high crude oil price environments– so we are being generous to the naphtha process. We discuss this assumption later.
  • The analysis is based on a capacity of 1.2bn pounds of polyethylene operating at 95% of capacity
  • We are assuming that we are making High Density Polyethylene
  • We are assuming that the clearing price for US polyethylene is set in the US and equivalent to the price setters cost, regardless of that location. (In the cost curve analysis that follows, the price setter, i.e. the marginal supplier is in Europe). This assumption is conservative based on historic fact, but we will challenge this assumption shortly as it is possible that as US exports rise, prices in the US could fall to reflect the price in export markets less the cost of freight from the US (particularly for the more commodity grades of plastics)
  • The integrated capital cost of building capacity to separate ethane, make ethylene and then make polyethylene is $1.0 per pound – this is well above most recent estimates from manufacturers and consultants, but consistent with some of the costs indicated by producers in the US contemplating projects today.

To account for the shutdown cost issue raised in this section, we have taken down the polyethylene price in Exhibit 10 by 10%, and the results are shown below in Exhibit 11. Based on the analysis that we outlined in the section on marginal suppliers, we may be conservative with the 10% cut – it is possible that we might need to see 15-20% to really penetrate the markets served by high cost but local ethylene production (for example: Inland Europe, Japan, Inland China).

Exhibit 11

Source: Bloomberg, IHS and SSR Analysis

The returns in Exhibit 11 are still good (particularly when compared with the industry history in Exhibit 1) but not nearly as compelling as they were and do not allow for much more closing of the natural gas/oil delta either pre or post 2020.

So What Do You Do Instead or To Offset The Risk ?

We have never been big fans of complainers – people who highlight the risks and the problems without ever suggesting a solution – so here are a couple of ideas.

Buy rather than build

If you are willing to pay $1.00 per pound to build integrated ethylene capacity in the US with a start date four to five years from now, you should be willing to pay more than that for existing capacity today. You should pay more as you have much more confidence in the feedstock advantage over the next three years than you have four to five years from now. Some of the investment numbers that have been floated by those planning to build are much higher than the numbers we are using.

  • Would DuPont sell its ethylene plant in Orange Texas for $1.5-2.0Bn?
  • Would Huntsman, Nova, Sasol, CP Chemicals or even Westlake sell?

Our analysis of gross margins suggests that it is much more important for this industry to consolidate than it is for it to build. Companies might be far better off using surplus cash to pay (a high price) for existing capacity than to build new capacity.

A full list of North American NGL based ethylene capacity is summarized in Exhibit 12. In this Exhibit we have not included facilities that have been closed for a long period, but which could possibly be restarted, we have not included facilities that do not consume NGLs and we have not included any announced expansions. The data is taken from the IHS World Light Olefins service and we have shown capacities in millions of pounds.

Exhibit 12

Source: IHS

Bring the demand home

We are not convinced that enough is being done to address what to us appears to be the most risky part of this expansion boom in the US – the fact that all of the product needs to find a market offshore. The issue is even more relevant when we think about how much plastic is consumed in the US as finished goods that are manufactured off-shore. Today, a significant portion of the plastic good consumed in the US is based on material originally sourced from the Middle East. However, we will end up with a situation where we are exporting boat loads of basic plastic and importing boat loads of finished goods (durables, toys, consumables, packaging etc.).

US producers of basic plastics should be doing more to bring conversion capacity back to the US. There are multiple reasons for this, both economic and strategic:

  • If we believe in high oil, then the higher rates we are paying to ship plastic out of the US and ship finished goods back will be sustained – this is economic incentive in itself to make more of these products in the US.
  • Labor costs in the US are not rising and we have millions unemployed – labor costs are rising in the developing world and the gap is closing.
  • Logistics – we have seen a couple of good examples of supply interruptions in Asia in the last 24 months and the impact that this has had on US businesses and US sales. Locating manufacturing in the US will increase reliability of supply, reduce supply times and reduce working capital.
  • Power costs – low natural gas prices in the US make US electricity costs some of the lowest in the world. Moreover, if we can get the natural gas trucking business working, we will also have lower cost short and medium distance transport costs.
  • Most important – if the forecast is completely wrong and if oil prices fall relative to gas 7 or 8 year from now, such that the US competitive advantage is essentially removed, we have captive local demand and the industry looks much more robust as a result.

This sounds great, but as long as the price profile shown in Exhibit 8 exists, it will not happen. Today, with the discounted price of polyethylene in Asia versus the US, there is no incentive for companies to move conversion capacity to the US. Clearly higher freight costs (driven by higher crude oil prices) make the economics of making plastics products in Asia and moving them to the US less attractive, but the basic plastic price difference acts as an offset.

For converters, durable makers, toy makers etc. to move manufacturing to the US there needs to be an economic incentive and it needs to be an incentive that is expected to last.

There is an opportunity, probably assisted by hedging, to set up a fixed price, or fixed margin contract, or shared margin contract, with converters that would attract investment in the US. This would ultimately be far better for the US industry for all of the reasons listed above, but someone needs to take the lead, and as yet we are not seeing such a move.

©2012, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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