SLOWER DEMAND GROWTH LIES AHEAD FOR U.S. PETROCHEMICAL PRODUCERS

A.D. Koen
Senior Editor-News

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Petrochemical makers in the U.S. probably won't be able to sustain recent robust margins as domestic markets ebb toward normal levels.

Petrochemical demand growth in the U.S. is starting to slow for all but a few derivatives. But the slowdown will be anything but disastrous compared with the industry's usual boom and bust cycles, observers say.

Expectations of steady U.S. economic growth will keep petrochemical demand growth from withering entirely. Meantime, the pace of announced capacity expansions appears adequate to avoid supply tightness for the rest of the 1990s.

Prospects for balanced markets, coupled with recent efforts among U.S. petrochemical producers to reduce pro- cessing costs and increase operating efficiency, should allow the industry to retain market share and reasonable profits.

But all is not assured for an industry in which increasing globalization spawns interaction among players in different regions. While petrochemical markets in the U.S. appear steady and predictable in the decade ahead, projections of double digit demand growth in Asia hold plenty of potential for surprises.

U.S. companies must divine whether demand in the Asia- Pacific region will develop as forecast, If so, they must decide whether capacity additions in the region will be enough to meet demand or whether U.S. producers should add capacity at home to serve export markets.

Such uncertainty is heightened in the U.S. by belt tightening by the federal government. When many are trum- peting the benefits of international trade, could cutbacks in the federal budget curtail access to international investment capital, thereby reducing international petrochemical trade?

OPTIMISM EXCEEDS FUNDAMENTALS

Despite the potential for problems from unexpected events, executives of U.S. commodity and specialty chemical companies voice an optimism that exceeds the positive fundamentals in domestic markets.

More than 80% of respondents to a survey by process management consultant Wright Killen & Co., Houston, said they expect North America to be the most profitable region for their businesses in the next 3 years. The same

majority expected regional investments in petrochemicals to be the greatest in North America. In addition, 70% of respondents said they will acquire petrochemical assets in the next 5 years, while the rest plans to sell assets.

Michael R. Krenek, Wright Killen's vice-president of chemicals, said the survey shows that future Asia-Pacific growth claims most of the attention. But the developing story may be reemergence of the U.S. and the rest of North America as the most profitable place to invest in petrochemicals for the next few years.

While part of the optimism undoubtedly stems from market factors, Krenek said, some comes from U.S. producers' restructuring efforts during the latest down cycle to reduce costs and improve efficiency.

"The U.S. petrochemical industry has made the difficult choices required to put their businesses in very competitive shape," he said. "So some of this optimism comes from looking at the rest of the world and realizing they can compete heads up with anybody

"That feeling, I think, has permeated senior leadership. And this spirit of optimism is giving them the confidence to place some of the big bets that are required to build petrochemical complexes."

Krenek said more cost cutting lies ahead in the U.S.

Most European and Latin American petrochemical producers are operating with higher fixed costs. In Asia, although many of the plants being built are based on the best available technology, the emphasis on keeping up with rapidly expanding markets outweighs efforts to optimize operations.

UNPLEASANT COST CUTTING

U.S. petrochemical producers recognize that they must compete on a global basis to survive. More than 20% of Wright Killen survey respondents cited globalization of the industry as the third most critical factor likely to affect their success.

Perhaps more revealing are the two factors cited most by respondents: people (about 30%) and cost control (2223%).

Krenek said cost control likely would have been the top response if Wright Killen had surveyed the industry 3 years ago, before the recent round of restructuring. Similarly, industry leaders today reflect high sensitivity about people issues because of recent staff reductions.

"Now that a lot of the unpleasant cost cutting has been done, petrochemical leaders are less focused on further cuts and more on being competitive," he said.

While some companies have been more successful than others at trimming costs, Krenek said, over time it will become harder for a petrochemical company to stand apart from competitors solely on a cost basis.

"Competitiveness goes way beyond being the lowest cost producers,' he said.

"Creative business practices, thinking about competitiveness in a broader sense, taking reengineering beyond head cutting to implementation, and putting more emphasis on increased revenue are the kinds of things petro- chemical producers will have to focus on.

SETTING THE STAGE

Observers agree on the fundamental strength of U.S. petrochemical markets.

Prices early in 1994 were rising because of growing demand. That was before outages of ethylene plant steam cracking units in third quarter 1994 boosted prices to robust levels.

"Prices were moving up as operating rates were rising, and operating rates were rising because demand was rising," said Rob Harvan, director of chemical planning at Bonner & Moore Associates Inc. (BMA), Houston.

"Demand was increasing at a rate faster than gross domestic product (GDP) because we were in a recovery, which pretty much is the rule of thumb in commodity petrochemicals."

But after reflecting classic petrochemical market theory in first half 1994, the unexpected supply constraints pulled the rug from under an industry beginning to show clear symptoms of a supply/demand imbalance.

"Prices went absolutely ballistic," Harvan said.

Ethylene contract prices in September-October 1994 averaged 21-220/lb, while spot prices hit 40/lb, if a buyer could find a supply.

"Prices shot up 2-3/lb each month," Harvan said. "Between August 1994 and January 1995, prices in the derivative chain rose anywhere from 40% to 60%."

Everyone knew it couldn't go on, he said, and first half 1995 brought the first signs the feeling was correct.

"The first half of 1995 became a transitional period," Harvan said. "The change was to a more traditional market from a structurally short environment brought about mainly by cracker accidents and other supply dislocations that were not part of the historic cycle."

Viewed like that, the current softening of prices on U.S. petrochemical markets is merely an adjustment to fit more healthy market fundamentals.

WHAT'S HAPPENING NOW

With U.S. petrochemical markets returning to normal, sources expect U.S. demand through the 1990s to grow at about the same pace as GDP, about 2.5-3%, or half the recent robust rate.

Bill Uruqhart, a senior consultant at Pace Consultants Inc., Houston, said U.S. ethylene markets and some downstream markets have about 2 weeks of supply on hand. That volume is enough to avoid spot shortages, given the mix of planned downtime and new capacity coming on line.

Demand, meanwhile, is softening most for polyethylene (PE) derivatives for general packaging applications and polyvinyl chloride for construction. Demand is holding steady for polypropylene, polystyrene, and the paraxylene/polyester fiber chain.

Petrochemical prices reflect better market balance, rolling over from month to month. It appears the market is accepting the price increase proposed in the spring for polypropylene (PPP) but not uniformly PPP prices this month reached about 48/lb, up from 45/lb in April and May, Uruqhart said.

Signs of slowing demand growth in markets for plastics used in packaging indicate the expected slowdown is under way across a broad band of the U.S. economy

Since May, Pace has noted reports of producers offering to sell broken lots of material on a spot basis for as much as 5/lb below contract prices. "But we hear nobody down the chain is buying," Uruqhart said, in part because U.S. economic activity appears to be slowing.

"I think some customers are scared of recession," Uruqhart said. "They see no more upward pressure on prices. As a result, they're trying to pull inventories downstream in the ethylene chain."

While there are some signs that the pull on downstream inventory is not as large as intermediate suppliers want, Uruqhart said, some of that weakness could stem from the petrochemical industry's normal yearly cycle.

"We're about to enter July, the weakest month of the year for plastics," he said. "So if demand is in the process of bottoming out, we'll hear the thud in July"

Whether it turns out later this summer that the economy has slowed more than was expected, Uruqhart said, U.S. petrochemical profits will be down substantially from levels achieved in first quarter 1995,

ETHYLENE MARKETS

With no major recession in the near term, Wright Killen said, profits on ethylene market, the bellwether of petro- chemicals, should be attractive in the U.S. for several years,

Although several companies have unveiled plans to build grassroots ethylene plants in the U.S., Wright Killen said, the industry reacted to bright forecasts of ethylene demand by first planning plant expansions.

Ethylene capacity generally can be added at less cost with expansions than with grassroots projects. Relatively shorter start up times common for limited projects also improve the ability to meet demand. Most of the capacity under construction will not go or) line until after 1997.

Krenek said analyses of the rate of return (ROI) for a grassroots; ethylene plant underscore the strong financial health of the U.S. ethylene industry.

"We expect the latest group of grassroots ethylene plants to generate returns of I 6-18% yearly over their lifetimes," Krenek said. "We view these returns as quite attractive for investments of this size. And incremental expansions should deliver even better performance."

Wright Killen analyses further show the best time to begin planning a grassroots ethylene plant is near the bottom of ethylene cycles. A plant going on line 4-5 years after planning begins starts producing ethylene near the peak of a price and margin cycle. That allows it to generate strong cash flow in the early years of operation.

"A closer examination suggests the maximum ROI is generated when a plant comes on stream the year before the peak cycle," Krenek said.

Based on its latest analysis, Wright Killen expects U.S. ethylene prices to drift lower from current levels, bottoming out in about 1997 but still at levels that will allow reasonable returns. Starting in 1997-98, ethylene prices are to begin trending upward, peaking about 2003-04.

NO TIGHTNESS THIS DECADE

Pace's Uruqhart said U.S. capacity for most chemicals and plastics derivatives appears large enough to avoid market tightness until after the turn of the century. Many forecasters have been too conservative about estimating demand growth, lie said.

"If there is a recession in 1996 and that is followed by several years of very strong demand growth, these markets could again tighten fairly quickly," he said.

Uruqhart said future operating rates will range from the upper 80% to more than 90% at most U.S. chemical plants.

"The landing place for margins and profits with 90% operating rates on average probably won't be bad," he said. "I don't think we'll see the severe pressure on margins that would echo what the industry saw following the 1982 recession. Moderate profits will be maintained."

If U.S. monetary policy doesn't choke off domestic economic growth, SRI International expects U.S. ethylene capacity to surpass 25 million tons/year before 2000. Based on a forecast oil price of about $21/bbl in 1994 dollars by 2010, SRI also expects ethylene capacity utilization of about 90% through 2002.

SRI's Walter Sedriks detailed the company's conclusions in May at a Stone & Webster Engineering Corp. forum at The Woodlands, Tex.

NON-U.S. MARKETS

While the outlook in the U.S. for domestic petrochemical markets appears relatively positive, uncertainty on markets outside the U.S. seems sure to pose a problem for planners.

Forecasting economic or industrial activity in developing countries at best is more tricky than in developed countries. Factoring interplay among developing economies and regional markets around the world into an activity forecast increases chances for mistakes.

Depending on the way in which petrochemical capacity is added and new markets developed over several years, entire regions could swing from net importer to net exporter. Uncertainty about petrochemical construction in the Asia- Pacific region is a case in point.

"The track record of Asia-Pacific petrochemical plant construction has shown that not all plants announced are built. And not all plants built are built on schedule," Uruqhart said.

There are many reasons-and not limited to the Far East. Forecasters sometime deal with supply constrained demand or demand not correlated with GDP growth, where new supplies are snatched up as soon as a plant goes on stream. Conversely, a country can't always use a new plant's production when it starts up.

Because national industries all could be adding petrochemical capacity to compete for the same markets, Wright Killen's Krenek said excess Asia-Pacific capacity could be built even if demand growth rates stay high.

"This is not something we're predicting, but it's not impossible," he said.

"The timing of purchases by China is something that can swing the entire Southeast Asian economy around," Uruqhart said. "If China pulls back on purchases to try to clamp down on inflation, the shock could be felt around the world. They've done it in the past. They probably will do it peri- odically in the future."

In addition, political upheaval could delay plans much longer, perhaps permanently.

Wright Killen believes projected Asia-Pacific petrochemical demand is justified. But U.S. petrochemical makers must remember the booming market won't last forever and try to estimate when demand growth will begin slowing, Krenek said.

DEARTH OF FINANCING

BMA's Harvan said a wave of fiscal conservatism sweeping the U.S. could lead to budget cuts that would prevent some petrochemical construction in Asia.

'Part of the U.S. government's effort to balance its budget would involve a dismantling or shrinking of a number of government agencies and programs," Harvan said "This could well affect the World Bank and U.S. Agency for International Development, both of which are often the prime guarantor of loans for construction in developing countries."

Even in the U.S., lenders are requiring a much more vigorous analysis and forecast before they lend money on a new petrochemical plant, he said.

If federal funding of U.S. international financing agencies are cut significantly, it would become difficult if not impossible for some borrowers in developing countries to obtain loans.

Loss or delay of a significant volume of planned capacity in the Asia-Pacific region could force customers there to start drawing supplies from producers outside the region. In that case, demand for U.S. petrochemicals could be greater than expected, resulting in higher operating rates and mar- gins.

Conversely, planned petrochemical expansions in Asia are based on predictions of double digit demand growth for a decade. So if plants are built based on projections but expected demand growth doesn't occur, the region could become a net petrochemical exporter.

"if Asia-Pacific simply sees economic growth of 5% yearly, excessive petrochemical capacity could cause a prob- lem," Harvan said.

TRADE WARFARE

Because the U.S. petrochemical industry maintains the country's second largest favorable balance of payments, issues of international trade can have a disproportionate effect on the industry.

So deeply do U.S. petrochemicals penetrate foreign markets, Krenek said, the troubled trade relations with Japan and other large U.S. trading partners could harm domestic petrochemical makers. An automotive trade war with Japan alone could seriously hinder U.S. petrochemical exports.

Meantime, Krenek said, Japan and some European nations are aligning on manY automotive trading issues against the U.S. So even a limited automotive trade war with Japan could carry the risk of drawing in competitors based in Europe.

"if such trading alliances were to develop and automotive companies in several countries began putting up barriers to trade, that would hurt the U.S. petrochemical industry significantly," he said.

Uncertainty about the effects of international trading policies on U.S. petrochemical exports is further heightened by the domestic conflict pitting advocates of free trade against protectionists.

BENEFITS OF NAFTA

Krenek said the U.S. petrochemical industry would benefit if the U.S., Canada, and Mexico, as intended, managed to expand the North American Free Trade Agreement (Nafta) across the North and South American continents by 2005. That should be especially true of Latin America's two largest petrochemical markets: Mexico and Brazil.

Despite significant criticism of Nafta's effects in the wake of Mexico's financial crisis, Krenek said, sales by U.S. petrochemical makers into Latin American markets are sure to increase. The only question is how fast.

"We're telling our Latin American clients they should start working on their competitiveness now," he said, "so they won't be caught flatfooted when these agreements are implemented.

"Becoming competitive takes time, and the sooner the free trade zone expands, the greater the opportunity for U.S. petrochemical producers."

Whether Nafta will cover 100%, of both American continents by 2005-or ever-is anyone's guess.

"But free trade will grow in the Americas, short of some cataclysmic event like a trade war," Krenek said.

COMPETING IN THE FUTURE

Harvan said BMA is advising its U.S. clients to manage their assets more carefully if they wish to compete suc- cessfully in future petrochemical markets.

"The markets are not going to be as flexible and forgiving as they used to be," he said.

The threat of overbuilding to meet local needs will loom larger. With many countries developing their own petro- chemical capabilities, especially in areas of high projected growth, U.S. petrochemical makers less and less will be able to use export markets as relief valves for excess supplies.

"Product maturity and loss of export markets have caused major changes in the petrochemical industry," Harvan said. "Managers constantly must monitor what the industry is doing."

Even close watch of petrochemical markets might not be enough to sustain U.S. companies if a revolutionary product appears on the scene.

Krenek pointed out that a big technological leap could touch off a chain of adjustments throughout the polymer industry, "essentially changing the winners and the losers." New technology often leads to introduction of new families of products, changing the competitive picture and pressuring older technology to remain cost effective.

Perhaps most important, effects of new technology are not consistent from one company to the next. And adjustments fall most heavily farther down the derivatives chain.

"It's not enough to reduce costs in an era when new technology is being introduced," Krenek said. "Petrochemical makers have to reduce costs equal to or better than the competition and still provide a good product."

For example, because of its potential for altering market fundamentals, Wright Killen has been advising clients to obtain an understanding of emerging metallocene catalyst technology.

"They need to be thinking through the possible effects and reacting," Krenek said. "A petrochemical company can't necessarily know what's going to happen. But it can detect some key trends and start taking action to either take part in the trend or defend itself."

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