North American Polyolefin Industry: Challenging Long Held Truths

In North America, petrochemical consultants, market experts and industry commentators have over the years put forth a series of “truths” about the North American polyolefin industry. Some of those “truths” are that:

1. Logistical barriers in North America keep imports at bay; as a result, imports of polyolefins to the region are not large, and won’t be large enough to impact the domestic market
2. North American producers can export low-cost ethylene derivatives anywhere they want
3. There is so much margin for polyolefins in the region, particularly for polyethylene, that the regional industry will remain profitable regardless of the level of investment

Is that so?

Today, we will take a look at how some of those “truths” were successfully challenged last year, and the impact the challenges to those “truths” have had in the industry ever since. And then, we will put those truths to the test, venturing in the territory of “what would happen if” those truths were not to hold water in the future.

Let’s start with a little story…

Polypropylene: From the Ugly Stepsister to Industry’s Darling

For the longest time, polypropylene was the “ugly step sister” of the polyolefin family: poor, with fixed (and low) margins and crazy volatile prices. Even worst, poor polypropylene had no control over its faith. It was always the “mighty” (ahem) propylene deciding on its future. Propylene scarcity in North America, one of the unintended results of the lightening of the regional olefins cracking industry, had really affected polypropylene.  Propylene in the region was scarce and its prices were at times higher than those from the rest of the world and extremely volatile. Price formulas for polypropylene which fixed margins and forced prices to move in lock step with propylene were devised. Monthly swings in prices of as much as 10 or 15 cents per pound became normal. A very challenging pricing environment took hold.

North American PP Homopolymer & Polymer Grade Propylene Prices

Sources: ChemPMC Estimates (PP Homopolymer Domestic Discounted and Spot Domestic), ChemOrbis (PGP Spot Domestic U.S.)

With volatility and high prices, what happened to poor polypropylene? Product substitution ensued; demand was impacted, exports suffered and the product became even less attractive from an investment standpoint. As we can see in the next chart, by 2014 the region’s exports were just a third of what they were at their 2007 peak.

NAFTA-Region Polypropylene Trade

Source: PetroChemical Alliance International Consulting Group “Statistical Yearbook of the Americas”

But, to everybody’s surprise in this ugly scenario, North American domestic demand for polypropylene started to recover and to slowly grow. You have to admit, the material is versatile… It can replace a lot of other stuff, and depending on the relative price of the other “stuff”, it does. Polyethylene, polystyrene, even engineering polymers can be substituted by polypropylene… But I digress; the key thing is that we found ourselves in a market where demand was growing but ability to produce the material was not. And one thing we forgot to mention; capacity had been rationalized during the “ugly” years, not leaving much slack in the system. By 2015, domestic demand had surpassed the regional production; the NAFTA region supply was for the first time balanced with demand…

NAFTA-Region Polypropylene Supply & Demand Balance

Source: PetroChemical Alliance International Consulting Group “Statistical Yearbook of the Americas – Thermoplastics”

So, what was the industry facing?

Increasing demand Vs. Constant (and reduced) Supply.

And therefore, guess what happened?

Money happened! The happy times were here!

Pricing formulas that fixed margins were scrapped. We were now in a brave new world. Contract prices were now freely negotiated; formulas for PP contracts disconnected from propylene; margins expanded… The good times had arrived!

North American PP Homopolymer Domestic Discounted to Spot PGP Spread

Sources: ChemPMC Estimates (PP Homopolymer Domestic Discounted, Propylene to PP Variable Conversion Costs), ChemOrbis (PGP Spot Domestic U.S.)

So polypropylene margins in North America expanded. And polypropylene prices in North America, which were already out of step with the rest of the world, expanded their difference with prices in other regions. Why not? Here is where the “truths” come to play… Remember truth #1?

1. Logistical barriers in North America keep imports at bay; as a result, imports of polyolefins to the region are not large, and won’t be large enough to impact the domestic market

It’s the truth! It has always been like that! And it will always be!

But…

The Polypropylene World: Change, Change, Change

At the same time that polypropylene was becoming scarce and expensive in North America, the rest of the world was moving on. This was especially the case in China; the country is the world’s largest consumer of polypropylene, and this fact, together with increased investment in on purpose propylene production in the country, resulted in a continued wave of PP capacity expansions. The expansions in PP capacity in the country meant that, by 2015, the country had become virtually self-sufficient in polypropylene.

What’s the meaning of this change? It means that China, the market of choice for exporters, would require less and less polypropylene imports. We can see this in the country’s import stats, that show how imports, particularly those of homopolymer polypropylene, have been contracting since 2012, and the reductions accelerated after 2015.

China Polypropylene Imports

Source: ChemOrbis Stats Wizard

As a result, the situation in the Asian polypropylene industry was experiencing exactly the opposite than what was being experienced in the United States. The Asian market was more than well supplied. Prices, which for a short period of time after oil collapsed in 2014 provided producers with attractive margins, suffered a correction and margins got squeezed. There was more material than what the market could bear.

China Polypropylene Homopolymer to SK Spot PGP Spread

Sources: ChemPMC Estimates (Propylene to PP Variable Conversion Costs), ChemOrbis (China CFR Polypropylene Homopolymer, Propylene FOB SK)  

As China increased its self-sufficiency, about 2.4 million metric tons of homopolymer (2 million, if we discount the United States exports), required a new home. And it was time for suppliers to the Asian market to look for greener pastures.

Reduction in Chinese PP Homopolymer Imports by Country of Origin

Source: “Trade Map, International Trade Centre, www.intracen.org/marketanalysis“

The problem is that there are not many places big enough to replace the Chinese imports. Yes, you can send more product to Latin America (which Middle East and Asian producers did). Yes, you can send more product to Africa (which was done). But the deficit in those markets is nowhere near enough to compensate for the losses in China.

Wait, what do you say? What about North America? Can they send more its way?

Exporters to China wished they could. And, like in a Disney story, their wishes came true… Let’s look at it.

The Fortress North America: Barriers with a soft underbelly…

North America had historically been impervious to polyolefin imports. Why would that be? Well, because of non-tariff, logistical barriers against imports. You see, converters in the region are large. On “average”, converters in North America consume more than 10 KT of polymers per year (ChemPMC’s estimate). But, in reality, consumption concentrates in a smaller number of converters, whose plants on average can consume more than 40 KT of polymer per year, some even more. A converter of this size has very specific logistic requirements in order to be supplied with material. That is, polymer delivery needs to take place in bulk, by railcar or hopper truck. Most converters of this size keep their inventory in railcars, which are kept in holding yards waiting to be consumed. These logistical requirements effectively resulted in a non-tariff barrier against imports.

Why? Because material that is traded internationally tends to be packaged in either 20 kg bags or 1000 kg supersacks, that are transported in 20’ and 40’ seaborne containers. As a result, if a company wanted to serve those large converters in North America with imported material, they had to invest in the infrastructure to break bags and transfer them into bulk. In addition, they would have to secure hopper railcars or trucks to transport the material to the converter facility or holding yard. The problem then is that, in order to commit to do the investment in the required infrastructure, the supplier must secure a margin attractive enough (and for long enough) in order to make the investment profitable.

This, in efficient markets, is hard to achieve. That is because, as arbitrage opportunities (price differentials that justify the transportation cost and provide margin for the seller) open up, they tend to be short lived. Imports head the way to the higher price market, until prices correct and it is no longer attractive to bring product in.

But let’s look at what happened with polypropylene prices in North America. As you can see in the next chart, starting in mid-2015 the prices in North America were well above Asian prices, and not for a short period of time. Between the 3^rd quarter of 2015 and the 3^rd quarter of 2016, the arbitrage spread between North American spot prices and China CFR prices was way higher than the cost to to ship, de-bag and deliver polypropylene to North American converters. That sustained differential provided enough margin for importers (which could be traders as well as converters themselves) to invest in the necessary infrastructure and begin importing material into North America in larger volumes.

North America to China Price Arbitrage

Sources: ChemPMC Estimates (PP Homopolymer Spot Domestic, Transportation & Debagging Costs Estimate), ChemOrbis (China CFR PP Homopolymer Prices)

And invest they did, and import they did as well! As you can see in the next chart, soon after the arbitrage opened up in the 3^rd quarter of 2015, imports started to increase dramatically, and continued at that elevated level for as long as the arbitrage opportunity was open! And as soon as the opportunity closed, imports corrected.

Arbitrage Versus Imports

Sources: ChemPMC Estimates (PP Homopolymer Spot Domestic, Transportation & Debagging Costs Estimate), ChemOrbis (China CFR PP Homopolymer Prices), “Trade Map, International Trade Centre, www.intracen.org/marketanalysis“

But there is another thing to consider. Once the investment is done, it becomes a sunk cost. Therefore, with no additional investment required, as soon as an arbitrage opportunity opens, importers can take advantage of it, and will bring material into North America. The market had finally become efficient. We can see this on the prior chart; once the infrastructure was in place, as prices go above a certain threshold established by the transportation + debagging costs, imports expand and prices soon after correct.

Why is this important? Because in an efficient market, price differentials across regions will tend to moderate. If they were to open up because of regional reasons like supply disruptions (arbitrage opportunity!), imports would come, pushing supply closer to demand and equalizing prices across regions. The true development of a global price had finally taken place!

With this, polypropylene prices in North American will now be dictated by the highest cost region on a global basis, at a level that justifies reinvestment economics in the highest cost region, and with global prices equalized on a net-back basis to the lowest cost region on a global basis. On the positive side, U.S. producers can take comfort in the fact that those global prices still provide better returns than in the past, potentially providing enough margin to justify re-investment economics – as long as propylene prices remain in the dumps…

North American PP Homopolymer & Polymer Grade Propylene Prices

Sources: ChemPMC Estimates (PP Homopolymer Domestic Discounted and Spot Domestic), ChemOrbis (PGP Spot Domestic U.S.)

North American PP Homopolymer Domestic Discounted to Spot PGP Spread

Sources: ChemPMC Estimates (PP Homopolymer Domestic Discounted and Spot Domestic), ChemOrbis (PGP Spot Domestic U.S.)

What does this mean for polyethylene?

Polyethylene is in the midst of an escalation in capacity without precedent in this region. Capacity is expected to increase north of 6 million metric tons in the next four years, and virtually all of this new production needs to be exported. Remember the truths? These investments make sense when seen under the prism of truths 2 and 3:

2. North American producers can export low-cost ethylene derivatives anywhere they want
3. There is so much margin for polyolefins in the region, particularly for polyethylene, that the regional industry will remain profitable regardless of the level of investment

Up until 2017, with the exception of Braskem Idesa’s Etileno XXI project, polyethylene capacity in North America had not expanded significantly. In spite of this, exports out of the United States have continued to grow. This exports growth has been incentivized by the impressive margins that North American polyethylene sales are currently achieving.

United States Polyethylene Exports

Source: PetroChemical Alliance International Consulting Group “Statistical Yearbook of the Americas”

North American Discounted Contract PE Prices & Spot Ethylene

Sources: ChemPMC Estimates (LDPE, LLDPE & HDPE Discounted Contract Estimates), ChemOrbis (Spot Ethylene USA)

One fundamental difference between polyethylene and polypropylene is that, so far, polyethylene margins have not been curtailed by the global polyethylene industry. Imports are negligible, which is the factor we mentioned that has affected polypropylene since last year. But the one factor that positively impacts polyethylene is that global prices are being pushed high by Asian ethylene. There is very little value in the polyethylene side of the Asian margin equation, with all the margin being “protected” inside ethylene (see next chart).  So polyethylene producers in North America don’t feel the need to have the regional prices peel away from the global prices (which was the case in the polypropylene chain) in order to enjoy high margins. By keeping North American prices aligned with global prices, PE margins are huge and large enough to defend their domestic market and export virtually everything they make everywhere.

Far East Prices

Sources: ChemOrbis

Global HDPE Prices

Sources: ChemPMC Estimates (North American Discounted Contract Estimates), ChemOrbis (China CFR HDPE, Spot Ethylene USA)

Therefore, it appears that truths 2 & 3 hold truth for polyethylene. However, sustaining the future profitability of the polyethylene industry will rest in the North American producers’ ability to efficiently export all polyethylene outside of the region. The only companies that can compete with North American producers, besides Middle Eastern producers, are themselves. So failing to remove all the new polyethylene from North America may be the #1 risk that producers will face. This reinforces the importance of understanding the logistical infrastructure that is in place in the region and the measures that all the participants in the value chain are executing to ensure that the region can continue to export efficiently in the future.