Investing in China Speech given by Dai Yu General Manager Base Chemicals Shell Eastern Petroleum Pte Ltd The 3rd Asian Aromatics & Derivatives Conference Singapore June 28-29, 2007 1
Within a few years, China will almost certainly become the world s largest consumer of petrochemicals. It is already the key export focus for producers in Asia Pacific and the Middle East, and what happens in China will have an increasing impact on global petrochemicals markets. Since 1978 China s annual GDP growth has been close to 10%. Over the same period, petrochemicals demand has grown even faster. By the end of 2006, China was the world s biggest consumer of synthetic textiles, synthetic rubber, mono-ethylene glycol (MEG) and purified terephthalic acid (PTA), and the second largest consumer of polymers. As we know, in response to this burgeoning petrochemicals demand, China is implementing a significant expansion of domestic production capacity while also encouraging an increasing level of participation from international companies. The main focus of my presentation today will be on the opportunities and challenges relating to petrochemicals investment in China and the experience of Shell Group companies. But first I will look briefly at some of the developments taking place in China s aromatics markets, mainly benzene and paraxylene, which offer some pointers to investment generally. I am sorry that there are lots of statistics in this section. But as you will see, they illustrate the dynamism in China s aromatics markets, particularly the increases in domestic capacity that will impact future imports. Aromatics: the growing influence of China Over the past decade, we have seen a significant shift in emphasis in aromatics towards Asia Pacific, and particularly China, and the Middle East. For example, in the mid-90s, the bulk of benzene demand was split between three roughly equal consuming regions: the Americas, Europe and Asia Pacific. Today, Asia Pacific and the Middle East - which hardly figured ten years ago - together account for half of global benzene demand, with growth in large part driven by China. Similar patterns have emerged for mixed xylenes and paraxylene, which have seen demand growth driven by Asia Pacific s burgeoning polyester fibre and PET industries. In 2006, China s total benzene consumption was about 3.5 million tonnes. Currently, domestic capacity is around 4 million tonnes, while production is about 3.3 million tonnes. As this chart shows, styrene monomer, phenol and polyurethanes account for almost 80% of total consumption. Styrene alone accounts for over 50%. 2
Geographically, benzene production and markets are concentrated in Eastern China, which accounts for about 40% of total demand and has excess capacity in the region. North East, North and South China each account for 18%-19% of total demand. South China has capacity below demand levels. While the overall geography of China s benzene market is unlikely to change significantly in the next decade, capacity in South China will catch up with regional demand when world-scale projects in Fujian and Guangzhou Nansha come on-line. Central China s petrochemical output will also be boosted by two world-scale projects in Cheng Du and Wu Han. Historically, China has been short of benzene, relying on imports to meet demand. Korea provides about 75% of total imports, with the rest coming mainly from Japan, Malaysia and Singapore. China s benzene import growth peaked in 2004-2005 and has subsequently slowed. In 2005, China generated 92% of demand, and this level rose to 97% in 2006. Recently, China s benzene capacity has been growing by 20% - 25% annually - from both refineries and crackers - while downstream demand has boosted consumption by 15% -18%. During 2008, a number of new and revamping projects will start up, which will move domestic capacity up to 9 million tonnes - close to demand levels - and by 2010, Chinese observers predict the domestic market could be long - although overseas analysts have their doubts! However, China s current policy of providing no VAT rebate on exports of benzene and other petrochemicals would discourage potential exporters. It is also worth noting that between 11%-16% of China s benzene production will be generated by the steel industry, which has increased capacity of benzene encouraged by rising benzene prices. I should explain that coal is extensively 3
used in steel production. Before coal can be used it needs to go through a coking process to drive off all light products. As a result light oil (almost 100% BTX) and coal tar are produced. The light oil can be converted almost entirely to benzene through the littol process (ABB). What are the economics of crude benzene hydrogenation in China? Capital expenditure estimates for a 100,000 tonne/year pure benzene production plant using crude benzene feedstock and a hydrogenation process are between US$30-40 million. The hydrogenation process is not much different from traditional hydrogenation processes for pygas from ethylene crackers i.e. hydrogenation plus extraction. The total cost of pure benzene from coal is about US$200-300/tonne lower than benzene from petrochemicals. Today, China s major benzene producers are Sinopec and PetroChina. Internal consumption accounts for 55% of Sinopec s output and 78% of Petrochina s production. Sinopec supplies 65% of China s benzene commodity market, while PetroChina has 13% and other players - joint ventures and steel companies - provide the rest. Let s move onto paraxylene. In 2006, China s paraxylene consumption totalled 4.3 million tonnes,of which about 1.8 million tonnes were imports with almost 47% coming from Japan and 42% from Korea. Demand from China s PTA industry accounts for almost all of China s domestic paraxylene production and imports. But China is also heavily reliant on PTA imports - 50% in 2005 - to meet domestic demand for polyester fibre and PET. With China targeting PTA self-sufficiency, the National Development and Reform Commission has listed in the country s 11th five-year plan ten PTA and paraxylene projects, which will gradually come on-stream by the end of 2009. Four are revamping projects, creating additional capacity of 1.8 million tonnes, and six are new projects, adding 4.3 million tonnes. Geographically, paraxylene consumption and PTA production is located in East China. The principal NDRC rules for new paraxylene projects say they must achieve: Economic scale and advanced technology Prioritise revamping projects Encourage domestic technology and equipment Feedstock integration with a refinery and/or cracker: no isolated paraxylene project will be considered Paraxylene production aimed for PTA use, and with geographic advantage. By 2010, China s annual paraxylene capacity will be just below 10 million tonnes and production will be almost 9 million tonnes. So while supply will 4
remain short for the next 2-3 years, from 2010 onwards paraxylene supply and demand in China will be close to balance. Currently, paraxylene production plants in China are all integrated with refineries. Some plants will require an input of mixed xylenes to supplement the feedstock requirement, especially after capacity expansions. Xylene Balance in China 12 10 million tons 8 6 4 2 Capaci t y Pr oduct i on Consumpt i on 0 2006 2010 Source: ChemNet Before moving onto investing in China, let s look quickly at toluene and xylene. At the end of 2006, China s toluene capacity was 2.2 million tonnes with production at 1.8 million tonnes. China s toluene demand has increased rapidly in recent years and imports account for about 40% of demand. Benzene and paraxylene production account for 65% of consumption, while TDI and solvents together account for just below 35%. China s mixed-xylene production was 3.6 million tonnes in 2006, while capacity was 4.2 million tonnes. Around 65% of China s mixed-xylene production is used for benzene and paraxylene feedstock, while the rest is mostly used for solvents production. China imported about 400,000 tonnes of mixed-xylene in 2006. Having looked at some of the supply and demand patterns for key aromatics in China, let s focus on some of the opportunities and challenges relating to investment. Investing in China: Opportunities and Challenges 5
As I mentioned earlier, China has a very large market and high demand growth rates for petrochemical products. It has been the world s biggest importer of petrochemicals products for many years now, and the potential for significant market growth is encouraging investment by both the domestic and international petrochemicals producers. China is also opening up its markets to imports and investments with a number of measures liberalising business and trade, and encouraging a whole raft of petrochemical developments, such as the paraxylene/pta projects I mentioned earlier. Together, these are creating a business climate and business conditions that are much more conducive to foreign investment. China has been steadily reducing import duties on the vast majority of chemicals products. For example, import tariffs for benzene and paraxylene are now just 2%. China has enabled foreign companies to establish wholly-owned trading and distribution companies, with low capital requirement. (I ll talk about this when looking at Shell s chemicals strategy for China) In addition to liberalising overseas investment in petrochemicals, China s government recently reduced restrictions on foreign investment in refinery and oil products, including retailing. In the past two years, for example, two largescale, integrated refinery and petrochemicals projects have emerged, one of which is linked downstream with a major oil product retailing operation. One has approval, the other is being reviewed. 6
China also has huge coal reserves and interest in coal-to-chemicals projects has been growing in the last few years. With crude oil prices at high levels, the economics for coal-to-energy and chemicals projects look much more attractive. China has a large and growing pool of local equipment suppliers for new projects. In recent years, these suppliers have been exposed to both the demands of mega projects - in terms of meeting both domestic and international standards - and to competition from other domestic and international suppliers. Consequently, China s domestic suppliers have upgraded both their equipment and management standards, including those for quality and health, security, safety and environment. Most domestic suppliers are certified for manufacturing to both domestic and international standards and can offer very competitive prices. Driven by tax incentives, China is achieving a very significant rise in the quality of its manufacturing equipment, which is enabling domestic manufacturers to supplant imports. Today, China can build refineries and crackers with between 85% and 95% of equipment sourced domestically. In fact, China is becoming one of the major sources of global equipment supply. Now, China also has a large pool of local engineering and construction companies able to implement projects to international standards at very competitive prices. In fact, with the experience gained through participation in a number of mega projects in China, these companies are now beginning to compete in the international market. This is quite a turnaround. Based on my experience as a Chinese national working in the domestic industry, I would say that 10 years ago there was not one single engineering company in China that could manage a mega project independently. However, while we are right to be enthused by the opportunities, there are still considerable challenges to be faced by foreign companies investing in China. Not least is the challenge from China s domestic companies, such as Sinopec and PetroChina, which remain dominant producers and sellers in key markets in the chemicals sector, and which have developed very successfully in recent years. This combination of international investors and strong, local companies, some operating together in joint ventures, means competition in China is fierce. Another challenge is the high price of crude oil and gas, and - as a consequence - the high costs of petrochemicals feedstock. In this regard, the Middle Eastern producers have a significant advantage and their growing petrochemicals capacity is targeted primarily at China. Coal-to-chemicals projects face some disadvantages, including the high cost of investment, energy and water consumption. There are also issues relating to technology. However, the government s commitment to develop China s coal-toenergy and chemicals sector is likely to drive these projects forward. Rapid GDP growth in China is also causing some overheating in regional and local economies as demand for raw materials, equipment and labour causes shortages and drives up prices. 7
Other challenges include shortages of electric power, an over-stretched logistics infrastructure, especially in coastal ports and inland transportation, and environmental degradation. All of these factors can inhibit decision-making regarding mega project implementation. Among many local workforces there are also significant shortages of the talents and business skills required to meet the needs of fast-growing business, and there is a particular shortage of people who understand both domestic and international business. Many international investors are also concerned about intellectual property protection and wonder whether China will ensure their patents and rights are respected. A further challenge for international investors is China itself. Do they have appropriate knowledge of local markets, competitors, customers, the Chinese culture and ways of doing business? Do foreign companies have, or have the ability to build, the level of credibility necessary to succeed in China? Clearly, there is great opportunity to invest and build businesses in China. But investors should be both aware of and able to overcome the challenges. Now, I d like to turn to Shell and look at the Shell Group strategy for China and highlight some of our experiences of investing and doing business in the chemicals sector. The Shell Group is expanding rapidly in mainland China. In addition to petrochemicals, we are focusing on natural gas and renewable energy and new ways of using coal as well as providing consultancy services on energy efficiency and technological solutions. In our fuels, lubricants, bitumen and chemicals businesses, we offer the latest technological and environmental solutions to contribute to sustainable development. All Shell's core businesses are represented in China: Exploration and Production, Gas and Power, Downstream (Oil Products and Chemicals) and Renewable Energy. Currently we have some 21 wholly-owned or joint venture companies employing about 1,600 staff and joint venture staff, almost 90 per cent of whom are citizens of the People's Republic of China. We have partnerships with all three of China's major oil and gas companies, PetroChina (and China National Petroleum Corporation - CNPC), the China Petroleum and Chemicals Corporation (Sinopec) and the China National Offshore Oil Corporation (CNOOC). Shell's business objective in China is to help address the country s energy priorities including energy supply/security, environmental protection and energy 8
efficiency, working in partnership with Chinese companies and customers to mutual benefit both in China and overseas. Shell s strategy for chemicals in China The Shell Group's global petrochemicals strategy is simple: to be a global, world-scale, low-cost producer, optimising our feedstock and technology advantages. The Group s chemicals operating model is simple, too. We re concentrating on producing lower olefins and aromatics, and a wide range of intermediates and additives, which translates into: cracker plus one step. A key tenet of the Group s strategy is to optimise the synergies between the oil products and chemicals businesses by integrating refinery and petrochemicals complexes In 2000, about 25% of our chemicals assets were in the Middle East and Asia Pacific. By 2010, the aim is to have just over a third in these two regions, to take feedstock advantage opportunities and to be positioned to meet demand in the area of highest growth potential. The bulk of the Group's future chemicals capacity additions will be in these two regions. In the Middle East, we have two production joint ventures in Saudi Arabia, one producing ethylene, styrene monomer, EDC, MTBE and crude industrial ethanol, the other producing benzene. We are also planning a joint venture world-scale gas-based cracker and derivatives complex in Qatar. Shell chemicals companies manufacture and operate throughout Asia Pacific, but our main production centres are in Singapore and China. 9
In Singapore, we make an extensive range of products most of which are exported to Asia Pacific markets, including China. Shell Chemicals are currently building a new integrated petrochemical facility in Singapore, which includes a world-scale ethylene cracker, one of the world s largest mono-ethylene glycol plants and a new butadiene extraction unit. The ethylene cracker will be fully integrated with the Bukom Refinery to enable feedstock and operating benefits. The MEG plant will enjoy similar integration benefits with existing facilities in Jurong Island and will utilise latest Shell proprietary OMEGA technology. Construction started in late 2006 and the cracker is expected to start up in 2009/2010. Our petrochemicals strategy for China is multifaceted. Shell companies can supply China from existing plants in Singapore and the Middle East, and even from North America and Europe. Shell companies have also invested heavily in China and our Nanhai joint venture petrochemicals complex, which started up in early 2006, is now supplying the Chinese market from within. The complex is owned by the CNOOC Shell Petrochemicals Company, which is a 50/50 joint venture between China s CNOOC Petrochemicals Investment Limited (CPIL) and Shell Nanhai BV, part of the Shell Group. Located about 50 miles from Hong Kong - Nanhai has a total production capacity of 2.3 million tons, and includes 800,000 tonnes/year of ethylene and a full slate of petrochemical products. Virtually all of Nanhai's output will be consumed within China, but primarily it will supply local chemical plants and customers in the Guangdong province and the high consumption areas of China s southeast and eastern coastal economic zones. 10
In developing the project, the joint venture has used as much local content as possible, and utilised local design services where appropriate. The site has been built to accommodate significant future expansion and has the opportunity to exploit the oil-chemical synergy between the plant and CNOOC s adjacent refinery project, currently in construction. The cracker design includes a condensate splitter to allow feedstock flexibility between naphtha and condensates. Nanhai has been operational for over a year now and we are very happy with its progress. Commercialisation and marketing for products has been very successful, start-up and ramp-up performance are among the best examples in the Shell Group and the plant has achieved a commendable safety record to date. We are particularly pleased about the quality and motivation of the people in the Nanhai joint venture, who have played a key part in ensuring the project s success. From planning, through project management to start-up and operations, the Nanhai experience has been excellent. Another important development for the Shell Group in China is the business licence extension granted in 2006 enabling Shell China Ltd to import, export, buy and sell chemicals in local Chinese renminbi (RMB) currency. As a result of China s membership of the World Trade Organisation and its own economic reforms, its domestic markets have been deregulated, allowing entry for international companies for the first time. Previously, foreign owned companies were only able to trade in the Chinese US dollar chemicals market, 11
often via regulated free trade zones, with customers in the re-export processing industry. Imports of products into the domestic market were complicated by prohibitive import duties, the need to use agents and the presence of numerous local traders and distributors involved before the product reached the end-user customer. Under deregulation, import duties have been substantially reduced and import licences made available, giving foreign companies the flexibility to both import directly and trade locally. Having established the necessary sales, marketing, logistics, governance and customer service operations, Shell China Ltd completed the first commercial transaction by the end of 2006. The local currency business adds a third leg to Shell s chemicals interests in China, along with the USD re-export business, and our stake in the Nanhai joint venture. Together, the scale and growth of China s domestic market offer tremendous scope for developing a significant business presence in the next few years, as well as increasing our first-hand knowledge of Chinese customers, some of whom could be global accounts in the future. As I mentioned earlier, the market is currently fragmented but dominated by major local producers - Sinopec and Petrochina - as well as importers, speculative traders and distributors. All these players could be impacted by deregulation and there is likely to be some restructuring. A number of global players are expected to establish operations in China, which could lead to consolidation and alliances. However, there are still significant barriers to doing business in China, which is a very different and challenging market. The Shell Group has some valuable experiences from its involvement in Nanhai and from the re-export market in which we are one of the larger players, with over $500 million of annual sales. But operating in the local currency, through local business practices, and with rapidly changing legislation, is still relatively new territory. The spot nature of pricing, short lead times combined with commonly used cash before delivery terms, recruiting experienced local people and sourcing appropriate logistics, pose major challenges to newcomers. International companies in China will be operating without many of the business processes, systems and safeguards they are used to in other parts of the world. Understanding how the domestic market works requires a pragmatic approach to marketing and trading activities. The large volume commodity products commonly use cash before delivery terms, which increases the demands on finance and sales operations, and requires responsive supply chains and payment processing systems. 12
In the performance products market there is increasing use of credit and as the scope of business grows the risks associated with provision of credit will need to be understood and managed. At the same time, we have to ensure that all our activities comply with Shell Group standards in terms of Product Stewardship, Health, Safety, Security and Environment (HSSE), and Shell s Code of Conduct. HSSE compliance can be a challenge in a market where standards, infrastructure and training are not as established as in developed markets. It is important to work closely with service providers to convince them of the value of Shell s commitment to the protection of people and the environment, and to provide local support and expertise to drive HSSE performance. To mitigate commercial and HSSE risks the Shell Group has been taking a step-wise approach to market entry, starting with relatively simple transactions to build understanding of the market, customers and Chinese business practices, while also leveraging and introducing Shell s global processes wherever possible. As the business develops, the relevant Shell companies will also expand the range of products, strengthen local supply sources and look to broaden logistics support. To manage the chemicals business, Shell China Ltd has been building a locally recruited team, including a Commercial Operations Manager with extensive experience of the market. And one area of new business the team is already exploring is bulk trading of aromatics. There is potentially a lot of new domestic aromatics production coming from cracker complexes planned or under construction, as well as from reformers and the coal industry. By building on the existing relationships we have with some of these producers we hope to grow the aromatics business in China to complement our existing Asia-Pacific activities. So far, the steps the Shell Group has taken will allow us to accumulate valuable market intelligence and provide a good platform to be part of China s growth and expansion. In future, this will provide a channel for the sale of products from existing plants in Asia Pacific and the Middle East, as well as from the new assets under construction in Singapore. Conclusion I would like to conclude by leaving you with some thoughts about this very exciting but also very challenging market. 13
Adapting to a different business culture will always create a challenge for any company working abroad. For global players such as Shell Chemicals, operating successfully in China has been dependent on our understanding of different systems of administration and regulation, as well as general working practices and the local business culture. Respecting communities and environments where we operate is central to Shell s aim of being a preferred partner. Partnering is essential to opening up the difficult to reach resources of the future. This means partnering with local communities and host nations to develop long-term skills, and contributing to the national development of countries in which we operate by helping to maximise resources and ensure they meet the future needs of local industry and society. We feel that the Nanhai joint venture has created a new, composite business culture adopting the best of Chinese and international practices to make the project the success it has been. This reflects Shell s approach as a global group of companies in fostering local management, and transferring an appropriate share of ownership in major investment projects to local host governments and communities. There will continue to be very significant opportunities for international companies to develop important businesses in China, but they must meet the very extensive challenges and those quickest off the mark may well enjoy the most success. Investors should also bear in mind that in coming years China s chemicals producers will increasingly influence global as well as domestic markets and will also increase their international activities. 14
Having a strong local presence in China is essential. The domestic market is huge and has a strategic impact on global markets. Moreover, domestic markets and business practices will likely change very rapidly as China fully implements World Trade Organisation requirements. If you are not part of that change, it will be easy to get left behind. Thank you. 15