Petrochemicals

Shale is forcing North American petrochemical executives to unlearn much of what they thought they knew about their industry. And given that they are near the beginning of what is likely to be a long, prosperous period, they are more than happy to change their outlook.

Experiences early in the previous decade taught the region’s executives that their reliance on raw materials derived from natural gas to make ethylene put them at a cost disadvantage to the many other areas of the world that use petroleum-derived naphtha. Now ethane is so cheap that only the Middle East can produce ethylene more cost-effectively than North America can. And while petrochemical companies in other regions, notably Europe, are struggling to turn a profit, North American firms are raking in substantial returns.

Executives are learning to invest in North America again. A decade ago, executives thought that the investment of capital in domestic petrochemical plants would be limited mostly to maintenance. But since last spring, five companies—Chevron Phillips Chemical, Dow Chemical, Formosa Plastics, Sasol, and Shell Chemicals—have disclosed plans for new multi-billion-dollar complexes making ethylene and derivatives such as ethylene oxide and polyethylene. There’s a good possibility that more companies will unveil such plans in 2012.

Beyond large projects, nearly every producer of ethylene or derivatives is contemplating expansions to take advantage of low raw material costs. Shale is also beginning to underpin chemical deals. For example, the rosy North American outlook was important to Indorama’s $795 million purchase of an ethylene glycol plant in Clear Lake, Texas, from Old World Industries last month.

Chemical executives can be forgiven for having to get up to speed in short order. Until 2005, shale deposits—which lie beneath a wide swath of the country—were an eccentric source of natural gas. That was about the time that exploration companies perfected horizontal drilling and hydraulic fracturing techniques to liberate gas that was tightly locked into shale. Shale has since become the source of more than one-quarter of the natural gas produced in the U.S.

The new output has driven U.S. natural gas prices below $3.00 per million Btu for the first time in more than a decade. At more than $100 per barrel, oil is more than five times as expensive as natural gas on an energy content basis.

The main feedstock for North American petrochemical facilities is natural gas liquids, a mixture of ethane, propane, butane, and other hydrocarbons that is extracted from natural gas and then usually separated into its components. The remaining “dry” natural gas, primarily methane, is then piped to the industrial and home heating market. Cheap natural gas liquids put U.S. producers at a big advantage over European and Asian chemical producers that primarily use petroleum-derived feedstocks such as naphtha.

This advantage of natural gas liquids over naphtha is enormous. According to Carlo Barrasa, director of natural gas liquids and cracker economics at the consulting group IHS Chemical, the cash cost of making ethylene from ethane is 18 cents per lb. The cash cost of using light naphtha as a feedstock, in contrast, is about 46.5 cents per lb. Ethylene sells for about 68.5 cents per lb, IHS says.

Ethylene crackers normally have some latitude to change feedstock slates to react to changing market conditions. In recent years, they have been cracking as much ethane as they possibly can. Many crackers originally set up to take in heavier feedstocks such as naphtha have been retrofitted to allow them to crack more ethane. Dow, LyondellBasell Industries, Nova Chemicals, and Shell have undertaken such initiatives.

In 2004, Barrasa notes, only about 45% of U.S. ethylene production was based on ethane. Today, that figure stands at about 70%. “That just speaks to the fact that the cost advantage is so great,” he says.

Cracking ethane instead of heavier feedstocks does mean that ethylene plants aren’t making as much propylene, butadiene, and aromatics as they used to. Those cracker coproducts are in short supply and are becoming increasingly costly.

Although cheap shale gas is now the dominant driver of the U.S. petrochemical industry, the global financial turmoil is still making itself known. In particular, the possibility of a Greek debt default last summer caused uncertainty in financial markets and economic slowing.

North American producers felt the impact through some slippage in prices and volumes at a time when ethane costs were temporarily spiking. “In the second half of the year we saw things slow down a little bit,” says Grant Thomson, president of olefins and feedstocks at Nova. “The second half of the year was still pretty good, but it wasn’t as good as the first half.”

According to John Stekla, director of olefins studies at IHS Chemical, U.S. production of ethylene increased 2.0% in 2011, including a large buildup of inventories at the end of the year. However, exports of derivatives fell by 10%, Stekla says, as suppliers kept product at home to serve local customers. Overall, the net effect was a 0.4% increase in derivative demand for U.S. producers—not bad considering the U.S. doesn’t have a lot of spare ethylene capacity.

Profitability is now bouncing back. Brian Ames, Dow’s vice president of olefins, aromatics, and alternatives, says prices reached a low point in December. Since then, he has observed continual improvement as sales volumes crept back up and feedstock costs plummeted.

Stekla notes that profit margins for ethylene on the spot market are now the highest they have been since 1988. “Spot prices have been extremely high, even though demand is relatively tepid,” he says.

Observers expect the growth in North American output to be similar this year to what it was in 2011. Nova’s Thomson expects North American output of polyethylene, the largest-volume ethylene derivative, to rise 1.5−2.0%.

Although North American companies have been enjoying good profits for some time, the rest of the world is still near the trough of the petrochemical business cycle. In North America, the industry’s nameplate operating rate—the percentage of overall ethylene capacity that is up and running—stands at about 90%, according to IHS’s Stekla. The global average, in contrast, is about 87%.

“If you look at the global industry operating rate in 2011, we’re pretty much in the trough,” Dow’s Ames says. Yet with its higher relative profitability, the U.S. industry looks to be further along in the upswing of the business cycle.

Trough conditions are particularly evident in Europe, which must contend with a relatively high cost structure, economic woes over sovereign debt, and proximity to plants that opened in the Middle East in 2009 and 2010. According to IHS, Western European operating rates are about 84%.

During a conference call with analysts last month, LyondellBasell Chief Executive Officer James L. Gallogly disclosed that his company’s European olefins output fell by 13% during the fourth quarter while profit margins slipped to nearly break-even levels.

“We continue to aggressively pursue restructuring in this region,” he told investors, noting that the company plans to close two small polypropylene production lines in Wesseling, Germany. Similarly, Ineos is evaluating the future of the smaller of its two ethylene crackers in Grange­mouth, Scotland.

Gerd Löbbert, executive vice president of polyolefins at Austrian petrochemical maker Borealis, acknowledges that the situation in Europe is dire. “Profitability has eroded in line with demand and has been below sustainable levels,” he says. Löbbert adds that the benefits European crackers enjoy from producing lucrative coproducts such as propylene don’t “sufficiently offset the increasing European disadvantage versus gas-based production in the U.S. and Middle East.”

Europe’s woes are a 180-degree change from a decade ago, when U.S. executives thought that the disadvantages they faced versus naphtha-cracking counterparts in Europe and Asia would last forever. Now they believe that their relative advantage, if it isn’t permanent, will at least endure a number of years. The reason for their optimism is a so-called virtuous cycle that will secure a reliable supply of feedstocks.

Low natural gas prices have caused gas exploration companies to cut back on drilling. That might seem like bad news. However, high oil prices ensure that natural gas liquids sell at a healthy premium above natural gas, although at enough of a discount to oil to make them economical chemical raw materials. IHS’s Barrasa says drillers can charge as much as $11 per million Btu more for natural gas liquids than for natural gas.

The composition of hydrocarbon resources varies considerably from region to region. Exploration companies preferentially develop wells in places that will yield a large amount of natural gas liquids rather than in locations with mainly “dry” gas.

In a presentation at December’s Gulf Petrochemicals & Chemicals Association meeting in Dubai, Chevron Phillips Chemical CEO Peter L. Cella outlined the economics at play that promise to yield ethane for the petrochemical industry.

To earn a 10% return on the cost of capital for a new dry gas well, a driller needs natural gas prices of $2.00 to $5.00 per million Btu, he noted. However, for wells focused on natural gas liquids, “the 10% return price needed for the natural gas production is actually zero because the driller earns its entire return on the liquids production, which tends to be priced off crude oil,” Cella said.

This is the reason why the gas companies that are pulling back on natural gas drilling are also reassuring investors that they are increasing exploration for natural gas liquids, Barrasa observes. “The only thing that can meaningfully affect the drilling for gas liquids is if we get a sharp correction in oil prices,” he says.

“It really shows how much things have changed, where exploration companies actually talk about going after liquids and almost treating the gas as the coproduct,” Nova’s Thomson says. “It wasn’t long ago that they just went after the natural gas and the liquids were just by-products that you wanted to get rid of.”

Ethane oversupply is hitting the market from all this drilling. According to IHS, the U.S. will see more than 400,000 bbl per day of new ethane supply by 2020, a more than 40% increase from today’s levels. Since the beginning of the year, ethane prices have dropped from 84 cents per gal to 54 cents, Barrasa says.

With its success tied to petrochemical makers that buy natural gas liquids, the gas industry needs chemical companies to build more capacity. Given their own motivation to boost profits, chemical producers are willing to oblige. But it takes three or four years to build an ethylene cracker. Thus, the market will see only incremental capacity additions until 2016.

These projects will cap an enormous spate of capacity additions. North American firms will add about 8.4 million metric tons per year of new ethylene capacity by 2017, IHS’s Stekla says, a 35% expansion of the region’s output.

Of the companies that announced new ethylene crackers over the past year, Chevron Phillips was the first out of the gate with an announcement last spring. It intends to build a 1.5 million-metric-ton ethylene cracker at its Cedar Bayou facility in Baytown, Texas, and downstream polyethylene plants.

Dow was the second company with a cracker announcement. Its planned Gulf Coast unit is part of a comprehensive plan to integrate downstream ethylene derivatives into shale-based feedstocks. The initiative involves restarting a cracker in Hahnville, La., that the company idled in 2009 plus upgrades to other crackers.

Propylene is an important part of Dow’s plan. The company recently inked a licensing agreement with Honeywell’s UOP engineering unit for a propane dehydrogenation unit that would add 750,000 tons of propylene capacity in Texas by 2015. Dow plans a second propylene unit that would use its own technology.

Ames points out that Dow’s acrylic, propylene oxide, and epoxy operations are large consumers of propylene. “But with the propylene supply becoming tighter, the cost of buying propylene relative to the cost of buying propane and converting it into propylene is such that we are better off buying propane,” he says.

Dow isn’t alone. Eastman Chemical’s oxo chemicals business has a large appetite for propylene. When asked during a recent conference call whether the firm will restart a cracker at its Longview, Texas, complex, CEO James P. Rogers mentioned that the company is instead considering an “olefins conversion unit,” which likely refers to a metathesis unit that makes propylene from ethylene via a butylene intermediate. Similarly, LyondellBasell is building another metathesis unit at its Channelview, Texas, complex.

Sasol is studying a cracker at its Lake Charles, La., complex that would have up to 1.4 million metric tons of capacity. A spokesman says the company is in discussions with a potential partner for the project. “If we build an ethylene cracker, there will be some derivatives that will be Sasol only, and some partner derivatives,” the spokesman says.

Shell is also planning a cracker, but unlike the other projects, its plant is planned for the Northeast to tap into the Marcellus Shale, a geological formation extending from New York state through West Virginia. The company hasn’t yet selected a site for the project.

Formosa Plastics is the latest firm to announce a new ethylene cracker. Last week, the company disclosed plans to build an 800,000-metric-ton-per-year ethylene cracker at its Point Comfort, Texas, site. The $1.7 billion project, to be completed in 2016, will also include a low-density polyethylene plant and a 600,000-metric-ton propane dehydrogenation unit.

Occidental Petroleum has hinted that it is considering building an ethylene plant. Last June, the firm signed a transport agreement with pipeline firm DCP Midstream so it can ship natural gas liquids from the Eagle Ford Shale basin in Texas to a proposed gas processing plant in Ingleside, Texas, where Oxy makes vinyl chloride. At the time, the company said the processing plant would allow it to “explore various options for the future supply of ethylene” at the plant.

Beyond those that have been announced, one or two more crackers could be proposed for the U.S., IHS’s Stekla says. One could be a second project in the Northeast to take advantage of the Marcellus Shale. There might also be another cracker on the Gulf Coast, although he notes that even with the flood of ethane due to hit the market, an additional cracker in the region might run into feedstock constraints.

Many firms that aren’t building new crackers are expanding existing facilities to leverage the shale boom. Nova is perhaps the most ambitious of these companies. It has inked agreements to bring ethane from the Marcellus Shale up to its complex in Corunna, Ontario, and from oil fields in North Dakota to its plants in Joffre, Alberta. The company is also conducting studies, due for completion later this year, about expanding the Corunna cracker and perhaps building polyethylene plants in Corunna and Joffre.

When all the new capacity hits the market around 2017, the U.S. could very well see a downturn in the petrochemical business cycle. Yet Nova’s Thomson notes that the North American industry seems to have missed the current petrochemical trough entirely, a phenomenon that has caused him to doubt what he long thought he knew.

“The longer I’m in the industry, the less I believe in the cycle,” he says. “When I first came into the industry in the late ’80s, everybody talked about how it’s a seven-year cycle, and we’re going to have two good years, and everybody is going to build capacity, and we’ll have five bad years. I just don’t believe that anymore.” Shale gas, he says, has “turned all of that upside down.”