February 12, 2012

Global Petrochemical Feedstock Developments: The Implications for GCC Players

Petrochemicals feedstock developments across the world namely the shale gas boom in the US, gas shortage in the Middle East and Coal-to-Olefins developments in China provide new opportunities to GCC petrochemicals players but require new capabilities.

Following two decades of expansion driven by an abundance of natural gas at advantaged prices, GCC petrochemical companies established a leading position in their industry. However, recent shifts in both supply and demand have led to growing gas shortages of natural gas in the region. At the same time, feedstock developments in other parts of the world pose threats as well as provide opportunities to GCC players. Booz & Company’s latest report on these feedstock developments analyses these threats and opportunities and provides the implications for Middle East petrochemicals players.

“The region’s diversification effort to increase non-oil-related GDP has seen boosts in local employment, including in industrial sectors that are energy-intensive, and driven by low gas prices. As a result, the GCC is projected to experience a sizable—and growing— shortfall in natural gas for the coming years. Consequently, ethane supply is not expected to grow significantly and most of the anticipated supply is already committed to existing and new projects”, said Andrew Horncastle, partner with Booz & Company.

Adapting to this, petrochemical companies have shifted to more liquid feedstocks. Most new major projects across the region (such as the Saudi Aramco-Dow Chemical venture, Sadara) are expected to use mostly liquid feedstocks. This move to liquid feedstocks will reduce profit margins and overall competitiveness for GCC players, as they do not offer the same cost advantages as gas feedstocks.

Elsewhere in the world, feedstock developments are making petrochemical players more competitive. New sources of shale gas in North America, promising production technologies such as coal-to-olefin initiatives in China and conventional gas from the redeveloped sector in Iraq are all impacting the industry. Each development presents a significant potential discontinuity, but they all include uncertainties regarding precise production levels, the degree of competitive advantage for local petrochemical companies, and other factors. Still, in the aggregate they can lead to major changes in the industry and require close scrutiny.

North America: Advances in Shale Gas

Shale gas is currently projected to become the dominant source of natural gas in the U.S. by 2035. The growth in shale gas production has effectively decoupled natural gas prices and oil prices. From their peak in mid–2008, oil prices have fallen roughly 35 percent through late 2011, while natural gas prices have fallen some 68 percent. Unconventional natural gas sources such as shale gas will cap gas prices over the long term at $6 to $7 per million metric BTUs (mmBTUs).

“A significant uncertainty regarding shale gas is the ‘richness’ of the U.S. basins, or the relative levels of ethane and propane in the gas they generate. Gas from western wells is rich in ethane, making it more attractive as a feedstock. If this propensity continues, it could lead to new feedstock sources for U.S. petrochemical players, increasing their competitive advantage,” said Asheesh Sastry, principal with Booz & Company. “Reliable development of North America’s shale basins though will have to overcome environmental challenges, such as those posed by hydraulic fracturing or ‘fracking’ techniques and the production of high amounts of methane gas, as well as infrastructure obstacles.”

Europe: Limited Shale Gas Potential

The European petrochemical industry is driven by naphtha feedstocks, with a smaller percentage of natural gas. Natural gas from conventional sources is declining rapidly, and although shale gas has been discovered in some regions, it is unlikely to replace that supply. Technically recoverable shale gas resources in western Europe amount to about 370 Tcf, primarily in basins located in France and Scandinavia, which have fairly dense populations, little service infrastructure, and vocal opposition to environmentally unfriendly techniques such as fracking.

Poland and eastern Europe (including Ukraine and Romania) also have reserves of more than 200 Tcf, with lower population density and fewer environmental constraints. However, as with the rest of Europe, the basins cross national borders and have a range of geologic factors that make the development of shale gas a greater logistical challenge than in the United States. Further complicating matters, landowners do not typically share in the wealth generated from mineral development, reducing the incentive for them to allow drilling. These factors all lead to greater production costs and higher breakeven prices. As a result, shale gas is unlikely to become a substantial factor in the petrochemical feedstock mix in Europe.

China: Shale Gas and Coal-to-Olefins

China’s technically recoverable shale gas reserves are estimated at 1,275 Tcf, primarily in the Sichuan and Tarim basins, which feature the right geologic conditions. Other major basins in China, such as the Ordos, have the potential for coalbed methane and tight gas.

“The sheer size of China’s shale gas reserves poses a threat,” said Horncastle. “Production is not likely to increase substantially until 2020, and even then, the specific impact of the disruption is hard to quantify at this point—a more immediate and potentially larger disruption could come from China’s significant, recent investments in leveraging coal as a feedstock for petrochemicals.”

Combining the potential impact of shale gas and CTO technology, China’s feedstock market represents both the greatest potential disruption to the global petrochemical industry and the most significant uncertainties. The most optimistic scenario suggests that these two developments could add approximately 30 percent to China’s feedstock capacity in the short to medium term. However, this estimate remains highly uncertain.

Iraq: Tapping Oil and Gas Reserves

Iraq is emerging as a potential new source of feedstocks. The country’s oil and gas sector is undergoing a comprehensive redevelopment program and the government is now seeking to tap its sizable reserves.

The magnitude and timing of gas production growth in Iraq is highly dependent on oil production growth. Field development rights have been awarded to international oil companies in three licensing rounds, in which the treatment of gas varies. In some cases, gas will be gathered, processed, and marketed by the Basrah Gas Company. In other cases, individual license holders are required to gather and process gas and deliver it to the Ministry of Oil. For non-associated gas fields, the licensee will develop the fields in return for a fee. In all cases, current gas reserves of 112 Tcf will likely be expanded.

Iraqi oil production is subject to a wide range of uncertainty. Consequently gas production, ethane production and ethylene capacity in Iraq are subject to similar disparities regarding growth potential. Despite this uncertainty, we believe that the country could potentially add significant ethylene capacity by 2025.

Long-term Implications of New Feedstock Developments

Regardless of their impact in the short term, these feedstock sources present both material threats to the profitability of GCC players and new growth opportunities to consider.

“The shifts in the cost curve could lead to more competitively-priced feedstocks and new petrochemical capacity in all three markets: the U.S., China, and Iraq. Capacity additions from these sources could ultimately result in excess supply, and new feedstocks will likely replace older sources such as subscale naphtha crackers in Europe and Asia, pushing traditional players out of the market,” added Sastry. “At a time when petrochemicals production cost in the Middle East could rise due to the move to liquid feedstocks, the cost and margin advantages that Middle East petrochemical companies have enjoyed during the past few decades will likely decline marginally. Middle East producers may have an opportunity to set up projects in the U.S., China, and Iraq.”

Should China’s energy industry figure out a more efficient means of shale gas extraction, its large reserves will significantly impact upon the market. Middle East producers must hedge their bets, by maintaining both a strong market position in China and sufficient flexibility to react as the situation changes.

Finally, the structural feedstock shifts in the U.S. market, driven by shale gas, will distort the traditional pricing relationship between propylene and ethylene. Propylene margins may have a structural advantage, creating opportunities for on-purpose propylene or other ways to extend into the C3 value chain.

Middle East Producers Need New Capabilities

While dramatic changes aren’t immediate for the current capacity of the region’s petrochemical producers, Middle East companies must now work harder to identify new sources of growth. Below are three strategic responses that they can take:

Invest in petrochemical projects in North America driven by shale gas developments. This option requires enhancing several core capabilities that GCC petrochemical players already possess: financial strength, the ability to bulk produce basic chemicals in an efficient and cost-effective manner, strong partnerships with other enterprises, and a supply chain and distribution network that can be leveraged to source from vendors and deliver to customers in various regions. In addition, GCC players will need to refine their capabilities in terms of establishing large, capital-intensive projects in a cost-effective and timely manner.

Extend downstream into performance and specialty chemicals. This option entails expanding the current product portfolio away from basic chemicals toward end segments. It potentially allows GCC companies to leverage heavier feedstocks within the region and maximize integration synergies. To succeed, petrochemical players will need to diversify their business models in order to reflect different market positions and value propositions for each customer segment. Any company seeking to expand into performance or specialty chemicals will need to build up an innovation capability to protect margins on its more specialized products, along with a better understanding of the business models to serve end-use customers.

Consolidate the industry within the GCC and build scale. This is the most complex strategic option and will involve the full complement of institutional capabilities: financial strength, partnering and integration, efficient bulk processing of basic chemicals, a strong supply chain and distribution network, and the ability to establish capital-intensive projects efficiently and in a timely manner, as well as strong innovation and a solid understanding of suppliers’ and customers’ business models and needs. Most important, these companies will need to be able to efficiently run Verbund sites in customers’ markets in order to effectively capture synergies.

“GCC petrochemical players have some clear choices in how to respond to this competitive threat, through a number of strategic options both upstream and downstream in the value chain. However, each option requires a specific set of underlying capabilities,” concluded Horncastle. “Though many companies have some of these capabilities currently in their operational arsenal, they will need to be strengthened. Others may not exist within the enterprise at all, requiring that companies implement them entirely from scratch. Given those needed changes, it’s crucial that companies identify the best match between their current strengths and the future capability requirements of each strategic option.”

Companies cannot fight this battle on every front; instead, they must conduct an honest assessment of where their current strengths lie, along with areas in which they can make the most immediate and dramatic improvements, and then select the strategic response that provides the best match.

More Private Equity reports and whitepapers are available on the site’s Energy Thought Leadership page.