2008 was a tough year for ethylene producers. Demand from key customers such as the construction and automotive sectors was poor as Western economies limped to recovery, as per ICIS. Margins were weak and the lowest seen for several years in the US, Europe and Asia. China was the bright spot, as fueled by buoyant demand, its economy continued to grow, along with easy credit and large infrastructure and construction projects. The country's vehicle sales exceeded 10 mln in 2009. Strong imports of polyethylene (PE) and polypropylene (PP) salvaged the US and European producers who were faced with struggling domestic demand.
2010 started better, particularly in Asia, where naphtha cracker margins have seen a rapid recovery over the past three months, although this may be starting to reverse. Although few new capacities are starting up in the Middle East and China, considerable capacity will come on stream in the next couple of years after many delays, putting supply/demand balances under significant pressure. Demand growth will need to be "heroic" to absorb all the new capacity.
Ethylene margins for ethane and naphtha cracking in the US were markedly different in 2009. While the average contract-based ethane margin was the lowest since 2005, it was still higher than average margins from 2001 to 2004. Average US naphtha cracking margins for 2009 were the worst for a decade. Contract naphtha margins were nearly 50% lower than ethane margins in 2009. However, this apparent contract ethane advantage largely vanished again at the start of 2010. This clearly explains the move by US ethylene producers in 2009 to crack lighter feedstocks, as natural gas prices became disconnected from those for oil. In H1-09, natural gas values continued to drift down while oil staged a recovery. One reason was increased availability of natural gas in the US, as new drilling techniques opened up alternative sources of gas supply. ICIS calculates a simple variable cash cost margin. This represents the cash margin available for supporting direct/allocated fixed manufacturing costs, working capital, taxes, royalties, corporate costs, debt service costs, capital costs and owner's returns from the business. Hence, a typical producer has significant cash costs to support before its business will return a positive cash flow.
Tracking the variable margin gives a clear indicator of the business environment. When the variable margins fall close to zero and are unable to support fixed costs, there is no incentive to continue operating and assets should be turned down or even shut. In theory, weaker or laggard plants should be driven to close first. However, plant closures in practice can be far from intuitive for reasons such as complex multi-plant value envelopes, site exit costs exceeding the pain of continued operation, prohibitive contractual exit terms, or plant obsolescence and cross-business support.
Tracking the cash-flow model should make it possible to make an informed opinion on pricing. Using this model, there is an opportunity to structure deals around costs and margins that may mitigate, share or pass on risk through value chains. There is a strong appetite at present to lock in margin performance that can partially pave a survival road through difficult times. If a company can guarantee a portion of its cash flow, it may be compelling in today's market and a valuable tool to secure finance.
A report shows that in the five years from 2008 to 2012, around 29 mln tpa of new ethylene capacity will be added. Nearly 16 mln tpa will be added in the Middle East and around 14 mln tpa in Asia, of which China accounts for nearly 7 mln tpa. This is already partly offset by the 2 mln tpa that has closed in North America. Some 16 mln tpa of this capacity growth is still to become operational as of the end of February 2010.
However, ethylene demand actually fell in 2008, as economies crashed and extensive destocking took place throughout the value chains. In 2009, demand recovery has been weak. In "normal" market conditions, a rule of thumb indicates that ethylene demand globally grows at 5 mln tpa. Without plant closures and/or unexpected events, it can be seen that markets will be oversupplied for some time and global operating rates will remain under pressure. The volatility of today may well have some of its roots in low inventory management to control working capital levels and short-term demand shifts and supply reliability issues. But regional operating rates may be different. New players in the Middle East are expected to run at high rates because of their cost advantage from gas-based feedstocks. They will also need to generate cash flows to repay the high capital expenditures from building these plants. This will put operating rates in the US, Europe and parts of Asia under relatively greater pressure.
The strong increase in capacity in China raises a further question of whether China polymer import needs will be met increasingly by domestic production. US, European and Northeast Asian commodity polymer exporters are expected to be pushed out of the China market by the new low-cost producers. But if China's import needs start to decline, this low-cost product will be seeking new homes outside China, with Europe expected to be one of the ports of call.