The risks of oversupply in the Gulf petrochemicals sector

03 November 2009

Gulf petrochemicals producers are suffering as demand falls and key markets restrict imports

With demand for petrochemicals at its lowest level in three years, Gulf producers could hardly have chosen a worse time to add new production capacity. Yet they now have to find customers for an extra 15 million tonnes of output a year.

As they cry foul over protectionist measures in overseas markets and contemplate a future in which access to cheap gas feedstock is more restricted, companies are having to fight to retain market share. How they cope will play an important role in the success or otherwise of the efforts of Gulf governments to diversify their economies.

The problems in the industry have been evident throughout the year. When petrochemicals giant Saudi Basic Industries Corporation (Sabic) reported a net loss for the first quarter of 2009, analysts were shocked. They had predicted weak earnings for the three months to March, but not the SR974m ($260m) shortfall the company suffered, its first deficit in almost seven years. A collapse in demand had cut revenues and helped push the region’s biggest listed company into the red.

The results were not just a surprise for analysts; they were also a concern for other Gulf states. The petrochemicals industry has long been seen as the perfect way for oil-rich countries to diversify their economies and create jobs. Sabic, which has dominated the regional industry since the 1970s, was the example that others followed.

Declining profits

The Saudi giant managed to recover some lost ground in the following two quarters. From April to June, it booked a SR1.8m profit, and doubled that in the third quarter to SR3.6bn. But even that was just half the SR7.2bn it made in the third quarter of 2008.

A similar tale is offered by other Gulf producers. Fellow Saudi producer Sipchem has also suffered sharp falls in profitability this year. In the first quarter, it made a SR29.2m profit, 98.3 per cent less than in the same period last year. In the second quarter, its profits were just SR511,000, a 99.6 per cent drop, and in the third quarter they were SR54.7m, or 60 per cent less than a year earlier.

The UAE’s Borealis, which is jointly owned by International Petroleum Investment Company of Abu Dhabi and Austria’s OMV, made a e56m ($83m) loss in the first quarter of this year. It turned this around in the following two quarters, but its overall e25m profit for the first nine months of the year is still well behind the figure of e361m for the same period in 2008.

Gulf producers would be even worse off with-out the cost advantages they have over inter-national rivals. Saudi producers spend about $200 a tonne turning ethane – a by-product of the oil-refining process – into ethylene, which can be used to make everything from polyethylene plastics to detergents and polystyrene packaging.

By contrast, ethylene costs North American and European producers anything from $535 a tonne to $915 a tonne to produce, according to analysts at UK bank HSBC. South Korean producers find it even more expensive and spend as much as $1,015 a tonne.

It is because of these cost advantages that companies across the Gulf decided in the middle of the decade to build vast new petrochemicals plants. Billions of dollars were poured into new crackers to convert ethane into ethylene.

At the time, there was widespread optimism that growth in demand would continue in the coming years – petrochemicals demand tends to closely follow global economic growth, which from 2004 onwards had averaged about 5 per cent a year. Unfortunately for Gulf producers, those hopes of continued economic prosperity proved unfounded.

From August 2008, when prices started to slip, until March 2010, 15 million tonnes a year of new ethylene capacity will be added in the region. At the same time, China is adding 8 million tonnes a year (t/y) of ethylene capacity to its production lines.

“We started out…with an inflated view of growth and thought we needed this capacity to feed it. But it wasn’t sustainable”

Paul Hodges, chairman, International Echem

But as a result of the global economic slowdown, demand for petrochemicals is forecast to fall by more than 2 per cent this year. Paul Hodges, chairman of UK-based consultant International Echem, says this year global demand for ethylene products will fall to the same level it was at in 2006 – about 115 million tonnes. Even before the additional capacity in the Gulf and China had come onto the market, production stood at more than 132 million t/y.

“We have a tidal wave of capacity coming on stream,” says Hodges. “We started out in the boom years of 2003-08 with an inflated view of growth and we thought we needed this capacity to feed it. But it wasn’t sustainable and now, even with levels of 2.5 per cent of growth in the global economy, we have a lot of extra capacity to contend with.”

Gulf producers, who are using the most efficient technologies at their new plants, should be in a  better position to cope than producers elsewhere, who have older, less efficient plants and have to pay higher prices for raw materials. But governments in those regions, faced with rising unemployment, are supporting domestic producers by restricting imports.

“The problem is that these old crackers are being sustained at a high cost to keep jobs,” says Hodges. “While these countries won’t be able to export, the danger is that they might stop imports of ethylene products.”

The result is that low-cost Gulf producers will have to battle for market share in the coming years with rivals protected by their governments. That situation will continue until demand rises to meet supply. Hodges does not expect that to happen before 2012.

A rise in protectionism is already evident, according to Abdulwahab al-Sadoun, secretary general of Dubai-headquartered trade body the Gulf Petrochemicals & Chemicals Association. On 12 October, the association released a statement condemning what it said were anti-competitive measures by the US, the EU, India and China in investigating Gulf producers for ‘dumping’, or selling their produce below cost.

“During recessions, you would expect protectionist measures to increase, and this is a norm in this business,” says Al-Sadoun. “Having said this, Gulf producers have developed a cost competitiveness that has allowed them to withstand the downturn. Any protectionist measures taken in export markets are going to be counterproductive. The downstream industries of those countries will have to purchase their commodities at higher prices, and this will make them less competitive when they export finished and semi-finished products.”

Despite these tough market conditions, both Al-Sadoun and Hodges say Gulf producers will ultimately prevail and increase their market share. “In the commodity business, the Gulf producers will expand their share of global output and they will expand in Europe, Asia, and the US, which will become a net importer of polyolefins [such as polyethylene] by the year 2010,” says Al-Sadoun.

Industrial clusters

He adds that joint ventures and investments in markets such as India and China will help cement the position of Gulf producers. They should also be helped by the planned expansion of facilities using naphtha, another by-product of oil. This can be used to create a far wider range of petrochemicals products, although it does not offer the same cost advantages as ethane-based production, as naphtha is sold on the open market as a gasoline product.

Ethane, however, remains in short supply and petrochemicals firms are increasingly having to compete for it with power plant developers, so naphtha is one of the few options for producers wishing to grow. Saudi Arabia, for example, has not issued a new allocation of ethane to a petrochemicals company since 2006.

Al-Sadoun says the next step for petrochemicals producers is to create giant complexes that are fully integrated with the refineries that supply them with ethane or naphtha, and with the industrial clusters that use their products. Such schemes could provide significant employment opportunities and encourage local chemicals-based businesses to spring up across the Gulf.

In the short term, however, the region’s petrochemicals producers are at the mercy of foreign governments trying to control access to their markets and need to see wider economic growth. “It all depends on the economic growth of countries like India and China,” says al-Sadoun. “We just hope it is sustainable.”

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