Global petrochemicals Who is really benefitting from the growth in the new world?

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1 Competence Center Global Chemicals 1 Dr. Jaap Kalkman, Dr. Alexander Keller Global petrochemicals Who is really benefitting from the growth in the new world? Competence Center Global Chemicals

2 2 Global petrochemicals Who is really benefitting from the growth in the new world? Europe and the US historical hubs for the petrochemicals industry Building on both abundant oil and natural gas resources and strong government support, Europe and the US have developed large petrochemical clusters. In the US, Houston's Galveston Bay hydrocarbon cluster was producing 30% of the country's petroleum and 50% of its ethylene and propylene already in the 1940s. In Europe, the first petrochemical cluster was established in 1955 in Rotterdam to provide companies operating along the petrochemical value chain easy access to feedstock. A second cluster soon followed: Established in 1963, the Antwerp cluster has since become Europe's largest center for ethylene production. These early establishments of petrochemical clusters coincided with significant demand in the West, location not being an issue because of the collocation of market and feedstock access. Then the increase in demand for oil, lubricants and synthetic rubbers during World War II along with the commercialization and internationalization of new technologies during the reconstruction of Europe afterwards helped grow the industry further. In 1980, Europe and North America accounted for roughly 62% of the global petrochemicals production. Governments play a key role in developing the petrochemicals industry by incentivizing the establishment of clusters and R&D activities, building the necessary infrastructure and setting up the supporting educational system. This has helped establish Europe and the US as knowledge and technology centers for the entire industry. However, new entrants began challenging their dominance during the 1980s and 1990s on the grounds of cheap feedstock as well as targeted governmental investments and protectionist measures.

3 Competence Center Global Chemicals 3 When oil and gas prices increased sharply in the 1980s, countries in the Arabian Gulf started to leverage their cheap and abundant feedstock to develop their petrochemicals industry. Petrochemicals companies thus acquired a substantial pricing advantage compared to Western producers of ethylene, backed by additional action of the Gulf governments to foster domestic demand. The Singaporean government chose a different path in the 1990s and invested more than USD 23 billion in the Jurong hydrocarbon cluster. The government focused specifically on education and R&D to increase university throughput, attract foreign talent and effectively build a sound knowledge base in Singapore. These investments, along with similar efforts more recently in India and China, have eroded the dominant position of the West, and today, the US and Europe combined represent only 30% of the global petrochemicals production, less than half compared to 30 years ago. These examples demonstrate that the key drivers of the petrochemicals industry, namely proximity to demand, access to feedstock, access to talent and technology as well as supportive government actions, have stayed the same for the last 50 years. But the dynamics of these drivers are changing today's environment in the petrochemical market, requiring participants to adapt their operating models.

4 4 Global petrochemicals Who is really benefitting from the growth in the new world? Demand is moving East Market growth in polyolefins 1) is increasingly being driven by Asia Pacific and more specifically by China. The consumption in China is expected to grow at high annual rates throughout the decade, contributing to a healthy expected consumption growth rate in all of Asia of 5.5% per annum. A similar pattern is expected for Latin America, where consumption of petrochemicals is expected to increase substantially going forward, albeit from a lower base. The key underlying driver for this strong market growth in Asia is the economic development in China and to a slightly lesser extent in India. China currently has a per capita consumption of polyethylene and polypropylene of 10 kg per year, which is considerably less than the European per capita consumption of 45 kg per year. Estimates suggest approximately 500 million additional consumers will spend increasing proportions of their income on non-food items over the next 15 years. Many of these will be products derived from or based on petrochemicals. A similar development is expected in India with its significant and increasingly affluent middle class population. 1) Consumption of polyolefins is a suitable proxy for petrochemicals demand, as they are not used for captive consumption to produce other petrochemicals, but are used directly for numerous petrochemical applications such as automotive and packaging.

5 Competence Center Global Chemicals 5 Shale gas changes feedstock patterns Recent advances in oil and gas extraction techniques (e.g. horizontal drilling and hydraulic fracturing), along with high oil and gas prices, have made the exploitation of unconventional gas resources such as shale gas, coal-bed methane gas and tight gas economically feasible. Large quantities of proven shale gas reserves have been identified across the world and recent reports suggest that some 6,600 trillion cubic feet (tcf) of technically recoverable shale gas exist across 33 major countries. The US and Canada have significant shale gas resources and their exploitation is being pursued with high priority; the impact is already being felt on gas prices in the US. This development may well turn out to be a massive opportunity for the US petrochemicals industry to gain renewed access to comparably cheap local feedstock from ethane to supply its long-established petrochemicals clusters. For example, Dow Chemical announced plans to increase its ethane cracking capacities on the Gulf Coast by 20-30% and Bayer Material Sciences is interested in hosting an ethane cracker at its West Virginia facilities. In addition to its significant shale gas reserves, China is increasingly using local coal reserves as feedstock for its domestic petrochemicals industry in a bid to reduce dependency on oil-based imports. In Europe, however, shale gas will unlikely provide for significant additional feedstock. The major part of the European shale gas reserves are located in Western Europe, where environmental concerns about exploiting these reserves are very strong. It is therefore unlikely that Europe will exploit new and competitively priced feedstock from unconventional sources in large quantities in the near future.

6 6 Global petrochemicals Who is really benefitting from the growth in the new world? Advantage of cheap feedstock in MENA is unsustainable The increasing use of unconventional sources of feedstock as well as the recent discoveries of new gas resources have made ethane an abundant feedstock for the petrochemicals industry in many parts of the world. In the US, for example, prices have halved since 2006 and currently hover around USD 3-4 per mmbtu 2). However, at the moment, ethane prices in the Gulf countries are still the lowest globally at around USD 1-2 per mmbtu due to subsidies or rather the low opportunity cost of feedstock produced from gas. Petrochemicals companies in countries such as Saudi Arabia and Qatar are thus still at a clear cost advantage compared to their international competition. However, the opportunity cost of gas is starting to increase due to the increasing demand for power in the Gulf countries as a result of economic development. In addition to this, ethane production in the GCC is expected to peak soon. The use of enhanced oil recovery technologies will support this upward trend in feedstock prices due to the cost of these technologies and the resulting effect on increasing cost of oil production. Thus, the advantage enjoyed by Gulf companies in terms of access to cheap feedstock is subject to increasing pressure from two sides, as local feedstock prices are rising and those in competitor locations are falling. A similar development is expected for the cost of energy, which is currently very low but is expected to increase in the long-run. However, as these developments are in their infancy, petrochemicals companies in the Gulf region have some time to chart appropriate courses of action. 2) It is noteworthy that prices for ethane per mmbtu in the US currently differ by a factor of 5 from the oil and gas prices, while elsewhere the gap tends to be much smaller.

7 Competence Center Global Chemicals 7 European production assets are becoming uncompetitive The asset base in Europe is ageing, the youngest cracker in Europe having been built in the mid-1990s. According to recent estimates, 14 out of 43 crackers in Europe will become uneconomic by 2015 leading to a capacity reduction of 26%. In addition, new plants being designed and built in the Middle East and in Asia have an average production capacity of 1 million tonnes p.a. whereas the average cracker in Europe is just shy of half this capacity. Closing this gap by investing in new plants or in plant upgrades in Europe will need careful consideration, given the considerable size of such investments and the significantly higher price level for construction work in Europe. European companies are experiencing additional pressure on their margins due to expensive feedstock, high energy cost and ever tightening regulations. This makes it particularly difficult for European and to some degree US companies to compete in commoditized petrochemicals leading some players to consolidate, e.g. the merger between Basell and Lyondell, while others have exited the market to the benefit of companies outside Europe with access to cheaper feedstock, e.g. GE s sale of its plastics business to Sabic. Overall, these trends have resulted in a significantly reduced share of European companies in the overall market. Watching these dynamics raises the following questions: What does this mean for the different players in the market and what are strategic issues they are likely to face? Europe: Technology powerhouse with strong domestic market Europe today is one of the largest petrochemical markets in absolute terms. As a mature market, and its expected growth over the next years is far below those of the growth markets in Asia and the Middle East. However, petrochemicals companies in Europe have developed substantial technology and know-how that they can leverage to access price competitive feedstock and growth markets outside Europe. The excellent education and R&D infrastructure in Europe have helped European petrochemicals companies develop a substantial advantage in terms of technology and know-how. For example, the European industry is highly experienced in successfully developing and operating large-scale clusters such as the BASF Verbund in Germany or the Rotterdam-Antwerp petrochemical cluster. In addition, several waves of cost and process optimization over the years have greatly enhanced their efficiency in plant operations and management. Despite the operational improvements, European players find it increasingly difficult to compete in the commodity market segment due to expensive feedstock and lower growth dynamics in their domestic markets. However, they have built a strong market presence in the specialty chemicals segment, based on longstanding customer relationships as well as an excellent knowledge base. This evolution from commodity chemicals towards specialty chemicals is for example illustrated by BASF, which exited their styrene and fibers business and entering the pigments, plastic additives and care chemicals market by acquiring Ciba and Cognis. Overall, European companies have a very solid home market, access to which is difficult for players from MENA or Asia.

8 8 Global petrochemicals Who is really benefitting from the growth in the new world? To remain competitive in the specialty chemicals business over the long run, European petrochemicals companies can build on their strengths in terms of home market, technology and know-how to gain access to competitively priced feedstock and the major growth markets. They face a number of key strategic questions: > What is the most interesting feedstock in the long term and where is the optimal sourcing location? Moreover, what are the best structural approaches to gain access to these feedstock sources? Is it through joint ventures, through M&A or through organic growth? > Where are the most dynamic growth markets, given the product portfolio and key strengths of individual companies, and how can these markets best be accessed? How far should European companies go into specialty chemicals? > How can they best use their technological and operational know-how edge as a bargaining chip? > What is the best strategy for global R&D, given the importance of technical know-how and the problems with IP protection in several key growth markets? Is it really wise to move key R&D facilities into the emerging markets, or would a "hub and spoke" approach be better for protecting IP? > What should the companies do about their ageing asset base? Should they shut down, upgrade or replace old plants? Should they do this across the board or selectively? How does this tie into their strategy to securing feedstock and market access? > What other strategies might exist other than specialty chemicals or global integration? Are there specific niches that European players are particularly well suited to exploit? The Gulf region: The pending feedstock squeeze The traditional competitive advantage of petrochemicals companies in the Gulf region is their access to cheap feedstock. This advantage, however, will erode in the medium term as the opportunity cost of natural gas as the predominant local feedstock goes up and ethane reserves decrease. Therefore, petrochemicals companies in the MENA region need to gain access to technology and key growth markets to develop their business models beyond their diminishing feedstock advantage. Such an evolution of business models would also provide governments in the Gulf countries with part of the solution to their unemployment problems. Vast numbers of young citizens (about 50% of the population in Saudi Arabia is younger than 25) are demanding sustainable employment opportunities, which the governments can no longer provide in the public sector. The downstream petrochemicals industry is a logical choice for these countries to create valueadding jobs on the basis of their rich natural resources, central geographic location and existing infrastructure.

9 Competence Center Global Chemicals 9 Therefore, initiatives such as Saudi Arabia s Industrial Clusters or Abu Dhabi s Polymer Park concept are important signals that Gulf governments are willing to invest the substantial funds needed for developing a market setup in which integrated petrochemical plants can compete globally without subsidized feedstock. In addition to employment opportunities, further downstream developments provide a way for the Gulf countries to differentiate themselves. A key advantage of the Gulf countries is their geographic proximity and centuries-old trading ties to large emerging markets in Africa and in Asia, especially India. India s population is currently the second-largest in Asia, and is expected to equal China s by By that time, India s middle class will have grown to represent a consumer group larger than today s US population. While India is currently aggressively building up its petrochemicals industry, it will still have to rely on imports for quite some time. Market access for Gulf companies is made easier by longstanding business relationships and the established trading between the major ports in the Gulf and India. Current concerns regarding anti-dumping tariffs will fade as the feedstock pricing advantage of Gulf companies evaporates. In this respect, it is fortunate for the Gulf players that India has been lagging somewhat in creating a domestic petrochemicals industry, as they now have an opportunity to support India in catching up. While access to India as a key growth market is a key asset, Gulf companies need to strengthen their knowledge and skills base in terms of technology, research and efficient operations. The key partners here are the Western petrochemicals companies, especially from Europe, whose strengths and gaps are largely complementary to those of Gulf companies. Bearing this in mind, and considering that feedstock and operational costs in the Gulf will likely remain below those in Europe and the US, petrochemicals companies in the Gulf are facing certain strategic considerations: > What options do Gulf players have for dealing with the diminishing availability of advantageous feedstock? Will the feedstock pricing gap (e.g. with Europe) remain large enough to make feedstock accessibility a long-term asset for Gulf companies? > Should Gulf companies move into downstream businesses? Which ones? How far down the value chain should they move? Do they have the necessary capabilities to expand along the value chain sustainably without know-how from other market participants? > What are the options for an R&D strategy in this context? Should they build a domestic R&D platform? If so, what focus should it have, and what partners should they work with? Can the Gulf region offer unique advantages to foreign companies in terms of IP protection that China cannot? > What Asian countries should Gulf companies try to access first and what entry strategy do they need to adopt? Are there attractive markets other than China and India where Gulf companies can provide development support early on to capture the market?

10 10 Global petrochemicals Who is really benefitting from the growth in the new world? > How can these companies gain access to the required technology and operational know-how? Is buying European companies better than building knowledge through joint ventures and cooperation agreements? What would the business case look like for potential partner companies to invest in the Gulf and not in China? Asia: The growth market The Asian markets are expected to grow strongly over this decade, driven by its largest economies, China and India. Governments, especially in China, are keen to support the local petrochemicals industry. Feedstock availability and access to technology and management expertise will be the main strategic issues for petrochemicals companies in Asia. Domestic capacity increases will not be able to keep up with rising demand and Asia will remain a net importer of feedstock and petrochemical intermediary products in the medium term. For example, China currently relies heavily on naphtha as feedstock for petrochemical production, with 80% of its ethylene production facilities being naphtha-based. Simply put, refining capacity expansion will not be able to keep up with demand for naphtha as the country expands its petrochemical production capacity. This mismatch will be eased to some extent by increasing capacity for unconventional feedstock, in particular coal and shale gas. This process, however, will be gradual as the coal-to-olefins technology is subject to considerable environmental impediments and the ease of exploiting shale is still being investigated. India is facing similar problems, as it mainly uses naphtha for petrochemical production. Recent government initiatives to establish petrochemical clusters will fuel the need for additional feedstock.

11 Competence Center Global Chemicals 11 In addition, the technological and managerial know-how of Asian petrochemicals companies generally lags behind their European and American peers. To change this, Asian governments are actively developing their local chemical and petrochemical production and focusing particularly on R&D. For example, the Chinese government requires international companies to relocate parts of their value chains to China to secure any contracts in the country. The government is also encouraging and incentivizing local R&D activities in a bid to start closing the technology gap with the West. Consequently, companies such as Dow Chemicals and Sabic have established large R&D hubs in Shanghai to fulfill this local content requirement, and to create local value by specializing their product range, which in turn will start a process of technology development in Asia. Similar developments in India kicked off in 2007 with the Petroleum, Chemical and Petrochemical Investment Regions initiative to promote investments in the petrochemical sector. The key asset of Asia s petrochemicals sector is expected growth. Per capita consumption of polyolefins, a proxy for petrochemicals, is low in Asia compared to the US and Europe. However, the consumption growth rate has been the highest in the world for many years and is expected to remain high during this decade. The main drivers are China and India with expected growth rates of 6.3% and 10% respectively, attributable mainly to the expansion of the manufacturing sector and to improving economic conditions and standard of living in Asia. In fact, the number of Chinese consumers with an annual income above USD 10,000 is expected to increase by more than 300 million by 2020, and India s middle class is expected to reach 400 million by 2025, leading to increasing consumption of products with high petrochemical content. Asian petrochemicals players enjoy strong growth prospects and active government support, but also face gaps in technology and management expertise. Against this backdrop, they must consider a number of strategic questions: > What is the best approach to develop know-how locally? Establish local R&D facilities or acquire Western companies? > How will the product portfolio develop as the population s economic position improves? How does that affect the choice of international partners? How should Asian players position themselves within the global context? > Who are the natural partners for Asian companies? Is advanced technology from Europe and the US or strategic access to feedstock more important in the medium term? Are there ways to combine them? > How can Asian players structure this partnership to protect their domestic production from international competition? > What are the development gaps between China and the less developed Asian nations such as India? What strategic actions are suited to closing these gaps, and what partners do they require?

12 12 Global petrochemicals Who is really benefitting from the growth in the new world? United States: Back to its roots Since the birth of the industry, the US has been the leading powerhouse in the petrochemicals market. A substantial domestic market developed on the back of vast domestic feedstock available for most of the last century. Today, the discovery of large resources of shale gas and the development of technologies to economically extract it have laid the foundation for a resurgence of the industry. The rise of the petrochemicals market in Latin America places a major growth market conveniently at the US s doorstep. Traditionally, petrochemicals production in the US relied heavily on ethane as feedstock until prices for natural gas increased dramatically in the early years of this millennium. Despite a slightly more attractive product slate, the increasing use of heavier feedstock made the US one of the most expensive producers of ethylene in the world, which negatively affected the competitiveness of its companies compared to their global peers. This also triggered the use of shale (ethane) gas as feedstock in 2006, which ensures local supply of comparably low-cost feedstock to US companies in the years to come. In addition, the US currently has the highest per capita consumption of polyolefins worldwide at around 58 kg per year, providing US petrochemicals companies with a developed home market of substantial proportions. However, expected growth rates remain far below those of the big growth markets abroad, and US companies have turned their attention to Asia and especially Latin America as an upcoming growth market in their immediate neighborhood.

13 Competence Center Global Chemicals 13 The discovery of oil and gas resources in Latin America, especially in Brazil, has set off the initial stages of developing petrochemicals production. According to the Brazilian Association of Chemicals Manufacturers, local and foreign investments in the country s chemicals industry are expected to reach USD 26 billion by The attractiveness of Brazil and other Latin American countries is further underlined by their robust economic growth rates and relative political stability in recent years. For Brazil alone, the improving conditions for large parts of the population are expected to increase the per capita consumption of polyolefins by some 7.5% per annum during most of this decade. American companies have started to enter this attractive market despite protectionist governmental action. Given that they are technologically well advanced, command a substantial domestic market and have found renewed access to domestic, competitively priced feedstock, US petrochemicals companies are considering strategic questions that center on capturing growth in certain emerging markets: > Is China the most important market or should Latin American countries have a higher priority? What is the likely competition from European countries with strong cultural ties to Latin America? > What are the most promising ways to enter these markets? Is it through sales and distribution or does integrated local production offer additional advantages? Who are suitable partners? > What action will governments in Latin America likely take with regard to building a domestic petrochemicals industry? Is there room for American companies to play a role or will they be threatened by protectionist action? > Would it make sense to give Latin American players access to the US market on a quid pro quo basis? What would such an arrangement entail and how would US companies protect themselves?

14 14 Global petrochemicals Who is really benefitting from the growth in the new world? A globalizing game The petrochemicals market is becoming increasingly globalized in terms of technology transfer, feedstock sourcing and market access. The companies active here all face the same basic issues of access to technology, feedstock and markets, but players have different starting points based on their respective strengths and weaknesses. And while the strategic issues are specific to each geographic group of companies, all of them are facing the basic issue of how to compensate for their weaknesses within this increasingly global market setup. Possible actions include joint ventures, M&A or organic international expansion aimed at up- or downstream integration, product specialization or development of scale. The implications of any strategic decision are substantial due to the amount of investment involved, and careful analysis and evaluation of the available options is key to long-term success. It is therefore still a completely open question who will capture the new market demand. Will it be players from the fast growing Middle Eastern or Asian countries, or will American and European companies stage a strong global comeback?

15 Amsterdam 16 Global petrochemicals Madrid Who is really benefitting from the growth in the new world? Barcelona Manama Beijing Milan Beirut Montreal Berlin Moscow Boston Mumbai Brussels Munich Bucharest New York Budapest Paris Casablanca Prague Chicago Riga Detroit Rome Doha São Paulo Dubai Seoul Düsseldorf Shanghai Frankfurt Singapore Gothenburg Stockholm Guangzhou Stuttgart Hamburg Taipei Hong Kong Tokyo Istanbul Vienna Jakarta Warsaw Kuala Lumpur Zagreb Kyiv Zurich Lagos Lisbon London Roland Berger Strategy Consultants 11/2012, all rights reserved