GLG News by Kevin Boyle

Implications: Ethylene producers have returned to profitability.  While ethylene prices are dropping quickly, feedstock prices are dropping faster.  While heavy feedstock cracking may still be negative, the overall industry (median margins) are back in positive territory.  Derivative margins are quite strong.

Analysis: Ethylene producers, as a whole, have returned to profitable territory.  There have been lots of questions over the past few months about the continued health of petrochemical producers, and speculation about weak plants shutting down.  In general, this just isn’t the way the industry reacts.  Producers know that, eventually, costs, prices, and demand will realign and capacity for ethylene production will be needed.

While spot ethylene prices have dropped from a high of 65¢/lb in mid-July to the current level of 50¢/lb for August, feedstocks have fallen faster.  Ethane traded at $1.44/gal in mid-July, now it is $1.02.  Natural gasoline, representative of heavier feedstock has fallen in price from $3.11/gal to $2.52.  To further benefit heavy feedstock crackers, important coproducts like benzene have risen in price from about $3.80 per gallon to $4.40.  The fall in feedstocks can be attributed directly to dips in oil and natural gas prices over the same timeframe.

The median cash margin for U.S. producers is now 1.2¢/lb, by my calculation.  While cash margins at the ethylene level may still be negative for heavy feedstocks, producers really don’t sell ethylene (in general), they sell the derivatives like polyethylene.  Polyethylene producers announced a 5¢/lb increase in June, 7¢/lb in July, and are aiming for another 8¢/lb in August.  The industry believes they got the June and July increase, August is yet to be seen.  Spot prices for polyethylene, depending on grade, run from 82-90¢/lb.  The bottom line is that even naphtha-based ethylene derivatives are profitable, so producers will continue to run.

With costs now realigning with the market, concerns shift back to demand.  Domestic demand, generally a function of GDP, is softening.  Exports have been good, but are likely to dwindle in the short term, as Asian producers crank naphtha crackers back up, due to lower costs.  In the long term exports are vulnerable because of low cost Middle Eastern capacity coming on line.

While the U.S. petrochemical industry still faces many challenges that will require creative solutions, a eulogy is certainly not in order.

Implications: Japanese ethylene producers are beginning to reduce operating rates to adjust to market conditions.  Because of their relative high costs in Asia, Japanese producers are the marginal suppliers.  As they reduce production, we see the deepening of the trough hit Asia.

Analysis: To gauge the temperature of Asian ethylene and plastics markets, Japanese producers a good ones to watch.  Imported feedstock, high energy costs, high labor costs, high infrastructure costs, and below average economies of scale make Japanese ethylene producers marginal in the region.  Controlled markets for ethylene derivatives like polyethylene make domestic production and sales profitable and preferential to Japanese producers.  But competing in the export market is a different story.
 
A couple of weeks ago, a Japanese chemical trade association indicated that Japanese producers would ease out of the export market for polyolefins and just produce for the domestic market.  The article noted here indicates that Asahi Kasei (3407.T) will reduce operating rates at Kurasiki.  Another news item says Mitsubishi (4188.T) will delay the restart of its naphtha cracker at Kashima, effectively reducing operations.  

With naphtha at or above $1150 USD per ton (Singapore) and the spread between naphtha and polyethylene hanging below $700 per ton, naphtha-based Japanese producers are not profitable.  Many traders are reported to have pulled bids and offers from the market to watch from the sidelines as the market unfolds.  Natural gas based feedstock producers in Taiwan, Malaysia, and India can still compete in the Asian market, along with the growing Middle Eastern capacity.  But as demand softens, high cost producers in Japan first, then Korea, are likely to find offers unacceptable.  

Since the Japanese producers and associated trading houses have resources beyond Japan, their financial results are more likely to keep pace with the rest of the industry.  Korean producers, being less global, will have to count on higher prices for key exports like polypropylene to balance operating costs.

Implications: The hopeless housing market puts US PVC makers in a very poor position.  Global PVC capacity is up, and prices and margins are falling.  New capacity will toughen the market conditions on a global basis.  In the meantime, falling chlorine consumption is sending caustic prices higher.

Analysis:  The largest PVC producer in the world, Shin-Etsu (4063.T), Shintech in the US, will bring on nearly 600 MmT of new PVC capacity some time soon.  They have delayed this addition for nearly two years due to supply commitments and the PVC market collapse.  Thankfully for other US producers of PVC, Shintech will send much or this production offshore.  Still, the woeful PVC market in the US will not benefit from this addition. PVC production was reported to be less than 1 billion pounds in April.  This puts operating rates well under 70%.  A seasonal uptick in housing starts just isn’t coming along to perk up the market.  Other major producers like Georgia Gulf (GGC), Westlake (WLK), Formosa Plastics (6505.TW), and OxyVinyls (OXY) are bound to suffer to varying degrees, based on their forward and backward integration. Shintech’s response is to use its enormous global presence to send PVC offshore.  Here, they will be dealing with the emergence of China as a PVC producer.  China is self-sufficient in PVC.  Some 80% of new capacity additions have been in China.  Now half of the global PVC capacity is in the Asia-Pacific region.  Some good news is that much of this capacity is based on acetylene VCM, not the chlor-alkali route. PVC producers who are back integrated to chlorine will get some benefit from that business.  The decline in PVC demand has stunted chlorine demand.  Chlor-alkali operating rates were down to 84% last month.  This results in a shortage for the co-product caustic soda.  OxyChem and Formosa are leading a $100 per ton increase in caustic soda prices.  Georgia Gulf and Westlake, both of which have some chlor-alkali capacity, will receive some of this benefit as well. The question is how much benefit will the forward integrated producers – Georgia Gulf, Westlake, and Formosa – get from this strategy.  All have a home for some of their PVC in their own pipe and profile businesses.  Formosa is a well-balanced, global business.  But for Georgia Gulf and Westlake, those downstream businesses are confined to North America.  Since North America is the source of the housing/PVC market slump, just how much advantage they will get from this is questionable. PVC producers are in for a tough time over the next couple of years.  Those with chlorine capacity, a highly consolidated market, are likely to fair better than those counting on profits from the fragmented downstream businesses.

Implications: Dow seeks to lead the industry to try to recover the increase in energy costs.  An across the board increase makes sense if energy costs have equal effect on manufacturing costs.  The move certainly gives them another opportunity to raise the awareness of energy prices on chemical producers.

Analysis: Dow has proposed an across the board, 20% price increase for all of its products, worldwide.  The reasoning is the substantial hike in energy prices.  While chemical processes do use significant amounts of energy, more importantly, energy costs directly affect feedstock prices.

What would this mean in real terms?  Well, polyethylene would increase 15 cents per pound, propylene would be up 14 cents per pound, benzene would would be up another $1 per gallon.  Just for perspective, polyethylene prices have risen about 6 cents in all of 2008, after falling by 2 cents per pound throughout the first quarter.  Molders have demonstrated some pricing power, but can a flagging economy really swallow this?  We'll see.

Dow has led a very vocal effort to make lawmakers aware of the impact of high energy prices on chemical producers.  In past times, Dow was more unique in the US in that they were not an energy producer as well as a chemical producer.  Others like ExxonMobil, Shell and BP, for example, benefited from high energy prices, which soften the high cost of feedstocks to the chemical units.  Now, with more chemical producers independent, like Ineos and LyondellBasell, Dow's campaign may have more footing.

Just how do oil and gas prices affect margins?  The relationship between base energy prices and the main petrochemical -- ethylene -- are complicated.  However, my sensitivity analysis indicate that, at current energy prices, a 10% change in oil prices results in about a 4-4.5 cent per pound change in ethylene margins (in the opposite direction, of course).  A similar 10% change in natural gas prices shifts ethylene margins by 2.5 cents per pound.

Currently, again according to my analysis, an average, integrated polyethylene producer makes about 15 cents per pound EBIT, from buying feedstocks to selling HDPE.  Returns (ROI) are satisfactory, but not impressive.

It will be interesting to watch the market reaction as Dow pushes the chemical industry problems through the rest of the economy.  They have been tapping Washington on the shoulder for years.  If the rest of the economy starts tapping with them, maybe someone will turn around.

Implications: First quarter results from converters confirm that demand for plastics packaging materials is down.  The good news is that higher revenues are attributed to thier ability to increase prices.  If converters have pricing power in the market, this should be good news for resin producers.

Analysis: Graham Packaging is one of the largest converters in the world.  They produce packaging materials including plastic bottles and other containers across North America, Europe, and Asia.  The announcement of the first quarter results is a good indication of what resin producers already know – demand for plastics is down this year.  These materials include the high volume plastics like polyethylene, polypropylene, polystyrene, and PET.

The article specifically notes that their sales of household goods and personal care packaging materials was lower this past quarter than Q1 of 2007.  This is particularly indicative of market conditions related to a poor economy.  This product category – bleach bottles, detergent bottles, mouthwash and make-up – are often viewed as resistant to mild economic downturns.  The items might be considered non-discretionary and, therefore, recession proof.  If sales of these goods are down, this strikes at the core of the polyolefins business.

The good news captured in the article is that Graham’s sales were higher because they were able to pass on higher material costs.  Resin producers have faced very stiff opposition to attempts to raise resin prices this year.  Announced price increases in January failed and some prices actually fell.  Thus far, spot prices for contain materials like HDPE and copolymer polypropylene have increase only 4¢ per pound and 6¢ per pound on spot markets this year.  As resin producers have faced stiff raw material increases from oil and gas derivatives, their margins have been squeezed about as thin as they can go.

If converters like Graham Packaging can continue to pass resin price increases on to their customers, then resin producers will have more room to try to recover the increases in their costs.  This provides some hope that, as operating rates continue to fall in petrochemicals and plastics, producers may be able to maintain breakeven economics, at least.

Implications: Energy costs are the most important input to chlor-alkali production costs.  Companies who have advantaged energy contracts, like those with low cost hydroelectric power, have a significant cost advantage in the market.  If Ineos can secure discounted electricity supplied to their operations in Runcorn, they pull closer to competing with hydroelectric power supplied firm, particularly in northern Europe.

Analysis: Since the production of coproducts chlorine and caustic soda essentially involve placing electrodes in salt water, and running a battery backwards, electricity is the key cost component.  As power markets become deregulated with electricity open for bid, prices become more volatile and seasonal.  This can wreck havoc on high power demand chemicals like chlorine, which carries through to derivative products like PVC.

Sensitivity models on chlor-alkali production costs indicate that a 10% increase in the per KWH electric price reduces cash margins on chlor-alkali production by about $15 (USD) per short ton, all other inputs and prices being equal.  The same 10% change in the other input -- the salt price -- results in about a $3 per ton change.  In turn, at today's prices, chlorine represents about 12-15% of the raw material costs for PVC.  So changes in the cost of chlorine, even for the integrated producer, move margins for PVC.

Several companies in Europe, Canada, and the US have a significant cost advantage in producing chlorine due to long-term power contracts based on low cost hydroelectric power.  Others are forced to purchase incremental power requirements in day ahead markets, placing them at a significant disadvantage for both cost and planning purposes.  For producers who want to expand their operations, simply obtaining economically priced power is often a critical factor.

Without knowing the discount that Ineos could obtain from British Energy over their current contract, it is impossible to say how this will affect their competitive position.  It certainly appears as if there is the potential for reduced costs, and, possible, economical expansion of the chlor-alkali and PVC operations.

Implications: Specialty chemical are not as sensitive to underlying raw material costs as commodities.  In addition, the structure of specialties softens the price volatility.  Commodity chemicals will not enjoy these kinds of results as energy prices increase, a recession looms, and increasing global capacity dampens export prices.

Analysis:  While specialty chemicals have a bit more leeway in margins, the commodities are on a short leash.  The constant dynamics in commodity plastics, for example, is the ability of producers to move price increases from volatile energy through to buyers.  Since demand has slowed, producers are caught between $100 oil, which translates into very expensive feedstocks, and buyers who can pick and choose when to add inventory.

Last year, exports provided the incremental volume to keep plant operating rates in plastics high enough to show acceptable margins.  With the domestic market down, there will be greater pressure on exports.  New capacity in the Middle East and Asia will put a lid on prices, most likely cutting margins.  The stable capacity situation in the US will shorten strife of a recession.  However, operating rates are still likely to fall over the next six months.

So, while the specialties have a bit of margin insulation, due to a technology premium in the price, the commodities don’t get this advantage.  The commodity assets are the expensive, inflexible ones that must pay off.

Implications: The price of oil has not yet impinged on the cost of not using it.  It remain economically efficient.  As inflation sets in, however, there will be less and less incremental budget to be spent on energy.  This will likely fuel inflation and hurt demand.

Analysis:  

Each time the price of oil spikes, there has been a softening in demand. However, this decrease in demand has been temporary, lasting no more than a month or two. Then demand resumes its normal growth pattern. During this period, people are evaluating their alternatives and adjusting their spending patterns. This is not because people and business have accepted $70 oil.

Consumers evaluate the opportunity costs of high oil prices. In other words, “If I stop or reduce what I do that is consuming oil, am I further ahead?” For most people, the answer is no. If I stop driving to work, will I be financially ahead – no. If I cut back and only go to work four days each week instead of five, will I be further ahead? No, I’ll be able to stay home all five days and collect unemployment.

The incremental spending on gasoline, for example, is coming from other parts of the budget. This may be savings, or other discretionary spending categories. Many are dumping their Suburbans and F-150’s for Kia’s and Cooper’s. Some are able to roll these costs through as higher wages or higher prices. This begins the cycle of inflation.

The prospects for lower oil prices come from Russia and other potential producers. Russia has vast amounts of oil that have not yet found a convenient way to markets. As pipelines from the central and other remote producing regions of Russia are completed, supply will increase substantially.

Other countries, like Turkmenistan, have significant oil reserves, relatively close to major consumers, like Europe. Pipelines from other central Asian nations, bringing oil and gas towards Europe are in the engineering phase. These countries have not been willing or able to develop these resources as yet, but are likely to do so soon.

Some forecasters (I am not among them) have actually said that oil is likely to drop below $50 per barrel, once these supply hit markets. This might even set up some competition with traditional producers who can easily lower prices from current levels and still make substantial profits.

Consumers have not gotten used to $70 oil. They simply do not have a choice yet. As inflation bites into their incremental income, demand will drop. Prices are likely to find some level, lower than $70, until supply expands. Then Economics 101 takes over again.