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Today’s oil executives share a tough reality: presiding over the peak and the decline of the gasoline age, a century-long growth period that brought in trillions of dollars in revenue. Gasoline isn’t going away, but it won’t be the sales driver it once was. So, oil companies are pivoting to the one end market for fossil fuels whose peak is decades away—chemicals.

Saudi Arabian Oil, the world’s largest oil company, plans by 2030 to send about a third of its oil to chemical plants, mostly to be used for plastics. The $100 billion project could transform Saudi Arabia from a midsize player in chemicals to a powerhouse, capable of single-handedly supplying enough plastic for all of the cars and planes built each year.

Chevron, whose CEO has said that no large-scale fuel refinery will ever again be built in the U.S., is constructing two major chemical plants through a joint venture with Phillips 66 and QatarEnergy—one in Texas and one in Qatar.

The problem is that too many companies are ramping up chemical production at the same time, leading to a serious glut that looks like it will last for years. Chemical companies could be looking at years of diminished earnings, taking some of the shine off their stocks.

Already, prices for the most abundant chemicals, which go into plastics production, have fallen more than 50% in the U.S. since 2021. The plunge hasn’t dissuaded most companies from planning even more new factories, though. Plants with capacity to produce millions of tons of unneeded plastics are set to swamp the market before the end of the decade, even as the chemical industry says it wants to reduce plastic waste. The glut could lead to both financial and environmental damage.

Shell recently opened a chemical complex the size of 300 football fields in Pennsylvania, with capacity to produce 1.6 million tons of plastic pellets a year. And China has built so many plastics factories in the past five years that it’s on pace to add as much capacity by the end of this year as currently exists in Europe, Japan, and Korea combined.

The global ramp-up is swamping an already saturated market.

“You’re looking at a historic oversupply,” says Nick Vafiadis, who leads Chemical Market Analytics’ global plastics and polymers team. “We’ve never seen anything like this in the industry.”

Chemical Market Analytics, a data and consulting service owned by Barron’s parent company, Dow Jones, is projecting that chemical plants making the basic plastic ingredient polyethylene will operate at less than 80% of their capacity this year for the first time in 40 years. For the industry to be solidly profitable, global operating rates usually have to be closer to 90%. Profit margins for chemical producers in Asia are already negative, and they’ve fallen sharply in Europe and North America, too.

“Barring shutdowns of existing capacity, this oversupplied situation will extend to 2030 and potentially beyond,” adds Vafiadis.

This isn’t just the normal ebb and flow of a cyclical business. For years, chemicals companies could count on demand rising one or two percentage points faster than global gross domestic product, with supply ratcheting higher or lower in response to the market. That’s not happening anymore, and it’s starting to rock the industry. BASF, the world’s largest chemicals company by sales, is slashing billions of dollars in costs and laying off thousands of workers at its flagship chemical complex, warning investors that “these conditions are not expected to improve anytime soon because they have become structural.”

It’s easy to see why fossil-fuel companies see chemicals as their best expansion opportunity. Most analysts think that gasoline consumption in the Europe and the U.S. is already past its peak. J.P. Morgan strategist Natasha Kaneva predicts that global consumption will peak next year, followed by a gradual—and permanent—decline. Chemical demand, by contrast, isn’t expected to shrink as the energy transition accelerates.

Most chemicals end up as plastics, and the plastic content of several everyday products has been growing. The average car had 411 pounds worth of plastic in 2021, 16% more than it did in 2012, according to the American Chemistry Council. Aside from single-use plastics like detergent bottles and straws, which have been targeted because of their environmental harm, most of the industry has escaped deeper scrutiny and regulations. Consumers don’t think of oil rigs when they pull on their polyester pants. Those pants—along with the bumper on your car, the rug in your office, and the PVC pipes in your home—will be much harder to replace than gasoline.

That’s encouraging news for companies pumping out the base chemicals that go into those products, like polyethylene and polypropylene. Energy research firm Wood Mackenzie expects that demand for naphtha and liquefied petroleum gas, two of the fossil fuels that act as feedstocks for chemicals, will grow by 50%, or seven million barrels a day, by 2050.

But it isn’t so simple to draw a straight line from here to there. Chemicals are derived from several feedstocks, including natural gas, that have historically been more cost-efficient as building blocks for plastics than oil. So, companies that make chemicals out of oil are at a cost disadvantage to those that have easy access to natural gas.

What’s more, the overall market for chemical products is considerably smaller than the market for fuels. Today, about 12 million of the 102 million barrels of oil produced every day end up as chemicals, according to the International Energy Agency. Gasoline, diesel, and jet fuel use roughly 60 million barrels. When a big oil company adds capacity in fuel markets, it’s like a large person doing a cannonball dive into a swimming pool. When that company jumps into the chemical market, it’s like they’re cannonballing into a bathtub.

China, historically the world’s largest importer of chemicals, is making the biggest splash of all. For more than a decade, chemical companies had relied on near-insatiable demand from China to sop up all of their excess supply. Its plastics demand rose more than 10% a year on average from 2015 to 2020, accounting for 70% of global growth. But China is now in the midst of an aggressive effort to become self-sufficient in the building blocks of its economy, from energy to materials and specialized manufacturing. Its plastics program is particularly monumental. The country has been using so much more oil for chemicals production since 2019 that it’s single-handedly lifting the market. Were it not for petrochemicals, and China’s in particular, total global oil consumption would still be below 2019 levels, according to the IEA.

Just as China’s capacity to produce plastic has boomed, the country’s demand for it has slowed, along with its broader economy. The result is that China can satisfy an increasing proportion of its own plastics needs, without as many imports. In 2018, China’s plants had the capacity to produce about three-quarters of the major plastics it used by ton. By the end of this year, China will make enough plastic to account for 105% of its consumption, though it will still need to import some plastics because the materials it produces don’t line up perfectly with the materials it uses.

Saudi Arabia is betting big on chemicals, too. State-controlled Saudi Arabian Oil, better known as Saudi Aramco, wants to turn four million barrels of crude oil and other petroleum liquids a day into chemicals by 2030. Aramco now processes about one million barrels of oil into chemicals, analysts say, so the expansion could have a major impact on the market, adding perhaps 10% more production capacity to global supplies.

“A shift of that scale is a significant commitment, on top of what they’re already doing,” says Daniel Yergin, an energy expert and vice chairman of S&P Global. Yergin thinks that Saudi’s move reflects a growing interest in product flexibility by oil companies as the energy transition advances.

Aramco’s chemicals program is estimated to cost at least $100 billion, and includes joint ventures both inside and outside the country. Sabic, a chemicals company that’s 70% owned by Aramco, has partnered on new chemical plants in China, as well as a new Texas plant co-owned by Exxon Mobil. Aramco didn’t respond to questions about its plans and the impact of oversupply on the market. Salem Al-Subayee, director of the liquids to chemicals program, wrote on LinkedIn last month that the company is “on track” to meet the four-million barrel goal by 2030.

The enormous investments by state-sponsored entities, and a demand slump, are weighing on independent chemicals companies.

Most of them missed earnings estimates in the fourth quarter, according to Matthew Blair, an analyst at Tudor, Pickering, Holt. Analysts have been reducing their estimates for the first quarter since the start of the year, dropping them by more than 15% for heavyweights like LyondellBasell Industries and Dow.

Still, the industry’s problems have not been reflected in most of the stocks. The average chemical company stock rose 18% in 2023, and is up another 9% this year, according to Blair. “We had major negative revisions, yet the stocks still moved up,” Blair says. Investors who are used to the normal cyclical patterns in chemicals are holding on to the stocks in anticipation of a rebound, but it keeps getting pushed off, he says. Without a substantial bounceback, the stocks could follow estimates lower. Dow and Lyondell didn’t respond to requests for comment.

Meanwhile, capacity is still on the rise. Big plastics producers such as Exxon Mobil, Lyondell, Shell, and Dow have collectively plowed tens of billions of dollars into new plants. Tom Sanzillo, director of financial analysis at the Institute for Energy Economics and Financial Analysis, calls them “business-as-usual investments that will fail to achieve climate and pollution-reduction goals, maintain profitability, and encourage investor confidence.” Chemicals were once considered an “industry savior” for fossil fuels in a decarbonizing world, Sanzillo says. Now, they’re looking like another albatross.

Although BASF has begun to downsize, several other companies are still ramping up. Shell opened its Pennsylvania polyethylene complex in stages starting in 2022. Once complete, it will span 386 acres. Former Gov. Tom Wolf said the complex, which is receiving an estimated $1.6 billion in state tax breaks and credits, was the largest industrial project built in the state since World War II.

But the rollout hasn’t gone smoothly. The facility has already had to pay fines for pollution, parts of the start-up were delayed, and it has opened into a particularly weak chemicals market. In the fourth quarter, Shell’s chemicals division posted an adjusted loss of about $500 million.

Sanzillo believes that the plant also came in way over budget and could eventually cause Shell to take impairments. Several media reports and a Shell-funded study had said the plant was expected to cost $6 billion. But CEO Wael Sawan noted on Shell’s latest earnings call that it cost “$14 billion or so.” A Shell representative said the company never released cost estimates in advance of construction, and that Shell wouldn’t comment on potential impairments. The company said in February that it would lay off 25% of the commercial staff in its chemical division.

The decision to build the plant was made before Sawan took over, but he’s grappling with its impact now. “The margins aren’t great,” he said on the company’s latest earnings call. “I mean that’s obvious, and I don’t know how long that lasts.”

Asked if he would greenlight the plant again if he had the choice, Sawan said that “we will make sure that we do less of what we would call the mega, mega projects.” He said Shell expects the Pennsylvania venture to become profitable in the next few years, and that the company will hold its chemicals spending flat through the end of the decade.

Exxon has likewise been expanding its chemical operations, and has run into some financial difficulties. In the fourth quarter, the company took $294 million in impairments in its chemical products division, although it didn’t respond to questions about what caused them. Big oil companies can weather downturns in chemicals because of the strength of their other businesses, but negative results can still sting. Shell’s chemicals loss was a 6% drag on fourth-quarter earnings.

The expansion of plastics production also complicates a public relations push by the industry to promote its efforts at boosting plastics recycling. Shareholder advocacy group As You Sow says 14 million metric tons of plastic is discarded in waterways every year, an amount that could triple by 2040 without more industry action. The oversupply of plastics has caused the price gap between virgin and recycled plastics to grow. New polyethylene is now 42% cheaper than the recycled version, making it more challenging for companies to go green in products and packaging.

The Plastics Industry Association, a trade group, disputed the idea that chemical companies are overproducing, arguing that recycling rates are improving and giving businesses more options. “Stable supplies of both virgin and recycled materials benefit end markets, particularly those favoring plastics for packaging,” said chief economist Perc Pineda in a statement. “Markets are more efficient when businesses have choices.” The group’s marketing slogan is “recycling is real,” an attempt to push back on statistics showing that 10% or less of plastics get recycled.

The industry is looking forward to a temporary slowdown in new chemical plant construction next year. The buzzword today is “destocking.” Companies that make raw plastic say their customers—who turn pellets into bottles and pipes—are working through excess inventories, which they hope causes prices to rebound. But a new wave of plants are coming in 2027 that are likely to destabilize the market again. By 2028, global capacity to produce polyethylene is expected to grow to 176 million metric tons a year from 147 million in 2023, and that’s before including the Saudi liquids-to-chemicals program, according to Chemical Market Analytics.

Somehow, the supply side of the industry will have to shrink. European plants owned by companies like BASF may be in the most precarious shape of all. The continent has minimal reserves of oil and natural gas, and has seen costs rise as companies stopped importing Russian gas following Russia’s invasion of Ukraine. Asian producers are in a similar crunch because they have to import feedstock. Companies operating in the U.S. and the Middle East sit on top of cheap natural gas and oil, giving them a cost advantage. But that doesn’t mean they aren’t exposed to the market’s problems.

Chemicals may well be the future of oil. But there can still be too much of them.

Source: Barrons.com April 12, 2024 | By Avi Salzman