Asian economic crisis to curb oil, chemical demand well into 1999

Arved Teleki, Lori A. Reynolds
Chemical Market Associates Inc.
Houston

John Vautrain
Purvin & Gertz Inc.
Long Beach

The continuing turmoil in Asian economies has caused Chemical Market Associates Inc. (CMAI) and Purvin & Gertz Inc. to re-examine the possible effects of the crisis on regional economies and on oil and petrochemical demand.

As a result of these developments, CMAI's outlook for petrochemical demand has changed materially.

In fourth quarter 1997, CMAI completed a comprehensive update of its supply/demand outlook using the economic basis then available.

But, because the Asian crisis is such a fluid situation, CMAI felt that an interim update of its projections was needed.

The overall impact of the Asian crisis, worldwide, will be slower growth in demand for oil and petrochemicals. Nevertheless, even within the countries and regions most affected, petrochemical demand is still anticipated to grow, on average, more than 4-6%/ year through 2002.

The Asian crisis

In retrospect, it is now quite clear that, during their long economic boom, virtually all of the countries in this area developed serious structural defects, committed serious macroeconomic policy mistakes, and, above all, failed to adequately supervise their entire financial sectors. Particularly damaging and very difficult to remedy are the cozy relationships among the ruling elites, in which economic and political leadership, industry, real estate, etc., were intermingled without adequate (or any) checks and balances.

The banking system failed to evaluate the soundness of investments. It merely channeled funds to borrowers who were primarily political allies, relatives, or industrial partners.

The lopsided reliance on short-term borrowing of foreign funds, financing of long-term prestige projects, and progressively more risky investments in real estate or stocks were particularly dangerous. Even the moderate slackening of economic growth, when coupled with an initially moderate reversal in the direction of the flow of international funds, has had a disproportionately severe impact.

In CMAI's view, these factors culminated in Thailand's severe currency devaluation in July 1997. The fact that all Asian countries are now at risk, only 6 months later, simply means that, while there are local variations, the main underlying problem is the same throughout the continent. This is the reason that the financial and economic ailment is spreading so easily, that each country's symptoms are so similar, and that the situation is so potentially dangerous.

Economic analysis

In the analysis of the effects of the Asian crisis, CMAI's August 1997 forecast was used as the base scenario. The base scenario includes the following assumptions:

• A strong world economy averaging 3.1% gross domestic product (GDP) growth in 1997 and 1998-the highest in a decade.
• All major economic regions of the world experiencing expansion.
• An expected slowing of growth in North America in 1999 creating only a minor slowing in world growth that resumes at about 3.8%/year thereafter.
• Following a prolonged collapse in the past, the once centrally controlled economies of the countries of the former Soviet Union growing vigorously in the future.
• Southeast Asia's financial panic causing a moderate degree of economic damage in the region.
• Economic repercussions elsewhere in Asia-especially Japan, South Korea, and possibly China-being noticeable but moderate.
• The world as a whole being little affected.

Revised outlook

The alternate scenario in the CMAI analysis involves continued and severe financial panic throughout Asia, with the situation getting worse before it can get better.

In this scenario, intervention by international financial institutions proves to be too little and too late through the spring of 1998. The downward spiral in currencies, stock markets, and property values will continue, with extreme volatility.

In this scenario, Japan is clearly endangered in spite of its great wealth and many foreign assets. Its inability and unwillingness to meet problems head-on has already led to a much weakened banking system. The country is mired in a 5-year stagnation and, as such, is vulnerable to shocks from abroad.

China's economy is an improbable mix of spectacular progress along Thailand or Taiwan lines and the worst features of the defunct Soviet model. It is highly doubtful that China can avoid being affected by the chaos that surrounds it. Its own banking system admits that more than 13% of its debts are bad.

India is expected to face great financial and commercial pressures with which it is ill equipped to cope. Other countries-the Philippines, Myanmar, Viet Nam, etc.-are likely to join the "sick list."

International financial agencies and potential large lenders such as the U.S. on one side and the Asian countries to be rescued on the other view each other with suspicion. The opportunity to act quickly and decisively has been lost.

The export push of individual countries will be at least partially successful but will be carried out amid competitive currency devaluations. These initiatives are therefore chaotic and much less effective. Countries that push exports will run the risk of inducing other potential exporters to institute protective import measures.

By the end of 1998, conditions finally may sort themselves out. However, a strong recovery is not likely to get under way until well into 1999. The consequences of this delay are much more economic damage in 1998 and a much less certain recovery in 1999 and beyond.

Latin America will be unfavorably affected, as all developing countries are now suspect in investors' eyes. Luckily, however, this region was "immunized" to a degree by the Mexican financial crisis 2 years ago.

Other developing countries, in Africa and the Middle East, that have a high percentage of their GDP dependent on income from exports, whether oil or petrochemical, will suffer a slowdown in GDP growth as demand for products in Asia decreases and competition increases.

The alternate scenario assumes that the domestic strength of the two largest economic regions-western Europe and North America-will continue unabated.

North America will have 2.9% GDP growth in 1998, which is unchanged from the base case but 0.4-0.6 percentage points lower than it would have been without the Asian turmoil (see graph, p. 23). Western Europe's 3.2% GDP growth in 1998 is 0.2 percentage points higher than the base case but about 0.3 percentage points lower than it would have been without the Asian crisis. The strong GDP performance in the areas will occur in spite of the Asian crisis.

This scenario, while quite somber, remains highly optimistic in the sense that it stipulates a strong recovery beginning about 1 year from now. This would be similar to the Mexican experience in late 1994 through 1996.

World petroleum demand

As a result of the Asian crisis, Purvin & Gertz Inc. has broadly analyzed the impact that CMAI's new economic scenario could have on global petroleum demand.

Several key assumptions were made in the analysis:

• Total energy elasticity will not be widely affected by the economic turndown.
• Existing long-term, irrevocable commitments to alternate energy sources will be honored.
• Currency devaluation initially will be passed through to consumers but eventually will erode through inflation.
• No fundamental change in energy policy will be implemented as a result of the economic downturn.

Based on these assumptions, the alternate scenario indicates that world crude oil demand growth will slow through 2000. The gains in demand in North America and western Europe will be insufficient to offset the reduced outlook for Asian markets through 2000.

After the Asian economies recover and world GDP growth is more balanced, petroleum growth will recover.

World oil prices will remain soft. The increasing imbalance between oil production capacity and demand will result in a short-term decline in crude oil production utilization.

Asian demand

In Asia, many refinery projects will be delayed or canceled, particularly in South Korea, Thailand, and Indonesia. The economic downturn in these countries, combined with currency devaluation, has reduced short-term requirements for new capacity.

South Korean and Thai petroleum product surpluses probably will turn to shortfalls by the medium term, and refinery margins should become more favorable by that time.

Over the short term, alternatives to petroleum-particularly gas and coal-will rise in market share. Other types of energy tend to have lower incremental cost, are often domestic in origin, and are committed under long-term contract.

Over the medium term, petroleum's market share will rebound. At this point, Asian countries, as a group, will have difficulty authorizing new long-term commitments that would bring new coal-fired power plants, LNG, or long-distance pipeline gas in the medium-term future. As the economies recover over the next 2-4 years and energy requirements expand, there will be a gap in the availability of new alternate energy supplies.

Asian refining margins will remain weak. Several countries have become oversupplied-particularly South Korea and Thailand-leading to poor margins around the region, with export supplies competing in available markets.

In addition, Singapore refinery throughputs are off, which is likely to continue over the short term. As the supply/demand balance is restored, margins and throughput in Singapore are likely to return to higher levels.

Eastern/Western Hemisphere crude oil differentials are likely to decline. The reduced refining margins in Singapore, coupled with the failure of demand growth to materialize at anticipated levels, will put downward pressure on crude oil differentials, reversing recent trends.

Asian consuming countries will continue to require products from external sources, primarily the Middle East. Over the short term, the Asian products market will become more competitive as regional refiners struggle with lower utilization and poor margins.

As a result of curbed Asian demand, Middle East crude oil producers will see greater competition. Diminished refinery utilization rates in Asian markets and poor margins will make refiners more selective and willing to turn down uneconomic crude oil supplies. The reduced outlook for world crude oil growth will affect Middle East producers, decreasing production levels there.

New LNG projects will be delayed. The inability of Far East consumers to make commitments for new LNG supplies over the short to intermediate term will cause producers to delay or shelve pending LNG projects.

Condensate availability growth will diminish as reduced LNG demand suppresses the availability of co-produced condensate.

In Western Europe, limited Med- iterranean gas oil exports to Asian markets will diminish over the short term.

Until recently, products from Western Europe did not move to Asian consumers. Starting in the early 1990s, Asian product shortfalls began attracting Mediterranean supplies of gas oil. With Asian refiners operating below capacity, the requirement for distant supplies will evaporate through 2000.

Over the intermediate to long term, opportunities for Mediterranean suppliers will return. Because the pace of Asian refinery construction and upgrading is likely to be disrupted by the inability to make large capital commitments and by temporarily poor margins, in the longer term, Asian refinery throughput is likely to rise, and product shortfalls will return. Unlike in the early 1990s, however, European refiners may not have appreciable surpluses available to provide.

The likelihood of sweet crude shipments from the North Sea to Asia will decline. Recent patterns of ever-widening circles of import suppliers to Asia are being reversed.

While opportunistic shipments have occurred in the past, North Sea producers are unlikely to find economic markets in Asia.

North American demand

The effect of the Asian economic downturn on North American demand will be small. A milder economic slowdown in 1999 will directionally increase demand relatively compared with the base case.

Atlantic basin crude oil exports to Asian markets will be reduced. Asian crude oil sources have been inadequate to meet rapid demand growth. Atlantic Basin sources-particularly sweet West African crude oils but also some North Sea and Latin American sour grades-had been anticipated to penetrate further into Asian markets (OGJ, Jan. 19, 1997, p. 16). The downturn in demand growth will reduce new opportunities for upcoming production increases to find a home in Asia.

Product demand growth will be strong. The improved economic outlook in North America will support higher product demand growth, particularly for light transportation fuels.

Excess Asian products are unlikely to have a major influence on North American markets. Asian products will continue to be unable to penetrate those markets.

Asian refiners, on the whole, are not equipped to produce the high-quality reformulated fuels that are in demand in North America. And shipping costs from Asian ports are quite high, even to the closest West Coast destinations, reducing the competitiveness of Asian supplies.

Higher Asian crude oil costs-resulting from higher-quality oil compared with average West Coast crudes and from the remaining Far East premium-make Asian refiners relatively uncompetitive on the West Coast.

Asia will continue to be unimportant for North American product exports. North American shipments of refined products to Asia have not been large, and, consequently, there is little room for direct effects on North American refiners.

Petrochemical demand

With ever-changing world economic conditions playing such an important part in petrochemical demand forecasts, Purvin & Gertz has performed a basic analysis of the possible impact of the new economic scenario on demand forecasts for a variety of products. This is in no way meant to imply that new demand forecasts are necessary, but rather to roughly quantify the effect that economic changes could have on regional and world demand for petrochemicals.

Following is a list of the basic assumptions that were used in conducting this analysis:

• GDP changes were adjusted for the new scenario.
• Product GDP elasticities were held constant by region.
• No adjustments were made in GDP elasticities to account for benefits, such as price elasticity, for non-durable goods such as polyethylene.

New demand values were calculated based on new GDP and existing elasticity. The overall impact of the Asian crisis, worldwide, will be slower domestic demand growth for petrochemicals.

Even within the countries and regions most affected, petrochemical demand is still anticipated to grow an average 4-6%/year through 2002, with worldwide growth averaging 5-7% across products.

A quick resolution to the economic crisis and a stronger-than-anticipated recovery could result in demand levels being influenced only slightly by the end of the study period. A prolonged economic crisis and a slow recovery would result in an extended period of depressed growth and the possibility of demand being unable to reach previously anticipated levels or the levels calculated for this study.

The more the economic crisis is allowed to spread to the dominant economies in Asia, such as Japan, South Korea, and possibly China, the greater the effect, across all regions, on world petrochemical demand. The restoration of confidence, worldwide, in the economic stability of the affected countries is vital to the return of foreign investment that would improve demand in Asia and internationally.

Increased worldwide integration is probable as the opportunity to purchase facilities or ownership in Asian companies becomes a possibility as a result of producers being cash poor and foreign ownership regulations being relaxed. Advancements toward worldwide free trade may be hampered as affected countries delay or cancel tariff reduction plans.

Depressed prices worldwide may, in the long term, help stimulate higher than anticipated demand and result in demand reaching previously anticipated levels. In the end, the delaying or canceling of new capacity may help reduce the possibility in 2000-02 of a worldwide petrochemical over-capacity that could further depress prices and earnings.

Asia

Domestic demand for durable goods will slow because the population has lost confidence in the economic stability of their countries. Many infrastructure projects and housing projects have been delayed or canceled, which will reduce the demand for durable products such as PVC.

Demand for non-durable goods, such as polyethylene (PET), also will be reduced by the crisis, yet the reduction may be softened because reduced prices should encourage higher demand.

Asian demand for import products will be filled to a larger degree by local or regional production, thereby reducing demand for exports from other regions such as North America, western Europe, or the Middle East. Increased exports are expected as domestic demand declines and countries and companies try to get hard currency to pay off debt.

Countries are targeting the intraregional markets of India, China, Pakistan, and Viet Nam that have not been influenced by the crisis. Higher exports to western Europe also are anticipated.

As competition for regional demand becomes stronger and domestic demand stagnates, production may need to be curtailed if storage facilities are not available to facilitate increases in inventory.

Raw material suppliers are finding that banks are hesitant to finalize letters of credit because the banks are unsure of buyers' ability to make the payments. This aspect, in the short term, would strongly affect supply and the ability of Asian producers to fulfill needed demand.

Although most current capacity expansions and new plants under construction will proceed, there is a strong possibility that new capacity or facilities that are under consideration may be delayed or canceled. This may, in the end, have a positive result, as it may allow more time for demand to catch up to supply and help alleviate the overcapacity conditions that currently exist in Asia and that have been depressing prices.

Some existing petrochemical companies-particularly those in South Korea and Thailand that are highly leveraged-will sell off part or all of their companies at depressed values to meet bank requirements. Buyers of these facilities are likely to be large, well-financed, international companies, which will look at their new Asian business from a global perspective.

Currency devaluations, although making it difficult to pay off U.S.-dollar denominated debt, will allow exporting companies to increase their competitiveness worldwide.

Middle East producers

Middle East petrochemical producers-particularly Saudi Arabia-are likely to be hit significantly by the currency turmoil in Southeast Asia. These producers are almost exclusively dependent on export trade to maintain their businesses, for which the Asian market has been key.

About 90% of Saudi polyethylene production is exported. About 65% of this quantity finds its way to Asian markets, with the remainder going to Europe, other Middle East countries, and Africa. Other derivatives are estimated to have similar export-to-domestic-use ratios.

The short-term effects on the profitability of Middle East petrochemical producers will be felt in substantially reduced operating margins and some losses of volume. Alternative markets, such as Europe, may offer some respite in the short term.

In the near to medium term, CMAI believes there will be a recovery in the Middle East and that the competitive position of producers there will allow them to become a major supplier of intermediates and feedstocks to Southeast Asia.

North American demand

The effects of the Asian crisis on North American petrochemical demand will be minor. Petrochemical demand is anticipated to be slightly stronger overall, because the economic slowdown in the U.S. in 1999 will be milder and the rebound more robust.

The U.S. petrochemical industry is largely a domestic industry with, on average, only 30% of petrochemical exports going to the Asia/Pacific region (including China). Only a fraction of that goes directly to Southeast Asia.

Products that have a high level of exports going to Asia may see exports drop as Asian plants run full-out, thus pushing excess product into the North American market.

Very small volumes of Asian petrochemicals are imported into the U.S. These levels are not likely to increase as domestic prices are already low and the additional freight and duty charges would bring the cost to levels equal to or higher than current spot prices.

About 40% of Canadian petrochemical production is exported to Asia. Because Canadian producers, especially those in Alberta, enjoy a cost advantage, production will continue at normal levels. But the Canadian volumes that are lost to Asia will be redirected to other markets-most likely the U.S.

As U.S. petrochemical demand remains stable to slightly stronger, increased imports into the U.S. from Canada would lead to cutbacks in U.S. production in an effort to avoid increases in inventories or exports to other markets that will quickly become oversupplied.

Western European demand

Demand in western Europe will be impacted only slightly by the Asian crisis. Imports from Asia are expected to see minor increases.

Western European demand is increasing, but the cause is stronger domestic economic growth. Petrochemical demand is growing strongly and is anticipated to continue to do so, as eastern European countries are importing greater volumes of finished goods and therefore helping to sustain and spur western European petrochemical demand.

Exports will be hit, however.

Imports from the Middle East will likely increase, thereby reducing operating rates.

Outlook

The economic situation has continued to deteriorate, not only in Southeast Asia but throughout Asia, from India to South Korea. The necessary corrective measures that are being taken are too little and too late and are experiencing considerable opposition from the intended beneficiaries of the rescue efforts.

The financial panic is still spreading with surprising ease in the majority of Asian countries. Occasionally, it affects unrelated countries as far away as Brazil and Russia.

Prompt implementation of the necessary fiscal reforms by Asian governments is key to restoring consumer, business, and investor confidence, which will lead to improved domestic demand. Delaying implementation of reforms would delay recovery of domestic demand and dampen petrochemical growth projections more than anticipated in this analysis.

The Authors