Petrochemical feedstock’s unwelcome surprise

Price volatility surrounding petrochemical feedstock is a harsh reality that creates distress all along the supply chain. Feedstock is the process derivative—e.g., ethane, propane, and naphtha—that comes out of petroleum and natural gas and is subsequently converted for use in everything from shampoo and solvents to plastics, glue, drugs, pesticides, computers, and cars.
By Frank O Smith, senior contributing editor (fosmith@thewritinggroup.com) March 1, 2008

Price volatility surrounding petrochemical feedstock is a harsh reality that creates distress all along the supply chain. Feedstock is the process derivative—e.g., ethane, propane, and naphtha—that comes out of petroleum and natural gas and is subsequently converted for use in everything from shampoo and solvents to plastics, glue, drugs, pesticides, computers, and cars.

Although they’re true commodities, feedstock markets more closely resemble industrial rather commodity trading exchanges. This adds to the complexity of dealing effectively with sudden price swings that often result in earnings-report surprises.

“The further you go up the chain, the harder it is to control the price,” says Ben Morse, senior editor covering petrochemicals for New York-based Platt , which generates industry reports. “Feedstock producers may try to push price increases to converters, but converters can’t pass the cost on because they’re locked into long-term contracts with their customers. So it doesn’t automatically mean that the price of a Coke bottle is going up.”

While price volatility has always been the case, “The issue is much more difficult with the trend upwards, causing significant impact on organizations,” says Sanjay Agarwal, principal with global consulting firm Deloitte . “It makes it very difficult for companies to accurately forecast earnings and profits, resulting in reporting surprises that are more negative than positive.”

The U.S. long held a cost advantage due to its abundance of natural gas, but “lost a good part of that in early 2000 when natural gas spiked,” says Mark Fisler, executive VP and CEO of Houston-based Chemical Market Associates Inc. (CMAI), a leading global research and consulting firm to the petrochemical industry. Even though natural gas has stabilized, its price has since been pegged to petroleum-based naphtha, which also affects market dynamics due to the sharp run-up of oil prices.

The U.S. long held a cost advantage based on its abundance of natural gas, but “lost a good part of that in early 2000 when natural gas spiked,” says Mark Fisler, executive VP and CEO of Houston-based Chemical Market Associates Inc. (CMAI).

The big shift on the horizon is the massive processing capacity buildup going on in the Middle East, anticipated to come online in the next 12 to 36 months. In an April 2007 press release, Dow Chemical estimated the industry will add 35 million metric tons of capacity for ethylene—the global bellwether feedstock—with more than 50 percent of that under construction in the Middle East.

“The most significant thing happening now is the relationship between the Middle East and China, with the Middle East set to become the world’s largest supplier, and China the sponge that drives global demand,” says Ihsan Rahim, managing editor for Platt. Though it’s difficult to accurately predict when Middle East capacity will actually come online due to severe supply constraints of engineers and construction resources, the effect—coupled with the boom in development in India and China—will create what one industry minister in the Middle East deemed a “new silk road” at an industry gathering in Dubai in December.

Even though expanding capacity will ease supply constraints, expanding global demand—especially in emerging economies—will continue to make price volatility a reality for years to come.

Deloitte’s Agarwal stresses that companies need to better accommodate the reality by adopting what Deloitte deems “integrated commodity strategies” based on clear, forward-view price forecasting models, with an arsenal of tactics to manage shifting supply-demand exposure tied tightly to a company’s core business strategy.

“Companies that say they can’t do anything but pass prices on to their customers—that’s not an option anymore,” says Agarwal. “There are various strategies you can use to reduce your exposure, and those that do will gain significant competitive advantage.”