US Ethylene – Irrational but Typical Behavior – This is How The Wheels Come Off

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

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gcopley@ / asalzillo@ssrllc.com

September 12th 2018

US Ethylene – Irrational but Typical Behavior – This is How The Wheels Come Off

  • The fortunes of the US Gulf Coast ethylene industry have been slowly deteriorating for a while but have been dramatically and very negatively impacted over the last two months, with the global ethylene cost curve today bearing no resemblance to one only 4 months ago.
    • Escalating US Gulf ethane prices and higher values for propylene and butadiene (co-products from other feedstocks) have moved US Gulf coast ethane-based ethylene from the bottom of the global cost curve to the top, a relative move in costs of $500 per metric ton.
  • Today there is no margin in producing ethylene in the US Gulf and much lower margins in ethylene derivatives than only a few months ago. But more worrying is that there is no competitive advantage today making ethylene in the US.
    • The US can continue to export ethylene and its derivatives today only because European and Asian ethylene prices remain well above costs, which provides a margin umbrella.
    • The umbrella is shrinking as US costs rise and prices fall for polyethylene and PVC globally.
  • Today the declines in international pricing are happening slowly, but as the US pushes more into the export market there is a risk that price declines outside the US increase in pace – looking at Exhibit 1 they have a long way to fall.
    • If the profile in the exhibit persists, which is questionable because feedstock constraints in the US are expected to ease, US based producers face dramatic declines in profitability.
    • Risks exist for all ethylene producers

Exhibit 1

Source: IHS, WoodMac and SSR Analysis

Details

This week ethane prices in the US Gulf have reached 53-54 cents per gallon, the highest price since January of 2012 and a jump of 14 cents per gallon in 2 weeks.   Ethane spot pricing in the Gulf is rising quickly versus both natural gas and propane – Exhibit 2 – as demand from ethylene units outstrips availability.  The question is who is paying these prices as there are no economics in making ethylene – cash ethylene costs are around 25-26 cents per pound at these ethane prices and while the spot futures market for ethylene jumped to 19.25 cents per pound last week from a last real deal at around 15.75 cents, the futures number remains well below costs.  Current costs are higher than August contract prices – Exhibit 3 – and we would expect contract prices to rise in September to reflect cash cost at a minimum.

Exhibit 2

Source: Bloomberg, WoodMac and SSR Analysis

Exhibit 3

Source: Bloomberg, WoodMac and SSR Analysis

The buyers of ethane at these inflated prices likely fall into one of two camps:

  • New ethylene unit operators looking to test the capacity of new facilities and inadequately covered on ethane supply.  This is possible but unlikely, as if they really are making no money, CPChem, Exxon and Dow would cut back other facilities to free up ethane for their new units.
  • Integrated ethylene/derivative producers looking at an incremental sale of something into the export markets.  This is the more likely option as pricing for polyethylene, PVC and other derivatives in both Europe and Asia is still high enough to justify paying the higher ethane price.

But this is a downward spiral as the US is forcing incremental pounds of ethylene into other markets using marginal local economics.  This might have made some sense when the cost curve for ethylene looked like it did in May – Exhibit 4 – as even if US actions precipitated pricing weakness elsewhere in the World, there was still a cost-based umbrella.

Exhibit 4

Source: IHS, WoodMac and SSR Analysis

As is shown clearly in Exhibit 1, the cost umbrella is gone and there is now only a pricing umbrella, which is far less stable and far more concerning. While we are seeing costs rise in the US, we are also seeing a slow erosion in US polyethylene pricing – 1-2 cents per pound per month (although more stable so far in September) – netbacks from exports are falling, so all producers would rather sell a few more pounds locally.  At the same time PVC pricing is weakening in Asia – a market that had been stable and strong for some time.  The US has surplus capacity of PVC and its precursors, EDC and VCM.  Like ethylene glycol (MEG), EDC is a liquid and is fungible (i.e. “one grade fits all”) – consequently it is straightforward to trade in bulk.  PVC itself is more fungible than polyethylene, in that pipe grade – much of the export demand – is both broad in terms of application and broad in terms of quality.   The declines in international PVC prices are part of the current problem and in our view opportunity with WLK.

The degree of irrational behavior in US ethylene today has never been seen in the past – Exhibit 5 – as we have never seen spot ethylene margins this negative, and frankly we did not expect the situation to last beyond June.  It is a clear consequence of the current and growing surplus of ethylene and derivatives in the US, and the discomfort required to find new buyers outside the US – especially if it is an attempt to replace an existing supplier.  The trade issues do not help – Chinese tariffs on polyethylene mean that US polyethylene must find markets elsewhere or accept lower prices.  We had expected demand growth in 2018 to be sufficient to soak up the new US capacity, and while this may still be the case (only Eastman has talked about cutting ethylene production in the US, everyone else is pushing volume), it looks like pricing could remain under pressure for the balance of the yearIt is worth noting that while ethane base margins look very negative in Exhibit 5, anyone operating a more feedstock flexible ethylene plant should be doing better, as even with high crude oil prices – propylene and butadiene prices are high enough to bring down ethylene costs from propane or condensate. The flip side to that argument is that anyone who could have switched out of ethane should have in August and yet ethane prices continue to rise in September.

Exhibit 5

Source: IHS, WoodMac, Bloomberg and SSR Analysis

While the cost move in the US has been dramatic – forcing ethylene spot prices off their lows and no doubt leading to a higher ethylene contract price in September than August, some ethylene derivatives continue to weaken and the combined impact on integrated polyethylene margins in the US is shown in Exhibit 6.

Exhibit 6

Source: IHS, WoodMac, Bloomberg and SSR Analysis

It is important to note that this feedstock problem appears to be isolated to the US Gulf Coast and the difference between Henry Hub and Conway ethane has hit another high in early September – Exhibit 7. The lower Conway pricing is of benefit to the two mid-west LYB ethylene units and the one WLK unit, but the assets, while helpful, are not significant enough in the grand picture for either company.

Exhibit 7

Source: Midstream Business, Bloomberg and SSR Analysis

While there is more new ethylene capacity to start up in the US Gulf over the next 6-9 months – Exhibit 8, there is an expectation that more fractionation and pipeline capacity will release a great deal of ethane trapped in the Permian today and that there shouldbe enough to satisfy current and future needs at much lower prices than we see today. That said, few would have forecast the spike we see in ethane today.

Exhibit 8

Source: Company Reports, IHS and SSR Analysis

The risks are twofold:

  • Ethane stays high because, although some or all of the bottlenecks from the Permian go away, new capacity for ethylene still requires incremental ethane from the Northeast – which has considerable transport costs and will be competing for volume committed for exports for INEOS from the new terminal in PA.
  • The low pricing for ethylene in the US continues to have a degenerative impact on the global markets and the pricing weakness that we have seen in PVC and polyethylene carries through to other derivatives or simply accelerates and undermines the high ethylene prices in Europe and the US indicated in Exhibit 1. European and Asian ethylene prices are summarized in Exhibit 9 and have been volatile but volatile at levels well above production costs – so far this year. The most recent moves have, however, been negative.

Exhibit 9

Source: Bloomberg

If what we outline above persists, we are going to see some significant earnings disappointments from LYB, WLK, DWDP, and EMN.  WLK was protected because of its exposure to the ethylene spot market, but that is little help when ethane pricing is pushing up spot ethylene prices. Integrated polyethylene margins in the US have now fallen to their historic average .  See recent work on LYB

Note that while none of these companies is expensive, none is close to what we would consider trough valuation – LYB has some yield protection versus the rest of the group, but if the cost curve in Exhibit 1 persists and global ethylene pricing falls to reflect the curve, LYB will likely not be able to afford its dividend.

Lastly, Dow should give a bonus to whomever it was insisted (at the last minute) on building some propane flexibility into its new Gulf Coast ethylene unit!

©2018, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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