Oil Collapse, China Heighten Long-term Structural Change in Chemical Industry

Transitory, near-term developments in energy, earnings, and the economy are augmenting long-term, structural changes in investment, the supply chain, and regulation to “flatten” global markets in ways that have specific implications for chemical producers, said Dave Witte, senior vice president at IHS and general manager of IHS Chemical. =

As this flattening proceeds, capacity additions will decelerate, and producers will shift from organic investment to M&A, said Witte. Demand will broaden worldwide and outpace supply, although the degree of change will vary significantly by value chain. Overall aggregate industry profits will drop in the near term, but recover as utilization rates and oil prices rise. Supply chains will continue to evolve in response to drivers beyond labor.

Among the transitory factors Witte discussed were the collapse of oil prices, China’s shift toward domestic consumption, and moderating earnings. Weak oil prices have flattened and lowered cost curves by reducing the competitive advantage of production based on natural gas and natural gas liquids (NGLs), said Witte. “While still substantive, the gap between gas-liquid economics and naphtha economics was cut by more than half in just one year,” he said. As the price of crude oil recovers, gas- and NGL-based production capacities will get back some of their former cost advantage, but the curve will be lower and less steep than the cost structure of 2014, he said.

China’s turn inward has, meanwhile, created opportunities for other low-cost regions to play a greater role in commodity production. During the 2000s, China accounted for an outsize share of chemical industry growth, Witte said. But the rest of the world surged forward during 2010-15, and IHS Chemical expects near parity during 2016-20.

Flattening cost curves have reduced overall chemical earnings and narrowed regional differences. Chemical earnings peaked in 2014 on margins from gas-based production, Witte said. But they declined 15% in 2015, mainly in the Americas and Mideast, amid stronger results in Europe and Asia. IHS Chemical expects earnings to decline another 10% this year on the combination of low energy prices and new capacity. However, earnings should improve as demand grows to meet supply during 2017-18, before peaking again as oil recovers late in the decade, Witte adds.

Under these conditions, producers will favor using their capital to reduce risk. “With respect to today’s chemical market, economic uncertainty and overcapacity in many areas is delaying deployment of capital for new investment, while severe capital and cash restraints on public and sovereign oil well-to-petchem integrated companies who have heretofore been huge investors in new facilities is significantly restrained by a need to protect dividends and maintain a healthy balance sheet,” said Witte.

Diversified chemical producers have been less constrained, Witte said. “Many of the diversified chemical companies are not suffering under the same weighty pressures induced by oil and have the balance sheets or share currency to drive M&A. In today’s uncertain environment, many companies seem to be concluding that the risk of synergy capture via M&A is a better way to capture value for shareholders than deploying capital to new builds,” he said.

Witte expects very few project announcements in the near future. “The net effect is that global capacity expansions [measured against existing capacity] drop fairly dramatically beginning this year and rapidly decline below anything seen in the last 15 years,” he said.

Longer-term, structural changes in spending are also underway. Producers increasingly focus their R&D spending on development rather than research, said Witte. Process technology is a diminishing source of competitive advantage, he said. Instead, producers increasingly differentiate themselves through application know-how.

The industry has also been changing the way it manages capital projects, flattening costs by engaging contractors with international engineering centers of excellence, using foreign labor for construction, and using modular designs that allow construction where labor is cheaper.

To keep up with globalization in the consumer product sector, chemical producers will need to support changing customer strategies, particularly the trend toward regional production.

“To do this auto suppliers are increasingly looking to their suppliers for solutions to the issue of standardization and flexibility,” said Witte. “This has implications and specific challenges for suppliers. Namely they must be able to have the scale to grow with the downstream supply chain and they must have the product application and development capability to adapt to the conflicting priorities of standardization and adaptability.”

Producers must also deal with increasingly global developments in regulation stemming from free-trade agreements and efforts to limit carbon dioxide emissions. Proposed taxes on emissions would increase the cost advantage of production from natural gas and NGLs over coal and naphtha. “While there is yet no clear path, timing, or mechanism for these taxes, IHS Chemical believe these risks should be incorporated into future investment considerations,” said Witte.