The More Things Change…

David Hanna, Global Director, Platts Petrochemicals

The global petrochemical industry has faced price volatility and disconnects among sectors for years, but thanks to a new willingness to adopt financial risk management techniques, the industry may be better poised to cope.

THE GLOBAL PETROCHEMICAL INDUSTRY IS confronting many of the same challenges that have haunted it since the late 1990s. But what's different now is that the industry is in a better position to tackle some of these chronic problems, both financially and in terms of its mind-set.

As a mature industry fractured into numerous sectors—ranging from large-volume commodity plastics such as polyethylene to thinly traded intermediates like vinyl chloride monomer—it is difficult to discern a single overarching solution that has been embraced across the board. The industry's response to the challenge of global competition, for example, has been schizophrenic, with mergers still being pursued by some players while divestments are being carried out by others.

However, a shift in attitude does appear to be under way in several key sectors, most notably in aromatics and polymers. Participants in these markets are slowly but surely overcoming the traditionally conservative mind-set that has held them back from embracing innovative solutions. This is particularly apparent in the new recognition that price volatility cannot be wished away but must be managed through hedging.

Volatility is Here to Stay

Since the latest commodity boom got under way in 2002, price volatility has become a central issue for producers, consumers and traders alike. Although industry players are debating whether the current downturn in prices is the beginning of the end of the bullish cycle or simply a temporary correction along a path of sustained high prices, one issue is beyond debate: high price volatility is here to stay.

Measured as standard deviation relative to average price, volatility for benzene in Europe—a useful barometer for the petrochemical market as a whole—has doubled from 7% to 14% since 2000 and appears to be remaining at this level.

Moreover, compared to oil, petrochemical prices have proven to be even more volatile, with volatility for benzene averaging 42% during the 2000 to 2006 period, compared with 34% for front-month Brent crude oil. This is not surprising, given that petrochemicals are by definition only a fraction of the size of the crude oil market from which they come, weighing in at about 400 million mt/year of global capacity compared to global crude oil production of roughly 4 billion mt/year (Figure 1).

1. Volatility of Benzene vs. Crude Oil. [CIF ARA benzene, $/mt; front-month WTI, $/bbl], 2000-2006. Source: Platts

The small size of the chemical markets contributes to volatility in two ways: the impact of individual spot transactions is often disproportionately strong, and price signals from the oil market are amplified. This is compounded by the inherent opacity of the chemical market, which often creates an exaggerated reaction to any factor impinging on price, whether it be real changes in supply-demand fundamentals or geopolitical events.

Renewed Interest in Hedging

In the current corporate environment that emphasizes shareholder value, the need to mitigate the impact of high volatility on the bottom line has become more pressing. To this end, the industry is seeing a resurgence of interest in hedging with financial derivatives such as over-the-counter swaps and futures contracts, most notably in Asia and Europe. Other risk management systems are also being explored.

In Asia, both a physical forward market and paper swaps have developed for key aromatics products since early 2006. These include contracts for products such as benzene, toluene, and paraxylene, mixed xylenes, and styrene monomer. For paper contracts to function properly as a hedging tool, there must be a reliable underlying physical benchmark to minimize the "basis risk" of a divergence between physical and paper prices. The emergence of swaps trade in Asia therefore reflects confidence in the prevailing physical benchmark, as well as the development of a critical level of spot liquidity. From February to September of this year, the number of market players involved in Asian aromatics swaps has ballooned from five to 18, while the depth of the swaps market has grown from one to five products.

Coinciding with the emergence of Asia-wide swaps, China is taking steps on its own to improve its hedging ability. Following the development of plastics futures contracts by the London Metal Exchange, the Shanghai Petroleum Futures Exchange is studying the possibility of launching domestic futures contracts for several polymers, as well as selected liquid chemicals such as methanol and monoethylene glycol.

In addition to paper, China is also looking at physical hedging. In March of this year, for example, China's Ningbo Dupute Liquid Petrochemical launched an e-commerce site, followed by a rival trading platform by Zhong Da Chemical in May. In September, Singapore-based brokerage Ginga joined the fray and launched its own proprietary system for physical on-screen trading of styrene, toluene, and monoethylene glycol in the domestic market. In addition, the Shanghai Petroleum Exchange is expected to launch physical forward contracts for liquid petrochemicals such as aromatics in 2007.

Meanwhile, in Europe, greater volatility has brought to the forefront the inherent problems of the long-standing quarterly contract pricing system. For some of the key chemicals such as ethylene and propylene, prices have traditionally been settled between large producers and end users once a quarter. This has been largely due to a desire by end users—which are themselves producers of polyethylene and polypropylene plastic resins—to secure stable margins. Ultimately, this desire for stability is driven by the relative inelasticity of pricing at the retail level, which includes giant supermarket chains, the biggest buyers of plastic bags.

The problem is, during periods of high volatility, a disconnect develops between contract prices and the intrinsic value of these products as expressed in spot pricing. Spot prices may fly up in response to unforeseeable factors like plant outages, at which point spot prices overtake term prices. During such periods, producers are often compelled to buy on a spot basis at high prices to cover their supply obligations to term customers, who had paid for the material ahead of time at lower prices. Conversely, during a down-trend, spot prices are the first to react to bearish news, creating another gap. In this situation, term customers have historically tended to demand a downward revision in their contract prices or a delay in deliveries. In both cases, it tends to be the producers who suffer the most. Compounding this problem is the fact that naphtha feedstock prices fluctuate on a daily basis, so production margins have become hostage to unpredictable changes in cost factors (Figure 2).

2. The Disconnect Between Spot and Term Prices. Source: Platts

As a result, the olefins industry in Europe has started to shift the basis of its contract pricing system from quarterly to monthly, which should reduce the inherent lag in price signals and dampen the whip-lash effect on margins. The move has been established in ethylene and appears to be under way in propylene.

In the U.S., where most steam crackers have flexibility to use crude-based or natural gas-based feedstocks, petrochemical producers have more options to manage their risk—an option they do not exercise. As a result, U.S. petrochemical producers find themselves competing with the power industry for access to natural gas, and coping with high gas and crude prices. This has prompted the National Petroleum and Refiners Association to lobby the U.S. government for relief in the form of subsidies or a change in national energy policies, neither of which has occurred. Ironically, the birthplace of the modern petrochemical industry and still the largest producer, the U.S., is also the furthest behind the times when it comes to hedging risk. To date, no U.S. producer hedges chemicals themselves, despite the high cyclicality of the markets.

Wall Street has proven how heavy non-commercial interests can hit the energy markets, but petrochemical players are still timid. Not only have attempts in recent years to start futures contracts for benzene and toluene failed, but even paper trading in the U.S. olefins and aromatics markets remains thin.

Good Times Ahead for Most Producers

Despite widespread complaints about the strong cost push from oil, margins for vertically integrated petrochemical producers have been strong, although non-integrated producers are faring less well. Moreover, if ethylene plant utilization rates remain a strong measure of profitability, the industry as a whole is expected to remain in the current profitable cycle through 2010 (Figure 3).

3. Global Average Ethylene Plant Operating Rates, 2000-2010. Source: Japan Ministry of Economy, Trade and Industry, April 2006

With more money at their disposal, the challenge for the industry will be to escape the chronic cycle of planning new capacity when times are good, only to see the market oversupplied when the capacity actually comes on stream as the market enters the next trough. There are some hopeful signs, however. New ethylene capacity expansions in North America and Europe have slowed and are expected to be well disciplined over the next few years. The bulk of the global marginal capacity will come from the Middle East—which benefits from cheap and abundant supplies of natural gas feedstocks—and Asia, the engine of global demand growth.

However, while the West is not building much capacity at home, it is expanding in Asia, particularly in China, to be closer to the main center of demand. Despite these ambitious capacity expansion plans, Asia is expected to remain short of most products, preserving the flow of trade into Asia, mainly from the Middle East (Figure 4).

4. Regional Supply-Demand Balances For Ethylene Derivatives: Asia to Remain Short Despite Growing Surplus in the Middle East. Source: Japan Ministry of Economy, Trade and Industry, April 2006

It is for this reason that, armed with the promise of continued growth in demand in Asia, combined with greater sophistication in managing price volatility through hedging, the industry may continue to plot a path of steady growth, at least for the next few years.