Get used to more-volatile petrochemical prices

David Hanna

With chemical prices swinging even more widely than those for oil, the industry is eyeing financial derivatives as a way to mitigate risk.

OVER THE PAST SEVERAL YEARS, THE SINGLE biggest development affecting the global petrochemicals industry has been the surge in price volatility. Gone are the days of stable, predictable prices. Prices of petrochemicals have become hypersensitive to swings in crude oil prices, yet—compared with oil—markets for them remain small and opaque, with the flow of trade concentrated between Middle East swing producers and the giant consuming center of China. Combined, these factors have contributed to unprecedented volatility, making the need for risk management more acute.

Nonetheless, the market still exhibits seasonal cycles, making prices fairly predictable on an inter-quarter basis. Prices typically peak during the spring plant maintenance period (when available supply is constrained) and during the winter shopping season, and hit a trough during the summer holiday lull. But volatility on a smaller scale is no longer easy to anticipate.

The trend toward greater volatility is undeniable. For example, swings in the price of ethylene, a barometer for the petrochemical market as a whole, grew from about 5% in 2000 to 9% in 2002 and to 14% in 2004, according to Platts estimates. However you measure it, the result is the same: Volatility is on the rise, and it's here to stay.

More sensitive, less transparent

Higher volatility in petrochemical prices has been attributed in large measure to their increased sensitivity to energy prices as a whole. For example, traders in commodity plastics such as polyethylene, which is three times removed from crude oil in the production chain, now track spot-market prices against crude oil prices. The old saying that petrochemical prices are "derivatives-driven"—that is, petchem prices are determined mostly by the prices of the finished products they go into—has been replaced by the realization that the price of crude now has the biggest impact on petchem prices (Figure 1).

1. Input/output. Finite element analysis of the price of low-density polyethylene reveals a close correlation with crude oil prices.

But other factors are at play as well. As mentioned, compared with oil markets, petrochemical markets are smaller and more opaque. With global production at about 325 million metric tons (mt) annually, petrochemicals account for only 8% of the barrel. The small size of the petchem market means that the impact of individual spot transactions is disproportionately large.

Compounding the impact, markets for petrochemicals are far less transparent than those for oil. With this opacity come greater uncertainty and market anxiety that routinely cause overreactions to changes in the price of oil and feedstock costs. The exaggerated swing in petrochemical prices in response to volatility in oil markets is particularly acute with benzene. While the volatility of crude oil prices in the first half of 2005 was estimated at 6%, the figure was 13% for benzene, according to Platts estimates (Figure 2).

2. Uncertainty creates volatility. Volatility in benzene prices is greater than in crude.

Yet another factor driving the increased volatility has been a growing concentration in the global market along two poles, with China on the buying side and the Middle East on the selling side.

On the demand side, the global petrochemical market is becoming increasingly dependent on China for growth. Moreover, China is arguably the most spot-oriented of all the markets and, therefore, exhibits the highest volatility. China's share of global petrochemical demand grew steadily from about 4% in 1996 to 5.5% in 2000 and is expected to reach almost 7% this year, according to estimates based on a forecast from Japan's Ministry of Economy, Trade and Industry (METI). This trend is likely to continue as long as China's economy continues its breakneck pace of growth.

Meanwhile, the Middle East has emerged as the world's largest incremental supplier of ethylene derivatives. Although the Middle East accounts for only 10% of global ethylene capacity and is dwarfed by the U.S., the region has the largest surplus: almost 7 million mt this year, exceeding America's 5 million mt, according to METI. Behind the Middle East's rise has been a drive to diversify away from oil exports by venturing downstream into petrochemicals while taking advantage of the region's abundant supplies of cheap gas feedstocks. Saudi Arabia, Qatar, Iran, and other Middle Eastern countries account for the lion's share of global capacity additions.

Managing volatility's risk

The uncertainly engendered by higher volatility has intensified the need for hedging by both producers and traders. The industry's burgeoning financial derivatives market has gained renewed vigor as a result.

Paper hedging instruments such as OTC (over-the-counter) swaps and futures are not entirely new to the petrochemicals industry. They have come and gone in the U.S., Europe, and Asia since the early 1990s, and a small but established market for aromatics swaps exists in Asia and America. One of the latest attempts to introduce a paper instrument was the launch of a plastics futures market by the London Metal Exchange (LME) in May 2005.

Volume growth in the new contracts has been faster than expected, and it looks as if the LME contract is here to stay. Larger converters have already begun to use it as a hedging tool. Among the pioneers have been the more financially sophisticated industrial companies that already hedge. Distributors and traders, however, seem to be steering clear of the contracts and concentrating their traditionally smaller-scope businesses on the physical market. The LME contracts are still in their infancy, and most futures traders readily admit that the contracts' future form will not resemble their present one. More amendments to the contract are expected as the industry moves up the learning curve.

A number of industry members have sought to mitigate the impact of spot price volatility in other ways. In the European ethylene and aromatics markets, for example, several producers and end users have started to move away from the traditional, quarterly term pricing mechanism to a monthly system. Ultimately, markets would benefit more if greater spot trading on a daily basis were to materialize. Why? Because both the upstream feedstock markets and the downstream polymers markets already move on a daily basis, with ethylene and aromatics sandwiched in between.

The need for risk management through the use of financial derivatives or other means has been become particularly important to producers as they face mounting pressure to maximize shareholder value, especially at a time when many petrochemical producers are going public with IPO (initial public offering) launches, either this year or in coming years.

Here's another way to think of these developments: The tolerance for market inefficiencies has become low, while the bar for financial performance has been raised. Although the petrochemical industry is currently at a peak in the profit cycle and is expected to enjoy strong margins overall for the next two years, producers understand that they must prepare now for the inevitable arrival of the next down cycle.