Market and product

The above chart paints a depressingpicture for anyone thinking it should be easy to make money via a major USethylene investment based on cheap ethane from shale gas. Itshows 2012 ethylene production (red column) was still below SuperCyclelevels, as were volumes for the two major derivatives –polyethylene (blue) and PVC (green). It highlights how lack ofdemand will make it very difficult to justify all the currently plannedexpansions.

Thus ethylene output in 2012was 24MT versus a peak at 25.7MT in 2004; PE output was 14.1MTversus 14.3MT in 2007, and PVC output was 6.3MT versus 7.3MT in2004. Equally, trade data from Global Trade Information Services suggests thatexport markets are unlikely to provide sufficient volume to justify the plannednew capacity. Net US PE exports have actually fallen by 1MT since2009, whilst PVC exports are already over 40% of domesticoutput. (The logistic costs of moving ethylene itself are tooexpensive to allow large volumes of exports).

This, of course, is an almostunbelievable message for any executive who moved into senior management duringthe later years of the 1983-2007 SuperCycle. Then demand was rising on aconstant basis and planning was based on the theme from the baseball movie 'Field of Dreams' that “if you build it, theywill come”.

But today, in the New Normalof slow and uncertain demand growth, the situation has reversed. The UShas had a major feedstock advantage versus oil-based producers since 2009,and its ethane costs have been back at pre-2003 levels for over a year. Yet it is has been unable to set new production records for any of the keyproducts.

How then will it manage to sell the10 million tonnes of potential new capacity that is currently being planned?

The would appear to be only 3possible developments that would enable producers to place sucha volume:

• A major and sustained increase in domestic US demand
• Major and sustained growth in key export markets
• Major closures of local production in key export markets

The first option seemsunrealistic, as domestic markets remain very slow despite the $tns ofgovernment stimulus. Certainly it would be a brave Board that sanctionedmajor new investment on the basis of such wishful thinking.

The second option is equallyunlikely, as growth is slowing in all major export markets. In fact, asthe Wall Street Journal noted recently, “the advanced economies, includingJapan, the U.S. and Europe, together are contributing more to growth in the $74trillion global economy than the emerging nations“.

So that leaves just the thirdoption, of forcing the closure of domestic production in key exportmarkets. In theory, this might seem possible. And the blog has hadmany discussions on this theme with enthusiastic investors, who imagine that aquick trip to China, followed by a whistle-stop tour of NE Asia and Europe,will quickly produce the right result:

• They ignore the fact, as the blog detailed again only last month, that whilst China has very high-cost production, this is of no importance to its state-owned producers. Their goal is self-sufficiency, and they have little interest in becoming dependent on suppliers from half-way across the world
• NEA producers do care about their high costs, but social conditions make it very difficult for them to close plants, as history has shown. Consumers and governments would also be very nervous of becoming dependent on a distant production base for such vital raw materials
• European producers have similarly major constraints. Clearly some smaller crackers will have to shut as demand remains so weak (as the blog will discuss tomorrow). But major closures would also threaten refinery viability, and so would be much more complex to negotiate.

This leaves only two possiblefall-back strategies, neither terribly attractive:

• One would be for companies to shut some existing NAFTA capacity in Canada and Mexico. This would be theoretically possible, as the US is obviously a secure local supplier in terms of logistics. But the volumes and cost advantage would be minimal, as many plants are also ethane-based, whilst their governments are unlikely to approve
• The second would be to adopt a ‘scrap and build’ policy. Companies could scrap their older plants around the world, and replace them with the planned new capacity. This would be expensive in terms of up-front closure costs, and would also probably need significant investment in logistics. But even if it made sense on a 10-year horizon, it would be a difficult sell to investors expecting an immediate payback

Shale gas thus provides ahigh-profile example of the New Normal in action. The sad truth isthat demand is no longer ‘guaranteed’ to rise in order to allow a low-costsupply position to be monetised. And without guaranteeddemand, many of today’s planned ethylene expansions may find itdifficult to gain final Board approval.