One of the most important features of the US shale oil and gas revolution has been the rolling wave of oversupply that has moved through the energy value chain, creating market imbalances and distorting long-standing price relationships between various hydrocarbons.
After surging domestic output of natural gas weighed on the commodity’s price in the wake of the Great Recession, upstream operators shifted their drilling activity to “wet” plays that also produced significant volumes of higher-value natural gas liquids (NGL) that enhanced wellhead economics.
The price of a mixed barrel of NGLs, some of which can replace naphtha and other oil derivatives in industrial and petrochemical processes, historically has tracked movements in the price of crude oil.
However, surging NGL production from prolific shale oil and gas fields swamped the domestic market and sent prices tumbling in early 2012. Oil prices, on the other hand, continued to hover around $100 per barrel until growing US output and declining imports catalyzed a precipitous selloff that began in summer 2014.
This rolling oversupply has created opportunities downstream, with an abundance of inexpensive natural gas in the US encouraging the development of export capacity and prompting electric utilities to accelerate the retirement of older coal-fired power plants.
In the crude-oil market, US refiners initially benefited from wide regional price differentials that lowered their feedstock costs relative to international competitors. Over time, new pipeline infrastructure in North America and the end of the US ban on exporting domestic crude oil have compressed these price differentials. Meanwhile, the collapse in oil prices has spurred growth in US gasoline demand after an extended fallow period.
Over the past several years, oil and gas companies’ overzealous production of natural gas and NGLs has restored the fortunes of domestic petrochemical producers, an energy-intensive industry that relies on these commodities to generate power and as feedstock.
Within this space, olefin producers have benefited the most thus far, thanks to extraordinarily low feedstock prices. The two most prominent olefins, ethylene and propylene, serve as the building blocks for three-quarters of all chemicals, plastics and synthetic fibers. Petrochemical firms produce these commodity chemicals in cracking facilities that heat ethane and propane with steam. The bulk of US olefin capacity is located on the Gulf Coast.
Depressed natural-gas and ethane prices gave major US olefin producers such as LyondellBasell Industries (NYSE: LYB), Westlake Chemical Corp (NYSE: WLK) and Dow Chemical (NYSE: DOW) a significant competitive advantage over their international peers—especially when oil prices traded at elevated levels. Naphtha and other crude-oil derivatives account for about 71 percent of the typical feedstock slate in Western Europe and 81 percent in Asia.
Check out this graph depicting the transfer of profit margins from US ethane production to ethylene and from ethylene to high-density polyethylene (HDPE).
But the multiyear boom in profit margins for US polyethylene producers appears to be winding down.
The first blow came with the collapse in oil prices that began in summer 2014, which shrank the cost advantage for US-based olefin producers and improved the economics of operators in Asia and Europe.
Although US ethylene producers still enjoy lower costs than their international peers, lower oil prices do improve the competition’s resilience and give candidates for closure a new lease on life, making it more difficult for American companies to take market share.
More worrisome, the impending wave of incremental petrochemical capacity on the Gulf Coast—projects approved in 2011 and 2012, when the price spread between oil and NGL remained at historically wide levels—will come onstream and ramp up over the next few years.
Although expected cracker start-ups in 2017 imply an incremental 300,000 barrels per day in ethane demand at a utilization rate of 90 percent, much of this capacity will come onstream in the back half of the year. Thus far, US olefin producers have benefited from polyethylene capacity coming onstream in advance of new crackers, helping to keep the market relatively tight.
These crackers also take time to ramp up, setting the stage for the oversupply wave to hit the polyethylene market in 2018 or 2019. The start-up of this new capacity will compress the profit margins of producers at this link in the petrochemical value chain and resulting in lower utilization rates.
The US Gulf Coast already exports significant amounts of polyethylene resin and other derivatives, suggesting that stepped-up production will force operators to rely more on international shipments to clear the glut. At these levels, North American polyethylene prices would need to retreat for the arbitrage window to open.
Finally, as new US olefin crackers come onstream and ramp up their operations, ethane prices on the Gulf Coast will need to increase to levels that incentivize gas processors to stop rejecting the NGL into the natural-gas stream.
Any uptick in ethane prices likely would prove temporary, as producers would respond to higher prices by ramping up drilling and completion activity. Nevertheless, this transitory uptick in ethane prices could squeeze US ethylene and polyethylene producers’ profit margins in the near term, especially those that lack the flexibility to crack propane or butane.
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Elliott and Roger on Mar. 20, 2018
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