Petrochemicals

North American petrochemical executives expected that 2003 would bring a long-awaited turnaround for their industry. But flat growth and high and volatile feedstock costs sabotaged any substantial recovery in the ethylene chain, making the year another disappointment and leaving producers grateful that matters weren't worse.

Petrochemical makers now believe that the industry will finally turn the corner in 2004. But from a three-year-long nightmare, producers are waking to a changed industry. The emergence of low-cost Middle Eastern players and a growing base of Asian players coincided with the disappearance of the ethane feedstock advantage that North American producers traditionally enjoyed. The industry is no longer able to move its excess ethylene derivatives offshore and must focus instead on domestic demand, itself eroded by cheap imports.

Feedstock prices dominated the petrochemical industry in the first half of 2003. Spot natural gas prices, which influence prices for the ethane feedstock on which 70% of the North American ethylene industry depends, surged from $5.00 per million Btu on the New York Mercantile Exchange at the beginning of 2003 to as high as $18 in late February because of low supplies and cold weather.

Meanwhile, a petroleum strike in Venezuela and anticipation of the war in Iraq drove prices for West Texas Intermediate crude oil to $36 per barrel, an increase of more than 40% for the year. This increase, in turn, significantly drove up prices for naphtha and other petroleum-derived feedstocks.

According to Mark A. Eramo, vice president of olefins for the Houston-based petrochemical consultancy Chemical Market Associates Inc. (CMAI), the feedstock push prompted price increases in ethylene and ethylene derivatives. Ethylene prices, according to CMAI, rose from 26.25 cents per lb in January 2003 to 31 cents in March. Customers purchased material in a frenzy, hoping to boost their inventories before prices reached their peak. As natural gas prices fell back to $5.00 by spring, ethylene rates eased, reaching 27.5 cents by July, and customers stopped buying. "We saw a real severe contraction in the second quarter," Eramo adds.

The situation became so bleak that at midyear, Eramo was predicting a decline in ethylene demand of 1 to 1.5% for the year. However, demand rallied in the second half--a bittersweet recovery for an industry that had hoped for 3% demand growth at the beginning of the year and had to settle for making the same 51 billion lb of ethylene it made in 2002.

"We were suggesting positive growth in ethylene demand in 2003, and basically we had none," Eramo says. "But from the perspective of where we were midyear--how bad we thought it was going to be and that it recovered to break even--we ended the year on a positive note."

Sven Royall, executive vice president for strategy, portfolio, and sustainable development at Shell Chemicals, agrees that, overall, the year was a letdown. In addition to high feedstock prices, he notes that the dramatic increase in U.S. gross domestic product didn't trickle down to the industrial sector. "A lot of the recovery in the economy wasn't linked to chemical production," he says.

IN CONTRAST WITH ethylene, propylene saw strong demand growth in 2003--growth that experts say is part of a long-term trend. According to Stephen N. Zinger, director of heavy olefins and elastomers at CMAI, the U.S. propylene market grew by 4%, reaching 35 billion lb in 2003. "Polypropylene has driven propylene demand, as it usually does," he says.

But like ethylene, Zinger says, the 2003 propylene market was marked by volatility. For propylene, however, prices were influenced not only by energy prices but also--because of propylene's status as a refinery by-product--by the gasoline market. Propylene prices increased from 21.5 cents per lb in January to 27.5 cents in March. Prices eased again by June, dropping to 22.5 cents. Because of high gasoline prices in late summer, there was an incentive for refiners to alkylate propylene into gasoline rather than sell it to the chemical market, which, Zinger says, stabilized propylene prices.

C. L. Tseng, executive vice president of Formosa Plastics Corp. USA, says market growth and high gasoline prices will add up to continued strength in propylene this year. "Demand is strong and will continue to be strong as the U.S. economy continues its recovery and expansion," he says. "On the supply side, we could see a tighter market and higher prices in the future" as refinery propylene is used to produce gasoline instead.

But propylene alone will not lift the petrochemical industry out of its doldrums, and producers are still awaiting a recovery in ethylene. At the onset of 2003, the petrochemical industry hoped that growth in ethylene demand would soak up some of the excess capacity it built just before the historic 10% collapse in demand experienced in 2001. But with flat growth, the industry made few advances in 2003. "Some people have referred to it as a 'lost year,' " Royall says.

The industry did get some relief from Dow Chemical's decision to close ethylene plants in Seadrift and Texas City, Texas, taking 2.2 billion lb of ethylene capacity off-line. Theo Walthie, the firm's president for hydrocarbons, energy, and ethylene oxide/glycol, says he is proud of the decision. "We took our weakest plants out, and we are buying from third parties, which is possible because the industry had overbuilt."

Eramo says the Dow shutdown, plus the idling of plants for maintenance, had a positive impact. He notes that effective operating rates--which don't include plants that are temporarily idle or closed for maintenance--have increased from a percentage in the low 90s in 2002 to 95% last year. "This is as strong a supply-and-demand balance as we have seen in two to three years," he says. "There is no doubt that the removal of a couple of billion pounds of capacity by Dow was really fundamental to some of the strength that we are seeing right now."

However, Shell's Royall, citing nameplate operating rates--which include all plants not permanently shuttered--points to the need for much more improvement. "If operating rates have gone from 80% to 83%, that's nothing to open champagne bottles over." He adds that the rates need to be about 10% higher.

Producers think 2004 will be different. Eramo expects 4.5% growth, which would likely bring nameplate capacity back up to 90%. It would take a 10% demand recovery, unlikely for 2004, to bring nameplate capacity to 95%, sell out plants, and significantly increase ethylene profit margins. Producers don't expect such peak conditions until 2005, 2006, or later.

Royall is optimistic about 2004, but his attitude is still wait-and-see. "The first signs are encouraging, but we really wouldn't want to play it stronger than that because we have had false starts before in the past two to three years," he says. "Nevertheless, if I compare this time of the year to where we were last year, the feeling is that there is more strength in the market than we saw a year ago."

PRODUCERS FEAR more setbacks from feedstock prices, pointing to a close call last December. After Thanksgiving, it looked like another major run-up was in the works, as gas prices climbed from less than $5.00 per million Btu to about $7.00 by early December, where they held for about a month. However, they dropped back down to $5.00, while oil prices climbed from $30 to $36 per barrel--more expensive on a Btu basis than $5.00-per- million-Btu natural gas.

Ed Dineen, Lyondell Chemical's senior vice president for polymers and chemicals, is relieved that the spike wasn't of the same magnitude as experienced in February 2003, but he is irritated that prices rose despite high natural gas production and inventories. "Going into the winter season, we were comfortable that inventories had built to sufficient levels where we shouldn't see a run-up," he says. "Maybe some of the nervousness in the market relative to what happened in past years drove prices higher than inventories suggested."

Producers also caught a break because crude oil and natural gas prices increased together. In a world where the U.S. petrochemical industry relies mostly on natural gas while European, Latin American, and Asian production uses petroleum-based feeds, a run-up of natural gas costs in the U.S. without a similar rise in crude oil puts the U.S. industry at a disadvantage. "The global commodity pricing picture is in better shape because we had more equilibrium between commodity prices around the world," Dineen says.

Producers are counting on parity between natural gas and crude oil prices to help turn around negative trends in the balance of petrochemical trade between North America and the rest of the world, particularly Asia. "Probably 50 to 60% of U.S. exports in C₂-based goods have disappeared since 2001," Shell's Royall says. "But with this current environment--a weak dollar and demand growth in Asia--it may be that we see a little bit of an export recovery in the short term."

But, observers say, over the long haul, there has been an irreversible shift in the petrochemical trade balance. Natural gas prices will average much higher than the $2.00- to $3.00-per-million-Btu rates that the industry enjoyed for years. Moreover, the Middle East, which has the lowest feedstock prices in the world, is becoming nearly impossible to compete with in Asia. And in Asia, particularly China, massive petrochemical projects are being built to accommodate local demand.

On top of these factors, Asia has a huge advantage in labor costs in downstream manufacturing. Imports of downstream products from Asia are flooding U.S. markets, making it difficult for U.S. manufacturers to compete. A famous example of such imports is polyethylene bags from Asia, which alone are said to bring into the U.S. the equivalent of 1 billion lb of ethylene annually.

A. Cenan Ozmeral, group vice president of petrochemicals, plasticizers, and solvents at BASF, says the international effects aren't limited to polyethylene products. He points to the U.S. textile industry's move offshore, which has eroded demand for polyester fibers and feedstock ethylene glycol. "We made a decision to get out of the ethylene glycol business in North America because of that," he says.

Though some producers have written off the ethylene glycol market for textiles, some say anecdotes, like the polyethylene bag example, aren't as serious as they sound. Graeme Flint, vice president of Western feedstocks and corporate development for Nova Chemicals, says imports of bags from Asia will dry up with the climb in international polymer prices and the recovery in petrochemicals.

"Many of the producers of those types of products are basing their purchases on spot supplies of polyethylene," Flint explains. "If we get into a situation where overall demand for products starts improving and pricing follows correspondingly, it is going to be more difficult for those exporters in Asia to purchase spot supplies of polyethylene and re-export the products into North America."

BASF's Ozmeral isn't counting on it. "I don't think that we will lose 3 to 4% growth every year, but what is lost is lost," he says. "We may see growth, but not because we are getting some of the business back. It is just organic growth from here."

Dow's Walthie says the North American industry is reconfiguring itself from an advantaged industry selling into a robust domestic and export market to one that serves domestic demand from a manufacturing base facing higher relative costs. To do this, he says, the industry will have to shutter inefficient capacity and will need to improve existing petrochemical assets instead of building new plants, much like European chemical makers did a generation ago. "Americans think this is new; this is already 20 years in the works in other places," he says.

PETROCHEMICAL MAKERS are already making these changes. The only major capacity increases on the horizon are a series of improvement projects at BP's Chocolate Bayou, Texas, unit that will lead to some 550 million lb of new ethylene capacity; and a 1.1 billion-lb ethylene expansion at Shell's Deer Park, Texas, plant that is currently starting up.

The 2 billion-lb ethylene cracker Dow had been planning to build in Seadrift, Texas, by 2007 has been delayed, though not canceled, Walthie says, because the market doesn't need it yet. "We would like to keep it open as an option," he says. "It is not like we shelved it, put it in the cellar, and threw away the key."

Moreover, some ethylene crackers that have been shut down will not reopen until the market improves significantly. Units that have been idled since early 2001, such as Chevron Phillips' 650 million-lb line in Sweeny, Texas; Huntsman's Port Neches, Texas, unit; and Equistar's Lake Charles, La., cracker. Observers say smaller and older gas-based units like these may close permanently over the next several years.

In addition, other lines, such as the ExxonMobil cracker in Houston, that not only are small and aging but also face nitrogen oxide reduction regulations, may have to be shuttered. "The amount of money the industry requires to keep their facilities in good shape is going to go up," Walthie says. "And some facilities that might not warrant investment would be candidates for rationalization."

ONCE THE U.S. industry shakes off such marginal capacity, CMAI's Eramo says, it will be left with a first-class slate of assets. "I am not in the camp that says high gas prices are going to be the demise of North American petrochemicals. There are some assets out there that will remain extremely competitive, and we are going through the process of weeding out the assets that won't survive in this environment."

And the industry is trying to take a bite out of energy costs. For example, Dow recently signed a contract to import up to 500 million cu ft of natural gas, representing the majority of its gas use in Texas and Louisiana, from a liquefied natural gas terminal planned for Quintana, Texas, in 2007. Dow is also installing fuel cells for power generation at its Freeport, Texas, facility. If new terminals can increase imports of LNG, producers say, they might add enough volume to cap prices at about $4.00 per million Btu, but not much less.

Even as the chemical industry is taking steps to improve the supply of natural gas, it is also reducing its reliance on it. Naphtha-based plants, which use competitively priced feedstocks and produce valuable by-products such as propylene, are becoming more attractive.

Dineen says Lyondell is already enjoying this trend, which, he says, will increasingly enhance Lyondell's competitiveness as a company in the future. "Roughly two-thirds of our capacity is liquids based, and that is certainly in contrast with the industry average," he says.

Heavier feedstocks are becoming more competitive largely because of the propylene coproducts that result from naphtha cracking. Because of high growth globally and because the ethane-based capacity in the Middle East produces little propylene coproduct, propylene is becoming increasingly valuable relative to ethylene. "As long as polypropylene has cost-performance advantages, it will grow faster than the other products," Walthie says. "The U.S. is really in a good situation here because it is still the place where the most propylene supply from refining can be made available."

Ozmeral says this trend for propylene was part of the rationale for BASF's metathesis-based propylene joint venture with Atofina in Port Arthur, Texas. The plant will be fed with ethylene from the company's cracker on the same site and butylene from the Sabina joint venture between Shell, BASF, and Atofina, which is currently starting up. He says the 700 million-lb plant is due to start up right after the butylene complex opens. "It is the right decision with propylene scarce and getting scarcer," Ozmeral says.

Though petrochemical executives have been down in the dumps for the past three years, many think that a fundamental change to the U.S. industry may not be so bad after all. It may, as the petrochemical industry has in Europe, trade in enjoyment of times of enormous prosperity for relief from times of excruciating suffering.