The Feedstock Advantage Continues for North American Chemical Companies

The boom in shale oil and gas has given North American chemical companies a feedstock advantage relative to their competitors in other regions. The recent plunge in the price of crude oil has led industry participants and market observers to consider whether the feedstock advantage is sustainable and long lasting. We believe that this advantage will continue and that the market dynamics promoting the North American Chemicals 2020: Capturing Opportunities in the Revitalized Industry will not be significantly affected.

Pricing Dynamics Spurred Investment

The attractiveness of North America–based production of major chemical building blocks and their derivatives, especially methane and ethane derivatives, is based on two somewhat interdependent factors:

• The Low Price of Natural Gas and Natural Gas Liquids (NGLs), Especially Ethane, in Absolute Terms. Because ethane is a by-product of natural-gas drilling, it tends to trade at its marginal disposition in the market. Since 2012, the supply of U.S. ethane has greatly exceeded the market’s ability to consume it. As a result, the price of ethane has fallen to its fuel equivalent, which is historically low per gallon and per British thermal unit (BTU).
• The High Price of Heavy Feedstock Relative to Natural Gas and NGLs. Heavy feedstocks are derivatives of crude oil. When crude oil traded consistently above $90 per barrel, from 2011 through 2014, the ratio of oil price to gas price on a barrel-of-oil-equivalent basis was often more than 3 to 1 and reached as high as 9 to 1.

These factors combined to create a substantial advantage for U.S. chemical production—for example, U.S. ethylene producers using ethane enjoyed cash margins of nearly $1,000 per ton. (See the exhibit, “North American Ethylene Producers Enjoy a Significant Feedstock Advantage.”) These pricing dynamics spurred a tremendous amount of investment in gas-based production capacity, as product prices globally continued to be set on the basis of utilizing heavy-feedstock capacity in production.

The Oil Price Plunge Has Limited Effects

From the last quarter of 2014 through the first quarter of 2015, the price of crude oil declined rapidly and sharply, by more than 60 percent from its highs. Natural gas prices also declined, and the ratio of oil price to gas price decreased toward 3 to 1. Some in the industry feared that construction of gas-based production capacity in the U.S. might be halted even before the first new units became operational.

Around the globe, some petrochemical projects were canceled or delayed indefinitely, including several greenfield projects and expansions in the Middle East and North America and a gas-to-liquids project on the U.S. Gulf Coast.

In our view, the recent plunge and volatility in the crude-oil market may cause new investors to reconsider or delay announcing new projects or put off initiating construction. However, we believe most projects that have already broken ground, or are close to doing so, are likely to proceed.

Two reasons support our conclusion.

First, although we do not expect a significant, sustained recovery in oil prices in the near to medium term, the low prices reached in January 2015 are not likely to be sustainable over the long term. (See “Lower, and More Volatile, Oil Prices: What They Mean and How to Respond,” BCG article, January 2015.) In the medium term, prices below $50 per barrel for Brent crude support only 34 percent of planned production additions through 2020. In the long term, reinvestment economics require that oil prices exceed $70 to $80 per barrel, depending on how the cost structure within the entire energy industry evolves. Many OPEC countries are running budget deficits at current oil prices, which is sustainable in the medium term but not forever.

Second, the long-term fundamentals supporting the opportunity for investors in new projects are still in place, including low-cost, abundant U.S. shale gas and NGLs:

• The feedstock dynamics in the U.S. that are driving the availability and low cost of natural gas and NGLs are not materially affected by low oil prices. Shale oil drilling has slowed but drilling for shale gas, which creates the majority of NGLs, has not. In the U.S., approximately 1,500 trillion cubic feet of natural gas (the equivalent of 30 years’ supply) is extractable at costs below $5 to $6 per thousand cubic feet. In fact, the decline in the production of associated gas from shale oil may actually drive incremental demand for shale gas. The oversupply of U.S. ethane is not affected by low oil prices and, combined with the declining price of natural gas, has meant that ethane has actually become cheaper per gallon and per BTU. Our forecast for the ethane supply-demand balance indicates that the oversupply will continue, which suggests that ethane will trade at the historically low fuel value for years to come.
• Product prices will still be set on the basis of naphtha-based production, which is a more expensive production route than using ethane at or near its fuel value. Naphtha’s value is trending lower, in line with crude oil and the North American gasoline trade balance; however, the price difference between naphtha and ethane is still substantial, as is its impact on the economics of ethylene production. Our research indicates that the global ethylene supply curve flattened as of January 2015, but U.S. producers still earn cash margins of approximately $500 per ton. If crude-oil prices recover, naphtha prices should recover as well, which would increase ethane’s cost advantage.
• Market demand is still strong. Most of the projects announced relate to the production of base chemicals, polymers, and intermediates. Growth in these product segments is generally driven by global GDP, and other products cannot be readily substituted for them. Ethylene alone was a 133-million-ton market in 2013 (as measured by demand) and had been growing at 3 to 4 percent annually. Multiple world-scale steam-cracking complexes are required each year to maintain current operating rates.
• The lower crude-oil price may ease cost pressures for petrochemical projects. In 2013 and 2014, the large number of new projects simultaneously planned in the U.S. heightened investors’ concerns about project overage risks with regard to both cost and time to completion. However, these risks may be mitigated, because the slowdown in shale oil drilling may divert skilled labor and engineering, procurement, and construction capacity to projects along the Gulf Coast.
• Capital continues to be available. Interest rates remain low and project financing is plentiful, whether for strategic investors with big balance sheets or consortia of financial investors looking to get involved.

It is also important to note that crude-oil prices appear to have stabilized above the price many analysts believed was the floor (approximately $40 per barrel). So, if projects have not been canceled yet, they are unlikely to be canceled in the future. Indeed, new project announcements have resumed as crude-oil prices have started to recover and stabilize. Moreover, many new projects are not expected to come onstream until 2017 or 2018. Depending on how quickly crude-oil prices recover, the low-price environment may not even affect these projects’ economics.