Based on exciting trends for the petrochemical production community, the opportunities for firms in the industrial construction segment are especially ATTRACTIVE for the next several years.
For the past several years, many eyes have been on the shale gas revolution in the United States. As U.S. oil and gas production has expanded exponentially, the attention has been on the impact on consumer markets, particularly such as natural gas for heating or oil and its attendant price impacts on gasoline at the pump. And while many have predicted a resurgence in U.S. manufacturing driven by cheap energy prices, the fact is that the needed investment in manufacturing facilities here has, for the most part, not been as significant or as quick as we might have hoped.
There are many possible contributing factors, such as public policy, labor immobility and decreased global demand for many manufactured products in the face of China’s economic challenges, preventing the manufacturing growth we all would have preferred to see.
Nevertheless, there is one area in which the manufacturing renaissance can be decisively described as being “well underway.” Chemical feedstocks are leading the Gulf Coast economy, with dozens of petrochemical manufacturing plants planned or under construction over the next several years. And while the current low prices may be introducing uncertainty and reducing investment in oil and natural gas production, in the words of Mr. McGuire of 1967’s “The Graduate,” “There’s a great future in plastics.” As worldwide demand for products like polyethylene and polypropylene continues to expand, industrial construction firms in the U.S. figure to have a role to play in helping Gulf Coast producers meet that demand.
Historical Movement of Petrochemical Manufacturing
Until the early 20th century, petrochemical manufacturing and processing focused on providing hotter-burning “coke” from coal to assist in smelting and other similar operations, and in the creation of aromatic compounds for use in textile manufacturing. However, beginning around World War I, petrochemical manufacturing became an end in itself, as Germany sought to create a synthetic tire rubber out of abundant coal, as a substitute for embargoed natural rubber.
Of course, in time many more useful petrochemicals were identified, and from the 1940s onward, the U.S. Gulf Coast region became the center of the worldwide petrochemical industry. Today, over 100,000 firms worldwide produce more than 70,000 distinct chemical compounds, many of which have their root feedstocks in crude oil, gas or natural gas liquids (NGLs). However, from the 1960s onward, the volatility of feedstock prices put petrochemical manufacturers at the mercy of the commodities markets and the national interests of the various oil and gas producing states.
For most of last decade, conventional wisdom held that Asian and Middle Eastern producers would remake the petrochemical industry to reflect their own capabilities. After all, more than one-third of the total operating costs of petrochemical operations are tied up in feedstocks and energy costs, and the U.S. could not compete with cheaper Middle Eastern oil. In fact, at the start of the century, Saudi Arabian manufacturing costs were believed to be only half of that of U.S. producers. Plus, as these nations sought to move from strictly extraction-based economies to ones which generated more national wealth through value-adding manufacturing, the Middle Eastern oil producers invested heavily. As a result, the growth in petrochemical manufacturing capacity was expected to increase at a rate of 20% per year while the conventional wisdom was that the United States was expected to stagnate.
And then, when hydraulic fracturing made its mark on the world stage, conventional wisdom went right out the window (see Exhibit 1).
Today the world consumes 90 million tons of propylene per year, and the U.S. supplies more than any other country. Most importantly, this is a reversal of a long-term trend; U.S. production of propane and propylene has more than doubled over the past few years after decades of stagnation. The manufacturing resurgence is here now, especially in the petrochemical space. Manufacturers of these petrochemicals in the U.S. are in an enviable position, as their competitiveness has increased just as demand for petrochemical products is anticipated to grow by as much as 40 million tons over the next decade.
Impact of Hydraulic Fracturing on Petrochemical Manufacturing
Hydraulic fracturing has had several concurrent and self-reinforcing impacts on the overall dynamics of the petrochemical manufacturing industry and particularly on the competitiveness of U.S. petrochemical manufacturers.
The key strategic cost drivers for petrochemical manufacturing don’t vary much based on where that manufacturing takes place. All producers, whether in the U.S. or the Middle East, require reasonably priced, secure, uninterrupted access to feedstock material. The energy used in manufacturing is another key cost driver, making local energy costs as well as efficiencies critical. Because of the extraordinarily high initial investment costs, petrochemical manufacturers must operate at high capacity year-round. Finally, processors connected to the broader refined products space can use existing relationships, storage, pipelines and skilled labor sources, thus making some degree of manufacturing to refinery integration important. We will examine how the U.S. energy renaissance has affected the price of feedstocks and fuels, and the strong positive impacts this has had for U.S. petrochemical producers.
Access to reasonably priced feedstocks and low-priced fuel
In the U.S., the feedstocks of choice come from natural gas liquids extracted during natural gas pumping. These NGLs tend to be high in ethane and propane, two hydrocarbons important in the manufacturing of ethylene, one of the most commonly used base chemicals. Ethylene is used in both polyethylene and HDPE as well as in vinyl chloride, PVC, CPVC and the styrenes and polystyrenes. These in turn become many products we use today (see Exhibit 2).
Ethane and propane prices have been extremely favorable for U.S. manufacturers of ethylene. Over the past two years, ethane prices have fallen by 60% or more, leading to a huge opportunity for producers of ethylene. Ethane prices are down to the equivalent of about $0.25/gallon (see Exhibit 3).
Propane, the other key feedstock in ethylene production, has had a similar drop in pricing, and although its pricing is more seasonally dependent than ethane’s, it, too, is remarkably attractive as a feedstock here in the U.S., where propane is selling at the equivalent of $0.48/gallon (see Exhibit 4).
With prices for two of the major chemical feedstocks on the decline in the U.S., petrochemical production would already appear attractive here. However, when you also take into account natural gas’s long-term low prices due to its oversupply situation, the energy cost of running petrochemical cracking plants in the U.S. also becomes quite favorable. With natural gas prices in the U.S. remaining below $4/MBtU (see Exhibit 5), the cost of energy to run these petrochemical manufacturing plants is only about one-third the amount it cost just six years ago.
Aggregate the cost savings on energy and feedstocks, and it’s clear that manufacturers have shaved between 15% and 20% from their cost structures — a reduction that has huge implications for profitability. The fact that all of these feedstocks and fuel supplies are both safe and local means supply disruptions are extremely unlikely. This implies that predictable low prices are the norm for the foreseeable future for U.S. petrochemical manufacturers.
One would anticipate that overseas producers would have seen similar, if not as significant, improvements in their cost structures as well, but this is not the case at all. Saudi Arabian and Iranian ethylene production, which like U.S. production is heavily tilted towards ethane and propane feedstocks, had been as much as 50% cheaper than U.S. production. However, the changing price structure of U.S. petrochemical producers noted above has come at exactly the wrong time for Middle Eastern producers. Because of OPEC limits on oil production, many of the region’s producers have severely curtailed production of natural gas (produced as a byproduct of oil production in much of the region), with significant accompanying repercussions for petrochemical producers. In both Saudi Arabia and Iran, ethylene manufacturing capacity has come online much faster than the natural gas needed to keep the feedstock supply chain fully engaged. This led to the Saudis declaring a moratorium on supplying new ethylene production facilities in 2006. As a result, undersupply issues at current facilities have been rampant the past five years.
European producers have struggled as well. European petrochemical production tends to be oil-based rather than natural gas-based, and ethylene is no exception. There, most ethylene is produced from naphtha from oil, which is already more expensive than ethane or propane produced from natural gas. And while we are currently in a period of low oil prices, it is reasonable to believe that trend will reverse itself in the not too distant future, and oil prices in the $75-85/barrel range will become the new normal. Should that be the case, European ethylene manufacturers will be operating with a greater than 100% price disadvantage with respect to their U.S. counterparts.
Finally, while Asian production has been a significant player, it too is dependent largely on naphtha feedstocks from oil. China is currently undergoing its own shale extraction efforts, but it seems likely it will find something more urgent to do with its natural gas and NGLs than ethylene, especially as China will likely need to replace coal as its primary power generation fuel to improve air quality and international standing.
Given all of these moving parts, it is clear to see that U.S. producers are advantaged compared to the rest of the world in terms of safe, reliable access to reasonably priced feedstocks for petrochemical manufacturing.
New Manufacturing Facilities are Underway or on the Way
Based on these exciting trends for the petrochemical production community, the opportunities for firms in the industrial construction segment are especially attractive for the next several years. In fact, five new plants are anticipated to be built in the Texas Gulf Coast area alone in the next five years, bringing online an additional 4.7 million tons of ethylene production capability (see Exhibit 6). These projects are only about half of the new ethylene production planned for the U.S. during the same time period.
These manufacturing plants will be built in the teeth of an extremely tight Gulf Coast labor market, which means that the ability to staff, manage and schedule these projects will be of utmost importance. While we have chosen to focus on one particular petrochemical product for much of this discussion, it is important to remember that similar pricing and demand pictures exist for dozens of other petrochemical products. This means that the industrial construction sector, and especially highly specialized aspects such as process piping, refractories, industrial coatings and other trades, will experience a surge in demand and extensive opportunities.
So, while the hoped-for surge in manufacturing (and its required construction investment) has not yet happened, there is reason for continued optimism. It is reasonable to say that just as the energy renaissance presaged this boom in petrochemical manufacturing, this particular expansion may be followed by a boom in plastics or chemical manufacturing. In short, industrial construction growth that is being driven by petrochemical manufacturing won’t be the last word we hear from this segment of the industry. Forward-thinking industrial contractors will be looking for the next trend and positioning themselves to capitalize on the next renaissance, rather than chasing already developed markets.
Mike Clancy is a principal with FMI Corporation. He can be reached at 713.936.4945 or via email at email@example.com.