Petrochemicals – No Longer a Fair Fight
Early in Q1 2018 (at a different company) we wrote a provocative piece that had as its core conclusion that investors should walk away from basic chemicals and that companies should immediately start looking at “lifesaving” consolidation opportunities. This flew in the face of massive US Gulf coast investments coming on stream at the time and some very attractive industry profitability. At the time our logic was that “peak oil” or “peak gasoline” would drive investments from oil producers and refiners to produce more chemicals in order to maintain demand for hydrocarbons. We saw this as a grave 2022-2030 risk to traditional industry participants who were not back-integrated into hydrocarbons.
In the last couple of years, we have seen zero consolidation in basic chemicals, despite a few rumors and a very public courtship of Braskem by LyondellBasell. What we have seen is a collapse in margins and a wholesale rejection of the sector by investors, as illustrated in the chart below. Much as we would like to think that our research influenced investor behavior, we are sure that the margin compression (real and anticipated) was the true story.
But, in our view, the supply risks still remain, and industry participants are now having to face two additional important challenges – a socially driven rejection of single use plastics and the dramatic rise of ESG influenced investing. The single use plastic issue looks likely to slow demand growth co-incident with continued investment in supply. Alone this could result in prolonged global overcapacity, conjuring up memories of the early 80s or most of the 90s, with the only real difference being the competitive advantage that natural gas based production has over oil based production, favoring capacity in North America and the Middle East (assuming that this advantage holds; see our earlier “daily”– if it does not we likely have bigger problems than the relative price of plastic). ESG, with all of its inaccuracies, controversy and influence will be the subject of a future “Scenarios” piece, but here is the soundbite; feedstocks could continue to work for US chemical producers, demand could remain robust, companies could execute some spectacular M&A and still underperform as public equities because of ESG!
The Heart of the Problem – EVs
The changes coming to the automotive world have far–reaching implications for many industries, with as many future scenario models as there are those interested or invested in the topic. While some of the models appear to be sophisticated and drive all sorts of demand conclusions for a variety of fuels and materials, everyone still struggles with the same problem: what are the right input assumptions. Today the range of possible assumptions is so wide that you can generate almost any 10-12 year set of conclusions that you could imagine. Here we focus on one aspect – falling demand for gasoline and diesel, whenever that starts and whatever the decline rate may be.
- Aramco and others are interested in securing oil demand and/or ensuring that refineries run at optimal rates. The suggested Aramco projects could consume as much as 30% of Aramco’s current crude production on an equivalent basis. This does not include a possible Second Sadara project, which remains in the planning stage.
- Aramco’s Motiva (until recently a JV with Shell) is talking about adding significant chemical capacity to the existing refining footprint including both aromatics and possibly a new ethylene unit.
- Shell is modeling a crude scenario where demand falls by only 1% per year post 2020 in part because of shift towards chemicals.
- If Shell is discussing a 1% decline in crude demand per year – be sure that the company is planning for something more severe.
- The proposed Aramco project in India would consume 1.2 million barrels of crude a day and produce 18 million tons a year of chemicals and plastics.
- And we cannot ignore the climate activists and the intensifying investor pressure and its effects on companies like Shell, BP, Total and others. This also points towards peak demand for transport fuels sooner rather than later – we can’t just plant trees.
We suspect that all refiners and oil producers are planning for two things that they fear the most: peak oil demand and declining demand for refined products. With that in mind they have two objectives, protect their oil demand and/or refinery throughputs. Refiners make very little money most of the time with their refineries running flat out – cut the operating rate by 10% and losses mount quickly.
Oil demand may peak, but chemical and plastic demand is likely to continue to grow – at least that is the current consensus. Reconfigured, refineries can make a lot of chemicals – ensuring throughput and crude oil consumption. The world processes over 4.5 billion tons of crude oil a year, much of it on some very sophisticated equipment designed to upgrade as much crude as possible to the more valuable products – today gasoline, jet fuel and diesel. Roughly 60% of global refining output is for gasoline and diesel, more biased to gasoline in the developed world and diesel in the emerging economies.
Refiners are already significant suppliers of chemicals, with most benzene, toluene and xylenes coming from reformers, most of which sit in refineries (there are some dedicated units operated by chemical companies in Asia). The FCC unit, common to most refineries, is already a major supplier of propylene. The unit also produces ethylene, but the concentrations are small, and it is generally consumed as a fuel. These facilities are optimized for gasoline, as the most valuable product, but catalyst choice and temperature can maximize propylene and ethylene output with no major capital investment. Significant capital investment would be needed to extract the ethylene from a largely methane and ethane stream but pooling of streams where refineries are close together (such as in the Gulf Coast) might improve the economics.
The chart below shows the output from an average US refinery. Even though refineries produce more than 50% of the propylene in the US and more than half of the aromatics, these account for a very small part of the barrel and are picked up in “hydrocarbon gas liquids” and “other oil for Chemical use”. Outside the US the “naphtha for chemicals use” fraction would be significantly larger as so much US ethylene is produced from NGLs (including condensate) rather than refinery-based naphtha. The US refiner is likely more exposed to declining gasoline and diesel demand than refiners outside the US because of the current refinery demand profile – however, the US already has significant ethylene and derivative surpluses.