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Petrochemicals: Natural Gas Fueling Domestic Competitiveness

By: Ken Stover & Katherine Walls, AccuVal Associates, Inc.

Petrochemicals, chemicals derived from petroleum, provide the foundation for many industrial and consumer products. These products include ethylene, propylene, butylenes, benzene, toluene, styrene and xylene, among others. In recent years, petrochemical feedstock diversification and expansion of international joint ventures have become increasingly important. The U.S. continues to leverage its natural resources to remain competitive globally despite the rising cost of oil. Economic development in emerging countries; the increasing cost of substitutes; and accelerating fuel efficiency mandates are poising the industry for continued solid growth in the medium-term.

SUPPLY

Petroleum feedstock prices are rising

Rising petroleum feedstock prices in North America have made for a challenging environment for petrochemical producers using these inputs. Recent unrest in the Middle East has exacerbated the problem and created unknowns in terms of what will happen to supply coming from the region. Even though the majority of Libyan exports are sent to Europe, the supply disruption could impact markets globally. As shown in the chart below, crude oil prices have more than doubled over the past two years.

Source: U.S. Energy Information Administration

In March, the U.S. Department of Energy forecasted in its Short-Term Energy Outlook report that there will be continuing tightening of world oil markets during the next two years.

As prices increase, it is more difficult for domestic manufacturers using petroleum feedstocks to complete internationally. In the Middle East, where countries sit on the world's largest oil and gas resources, feedstocks are obtained at much lower prices, creating a much more competitive environment from which to manufacture petrochemicals.

Domestic manufacturers turning to natural gas as attractive feedstock

Natural gas prices, however, have remained relatively low in the North America compared to oil. Natural gas prices have fallen 17 percent in the past year as the cost of WTI crude oil has risen 28 percent. In such, ethane, the second largest component of natural gas, is continuing its resurgence in North America as an ethylene-producing feedstock.

Source: U.S. Energy Information Administration

In response, companies are increasing steam cracking capacity (the process of separating natural gas into ethane and its components) and are increasing upstream investment in natural gas. In March 2011, Sasol, a South African petrochemical company, announced its $1.08 billion investment in Canadian oil and gas group Talisman Energy for its shale gas asset (Cypress A) in British Columbia. This is the company's second shale gas purchase in Canada.

New drilling techniques have rapidly increased production from shale foundations and other unconventional reservoirs. The U.S. Department of Energy projects that gas production from shales could double by 2035, potentially creating a robust environment for domestic petrochemical manufacturers. If gas costs stay relatively low in comparison to oil, U.S. producers of ethylene and polyethylene, the most used plastic in the world, are well positioned for growth.

Last year, U.S. manufacturers saw this strategy pay off as relatively low-cost ethane strengthened margins for ethylene and derivatives, and firms increased exports 28 percent over the previous year.

Domestic manufacturers increasing investment in international joint ventures

Many of the industry's top producers continue to expand operations globally. For example, The Dow Chemical Co. is continuing to make progress on a $20 billion joint venture in Saudi Arabia with Saudi Aramco, which is scheduled to be completed mid-2011. Dow has eight current and proposed Middle East joint ventures in the UAE, Egypt, Kuwait, Libya and Saudi Arabia. In March 2011, Exxon Mobil Corporation announced the selection of Al Jubail, Saudi Arabia, for its new joint venture plant with Saudi Basic Industries Corp. (SABIC), which will include plastics production. And in December 2010, Shell and Qatar Petroleum began a study of developing a large petrochemicals complex in Ras Laffan Industrial City, Qatar.

This expansion enables companies to source inputs from different international markets to take advantage of favorable shifts in feedstock prices, commodity prices and currency fluctuations. These advantages often outweigh the legal, economic and political risks associated with operating in foreign countries.

Increasing environmental regulations raising cost of production

The industry is subject to widespread federal, state and local regulations regarding the manufacture, storage, handling and disposal of hazardous materials. The objective of additional regulation is to reduce carbon emissions. Major regulations include the Clean Air Act, the Clean Water Act and the National Pollutant Discharge Elimination System program. Because the cost of complying with these and future environmental regulations is high, many domestic manufacturers are migrating overseas to maintain competitiveness.

2012 budget targets oil and gas tax incentives

President Obama pledged to eliminate tax incentives in the oil and gas industry, and he's acted on his promise. In the proposed 2012 budget, President Obama recommends repealing the Internal Revenue Code Section 199 domestic manufacturing deduction for oil and gas companies, which helps offset foreign subsidies some competitors enjoy. The impact of this could be nearly $20 billion over the next 10 years. Opponents argue that this would drive up the cost of petroleum products and petrochemicals produced domestically.

DEMAND

Demand from emerging economies strong

The continued urbanization and industrialization of emerging economies in 2011 and beyond is expected to bolster global demand for products derived from petrochemicals like plastics, packaging, automotive parts, building materials, beverage containers and personal care products.

China has emerged as the largest petrochemical market in the world as economic expansion in the country continues. China has maintained steady GDP growth throughout the recession. The region has seen significant investment in petrochemical facilities to meet its growing needs. Similarly, demand in India is growing. For example, Reliance Industries Ltd., the largest resin producer in India, is projecting double-digit growth in consumption of polypropylene and polyethylene. India's GDP increased 8.3 percent last year.

Cost structure impacting demand over substitutes

Another way in which plastic consumption will increase is when its cost structure becomes more competitive than substitutes.

A good example of this is grocery bags. Paper bags had long been the standard at grocery stores. Then in the 1970's, plastic bags entered the market as a durable and cost-effective alternative. Because it is cheaper to make plastic bags than paper bags, demand from retailers for plastic bags increased at the expense of demand for paper bags. Despite calls of concern from environmental groups, most grocery bags used in the U.S. today are still plastic because of this. Another example would be the growing use of PVC pipe as a substitue for copper in plumbing applications, due primarily to the skyrocketing price of copper.

Thus, as long as domestic supplies of natural gas remain abundant and costs to manufacture ethylene in the U.S. remain low, plastic demand will likely increase as a substitute for competing materials, like paper, cotton or metal, which face more rapidly rising costs.

Mandates for more fuel efficient vehicles increasing demand for plastics

Accelerated federal fuel efficiency requirements have advanced research and development into the use of plastics in automobiles. Industry experts have indicated that a 6 to 10 percent weight reduction equates to a fuel-efficiency savings of 5 to 7 percent.

While the use of plastics in automobiles has been increasing for some time, new applications are being explored, including as an alternative for windows, sun roofs and engine components. Any changes adopted on an industry-wide basis could have a measurable impact on petrochemical demand.

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