US Energy Advantage – Unintended Consequence; Global Overbuilding of Petrochemicals
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
Graham Copley / Nick Lipinski
April 10th, 2013
US Energy Advantage – Unintended Consequence; Global Overbuilding of Petrochemicals
- Companies in the North America are investing in petrochemical facilities to exploit the opportunity afforded by cheap natural gas. Those looking to protect themselves from the competitive threat posed by North America are also investing and adding further capacity.
- This risks oversupply and significant downward pressure on prices and margins, which may persist for many years. Industry forecasts for demand growth are, in our view, inconsistent with energy price forecasts, which call for sustained high oil prices – historically correlated with low demand growth.
- Overbuilding is focused in the US, but we may see surpluses emerge in China and only limited closures in Europe and elsewhere. This dynamic will compress the cost curve, which will reflect “break-even” economics rather than cost.
- The conclusion is negative for marginal producers in Europe, in particular those that spend money today to try and compete with (or protect themselves from) the lower cost US product. The conclusion is negative for everyone if the oil/US natural price ratio falls.
- We would focus on companies spending to exploit the US opportunity quickly and without capacity in other regions of the world – this leads us to Westlake, Axiall and Methanex, though all are pricing in a strong future already. In Exhibit 1, which plots estimated earnings growth against forward PE, LYB looks most interesting, but EMN is not far behind.
The annual petrochemical pilgrimage to Houston and San Antonio last month drew large and very diverse crowds; diverse both in terms of the industries represented and countries. The “is the shale story real” question, which was on everyone’s agenda last year, has been replaced with and acceptance that it is real, and a further set of questions:
- What does this mean for me?
- What can I do to get more of the action? What is my opportunity?
- How can I protect myself from the competitive threat that it represents?
This year was interesting, less so from a presentation content perspective and more so from a sentiment perspective: There is a sense of optimism and almost euphoria that is both similar to and different from the last annual events that shared the same positive degree of anticipation – 1989 and 1990. And here is where we can learn some lessons…
The mood in 1989 and 1990 was almost reckless. At that time everyone in the business, everywhere in the world was making more money than they ever thought possible. Then it was all about everyone spending money to add capacity to exploit shortage and the very optimistic forecasts of demand growth. Today it is different – in that not everyone is making money. The very high attendance at the conferences and the very high international mix of attendees, suggests that there are as many trying to answer the last questions posed above as the second one. If US shale gas and NGLs are exploited to the full, existing high cost producers in Asia, Europe and Latin America look pretty precarious unless they can find a way to put up barriers or make themselves more competitive – we think that this will involve adding more net capacity – i.e. expanding more than they close down.
Many companies made a lot of mistakes in the 1988-1992 period – they spent too much and overestimated both demand and their fair share of that demand – this is likely to happen again. Industry profitability took a major hit for several years: some companies emerged stronger; some did not emerge at all. Note that in Exhibit 2, margins fell from a high in 1989 to a low within 4 years that was below the levels seen in the early 1980s – a period of near despair for the chemical industry.
As companies react to the current opportunity, some are going to make mistakes, and it looks like we are going to face a similar level of oversupply that we saw post the building boom of the 1988 to 1992 period, which will adversely impact everyone, but some much more severely than others. The companies that make mistakes will make the same mistakes that were made last time around; they will be the ones who move outside their comfort zones in order to try and take advantage of what they think will be a long-term opportunity.
We should question any company doing any of the following:
- Assuming that the oil/natural gas differential we see today will last.
- Straying into regions or businesses that do not fit with their core competence.
- Taking unreasonable balance sheet risk.
- Assume that the apparent disadvantaged regions/companies are simply going to roll over and admit defeat.
- Building anything that is not cost competitive on a normalized feedstock slate.
- Allowing themselves to be dragged off-piste by a “really good idea”.
We like investments that have a quick payoff – those being pursued by Westlake, LyondellBasell and Dow Chemical – which will start up before the big wave of new capacity. We are concerned about those with the mega-projects – so this is an offset for Dow Chemical and those with substantial European platforms, and offset for both Dow Chemical and LyondellBasell. The mega projects in North America look robust from a return perspective as long as the US NGL to international crude differential remains high. The real problems will exist outside North America.
The Carrot in North America is Huge
While the level of drilling for natural gas in the US has been curtailed in the regions producing dry gas – because of the low level of natural gas pricing – the level of drilling for wet gas and for oil has surged ahead. This has produced enough methane, both as the primary component of wet gas and as a constituent of the associated gas coming off the crude wells, to balance the natural gas market and keep pressure on prices. Whether this will continue to balance the natural gas market or whether prices need to rise to attract more dry gas drilling is a subject of much debate, but what is clear is that the volumes of associated NGLs and condensate are rising quickly and are at levels that more than satisfy traditional markets. Even if natural gas prices rise, the surpluses of NGLs and condensate will keep meaningful downside pressure on pricing as they look for increments of demand, whether it is new users in the US (expanding or converting capacity to do so) or whether it is into export markets, setting US alternative values at whatever it takes to generate the export sale.
- Note: if you cannot move the co-products, you cannot effectively extract the gas or the crude
The new users come in many forms: chemical companies expanding or adapting capacity in the US are the most impacted and most talked about. But, conversion of vehicles to propane fuel, changing gasoline blending to incorporate more condensate (light naphtha), further conversion of power generation capacity, exporting propane as a fuel, or exporting propane and ethane as a petrochemical feedstock, are all taking place or in the planning phase.
The likely longer-term abundance of raw materials is a subject of limited debate these days. No forecasts show any of these materials selling at a premium to historic alternative values at any point in the future. There is, however, a lot of debate around what happens to pricing of products (and derivatives of those products) with which these raw materials compete. This US advantage looks compelling today as much because of the high global price of crude oil as it does because of the availability the raw NGLs. There is debate about how long the current relationship – Exhibit 3 – can be maintained, as there should be.
- The question here is “when, at any point in recent history (40 years), has the consensus view of forward energy pricing been correct beyond a four year horizon”? The answer is never, so why should it be right now?
So, near-term the margin carrot is huge, and long term the feedstock supply looks fairly robust. The question is who is best placed to exploit either or both in a risk appropriate manner.
In the cost curve analysis that follows later, we estimate that global crude oil pricing would need to fall below $80 per barrel, while US natural gas pricing rose to $4.50 per MMBTU before we would question the economics of the new mega projects in the US.
We Could Have The Oil Price Wrong – But There Is an Equally Significant Risk – Overbuilding
Outside the oil versus natural gas question, which is almost impossible to forecast beyond 3 to 4 years, we came away from the conferences and associated meetings with a sense of foreboding. Those companies with access to the lower cost natural gas liquids in the US are going to exploit the opportunity by building new capacity – this is a logical thing to do. Those faced with the prospect of a more disadvantaged position on the cost curve and cheaper competitive product from the US are going to build more capacity also – interesting this is also the logical thing to do at a more company specific level.
The forecast global ethylene operating rate that was presented by IHS this year was significantly weaker than it was at the same time last year. This is because they have more new capacity in their forecast than before and it is because they are starting from a weaker base year (2012) than they anticipated last year. But, and here is the added problem; we would take issue with their demand growth assumptions as we think they are too high and mutually exclusive from the high oil price forecast.
The Supply Comes From Everywhere – But Most Significantly China.
A year ago one of the more consensus view was that the US could add a lot of capacity because no one else was doing it and the world needed it. Currently, IHS is tracking more than 100 coal-to-chemical projects in China – all scheduled for the next 3-5 years. Not all of these make ethylene, but most of them do, and not all will get built, but the majority might. Also, the average plant size is perhaps a third to a quarter of the size of a traditional ethylene unit. However, as much as 12 million metric tons of coal to olefin (ethylene and propylene) capacity could be built between now and 2017.
However, this is a small part of the total, as including the more traditional approach to manufacture China alone could add more than 30 million tons of capacity for ethylene/propylene/butadiene from 2012 to 2017 (of which slightly more than half will be ethylene).
Then we have some Middle East and other lower cost regions adding, but this is small compared with the US and China.
But the other wild card is what actions are taken by the companies/countries under pressure. It would be wrong to assume that there is much capacity reduction. More likely, as was presented recently by Total, companies will divide assets into two buckets, those which are probably doomed, and those which can be saved through more investment. The “doomed” bucket will be small, in that it will be older, poorly integrated facilities with no obvious local feedstock of demand advantage – these are almost always the smaller units that have not seen investment for years.
The way to save the more strategic sites is to make them better and BIGGER. Total talked about spending as much as 4.5 billion Euros on two sites in Europe to add feedstock integration with adjoining refineries and to increase product sophistication. While there was no mention of expansion, no-one spends that much money in this industry without getting some more juice out of the machine.
We would expect to see investments like this all over the world as companies try to build bigger moats around their core facilities, while jettisoning smaller units that do not change the picture much. Ineos is investing to move ethane from the US to its units in Scandinavia and the UK. We expect to see an increase in propane exports from the US for use as chemical feedstocks in Europe, most significantly at the big coastal sites in Spain, France, Belgium, Holland and the UK, but possibly further up the Rhine if the price is right.
Will the economics be as good as those in the US? Probably not, but this game is not about being the fastest; it is about not being the slowest.
Tricky for Demand to Catch up In A High Price Environment
The world could add as much as 35 million metric tons of ethylene capacity from 2012 to 2017. Demand would need to grow by 5.5-6.0% per annum to get operating rates in 2015/16 and beyond that might cause pricing to rise above the break-even economics of the marginal supplier. We think that this is unlikely and the reason for that is best summarized in Exhibit 4. While the picture is not perfect, there is an inverse correlation between the price of oil and ethylene demand growth. Furthermore, there is a negative slope to the best fit line of annual demand growth Exhibit 5.
The trend in Exhibit 4 makes sense intuitively as the higher the price of oil the higher the price of ethylene derivatives and the higher the price of these materials the more incentive customers have to economize, in ways such as reducing use, using competitive materials and recycling. In the chart we are using the forward curve for crude oil prices. Our demand forecast is for growth of around 3.5% per annum through 2018, which is more in keeping with the historical relationship.
As a consequence we have an operating rate forecast that is more negative, with global rates hovering around 85% for the next couple of years and then declining. At no point do we reach an operating rate than might drive pricing power – Exhibit 6. With this operating rate outlook, and the prolonged nature of the expected overcapacity, competition will intensify. If this happens we will quickly realize that the widely accepted view of the “cost curve” is wrong. Another way of expressing the data is to look at the surplus ethylene capacity that is expected to exist – both in absolute terms and as a percent of expected demand – Exhibit 7. The Absolute data is quite scary, but as a percent of demand we do not get back to the depressing lows of the early 1980s but on a percentage basis we are at the woprst we have seen since the early 1980s.
The Cost Curve – Not The Same as the Shutdown Curve
More and more presentations today from consultants and from companies show, what is now a familiar ethylene cost curve – Exhibit 8. We feel well qualified to talk about this subject as Graham did the original work of ethylene global cost curves when a partner at CMAI (now IHS) in the early 1990s. Every chart you see presented today, while hopefully more sophisticated than the original work, is derived from it.
This is a chart of ethylene costs, and it necessarily makes approximations given that no one has complete data on the alternative values of every input and output streams for every ethylene plant in the world. For the purpose of comparative analysis it is accurate enough. But.. it is a view of cost of making ethylene only and does not represent the economics of any given manufacturing site. This is where it gets much more complicated, but important.
A facility in central Germany or in South Korea may look like an obvious closure candidate on the chart above (and it would be if it simply sold all of its ethylene), but when you then add up the profit made from the products derived from the ethylene, propylene and other co-products on the site or nearby, you could get a very different picture. A company may be willing to run its ethylene facility at a large nominal loss because of the profits made down the chain. In some cases it may be only one or two products that support maintaining the whole operation, but that may be all it needs.
Anecdotally, the two companies who could most easily (from a logistical and customer supply perspective) close facilities in Europe are LyondellBasell and Dow Chemical. This is because they have manufacturing capacity in the US and could supply their European customer base directly from the US with essentially the same products, based on cheaper feedstocks. Anyone else in Europe would likely have to abandon customers. Both LYB and DOW maintain that their European facilities are competitive and are not closure candidates.
If we assume that this integrated approach is the right one, ten we have to change the shape of the curve – and perhaps it looks more like Exhibit 9. The US natural gas based producer is still insulated, but the margin umbrella for the natural gas based producer shrinks.
To be clear; we have made up all the data to create the second line and the chart should be used only for illustrative purposes. Note that every ethylene plant runs at current global prices, which makes sense as they are all running today. The adjustment makes the curve flatter, and if we are wrong in our analysis here we would guess that the second half of the curve is not flat enough and possibly not low enough.
The point that we are trying to make here is that low cost US capacity may result in the shutdown of capacity in other parts of the world, but not a significant amount unless prices fall well below what is seen today as “break-even”.
Take this a stage further and compare the current “cost curve” with the future “break-even” curve and you get a picture that looks like Exhibit 10.
What this could means:
- US producers based on natural gas derived feedstocks will maintain a margin umbrella – as long as NGLs trade close to extraction break-even and as long as a significant differential exists between international oil prices and US natural gas prices. The rough and very simple math is as follows (1):
- If we are paying – best case – $100 per pound of new capacity in the US ($2bn for 2 billion pounds of capacity), we need a margin of 25 cents (10 cents depreciation and a 15% return on capital. This is $550 per metric ton.
- In Exhibit 9 the US margin umbrella is around $775 per metric ton, but this based on Brent at $115 per barrel and natural gas at $3.50 per MMBTU.
- If Brent falls to $80 per barrel and natural gas increases to $4.50 per MMBTU, the margin umbrella falls close to the $550 per metric ton of ethylene.
- Some if not many of the investments to “save” uncompetitive units around the world will look like mistakes with the benefit of hindsight. All margins will come down meaningfully but Europe will likely be hurt most severely.
- China coal based production will likely become the swing supplier and could operate intermittently depending on market conditions – not good if you are an investor in these facilities on in peripheral facilities.
- If oil falls relative to US natural gas – or vice versa – while demand growth may pick up, the competitive battle then becomes a more even playing field.
(1) Note – there are hundreds of moving parts in the calculation of the global curves – what we have provided is a very rough analysis for the purpose of adding perspective – our costs are probably +/- $100 per ton. A much more comprehensive analysis is needed to pretend to have any greater degree of accuracy.
Not Surprisingly: We Like Quick Stuff – And/Or Obvious Stuff
Only a handful of companies can react to the current environment in a meaningful way quickly. These are companies with the ability to restart old capacity or expand existing facilities quickly and at relatively low cost. We have seen some ethylene restarts and expansions – Dow Chemical, Westlake, Eastman, and there are others planned for the next two years, Westlake again, Nova, LyondellBasell and others. There are some methanol restarts which are also quite quick and lower costs. These are all good and sensible things to do for three reasons:
- There is more certainty about the forecast near-term – less can go wrong to screw it up!
- Cheap expansions have a shorter payback period. LYB is suggesting that the recently announced projects will be fully paid back before the main wave of new capacity comes online.
- It is much harder to predict the behavior/reaction of competitors looking our four or five years, just as it is harder to forecast raw material prices – more to follow.
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