Petrochemical Industry Consolidation Picks Up Pace

David Hanna, Global Director, and Ihsan Rahim, US Managing Editor, Platts Petrochemicals

Relentless cost pressures and a changing market landscape are hitting petrochemical companies' bottom lines. Aggressive companies are on a buying spree that reflects shifting global demand patterns.

THE PETROCHEMICALS INDUSTRY IS IN THE midst of a large consolidation period as the longest oil price bull run in history shows no sign of abating, and the balance of power shifts inexorably from the West to the East. Unlike previous cycles of megamergers in the 1980s and 1990s, the current cycle is being driven by interaction of a more complex set of global factors.

Feedstock Cost Pressure Remains High

First among these factors has been the ever present cost push from rising crude oil prices. With the current commodities boom starting in late 2001, the market has been in the longest sustained uptrend in living memory.

This cost push is unlikely to go away any time soon: in October this year, Goldman Sachs raised its 2007 oil price forecast to $85/barrel from an earlier forecast of $72 back in April, noting that there was a "high risk" of $90-plus. Shortly afterwards, the new era of $90-plus was firmly upon us. The main reason why many market observers such as Goldman have remained bullish for 2007 is two-fold:

1. OPEC's decision in September to increase output by 500,000 b/d was too little too late, and demand failed to retreat after the summer driving season this year as it should in "normal" years.

2. The housing and credit problems in the US this year have hurt the value of the US dollar, making dollar-denominated crude cheaper for voracious economies such as China, India and Japan. This has helped to drive up global prices. The softening of the US economy has also contributed to a shift in liquidity from equities to commodities, adding fuel to the fire.

But beyond 2007, the outlook remains stubbornly bullish, for a number of reasons:

*A thin cushion of spare crude capacity. At roughly 88-million barrels per day, global crude oil production capacity is currently only about 2% above demand, and this cushion of spare capacity could easily be wiped out by an unforeseen natural disaster (such as hurricane Humberto earlier this year) or geopolitical event (e.g., Iran). As a result, any unforeseen event will have an intensified impact on prices.

*Government held stocks on the rise. Governments around the world are seeking to build up their strategic reserves as a hedge against high crude prices, which ironically has exacerbated the price rise.

*Shortages of heavy oil refining capacity. A lack of sufficient investment in refining capacity upgrades in general has been a long-standing problem, particularly in the West, but the absence of large capacity builds for heavy cracking in particular has become more acute, especially as many of the new finds tend to be for heavy sour grades of crude.

*Robust global economic growth. On the demand side, global economic growth remains robust despite softening in the US associated with the housing slump and credit troubles. This is because we are no longer living in a unipolar world dominated by the US economy. Increasingly, China and India are becoming the engines of global economic growth, and their appetite for commodities appears to be insatiable at this point. In fact, because of these economies, the International Monetary Fund raised its global GDP growth estimate for 2007 and 2008 from 4.9% in April to 5.2% in July. Of course, all bets are off if China's economy overheats too much and high inflation prompts the government to slam on the brakes, but for now the economy seems stable.

1. West Texas Intermediate Crude Oil Prices vs. CFR (delivered) North Asia Low Density Polyethylene (LDPE) Plastics Prices, January 2000 to September 2007. Petrochemical prices have become increasingly sensitive to oil: the already high volatility of WTI is amplified as price signals are transmitted down the production chain to LDPE. This means less predictable profit margins.

Tail Wags Dog

Along with high feedstock prices, consolidation has also been driven by the rise of Asia on the world stage and the subsequent shift of pricing power to that region. China's share of global demand for ethylene derivatives—a barometer of overall petrochemical demand—grew from 11% in 2000 to 16% in 2006, and was expected to expand to 20% by 2011, according to estimates by the Japanese government. This translates into an average annual growth rate of 7.1%, compared to 5.1% for Asia and only 4.1% for the world average.

With this growth has come an increasing degree of leverage in the market. In the past, key Chinese domestic prices were often based on prevailing US or international prices, but in recent years a number of exporters to China have started to refer to domestic prices when negotiating their CFR landed prices into China. In addition, this year the bulk of the Asian benzene term contract suppliers have dropped the US contract price in their formulae in favor of a reference to the FOB Korea spot price, which is in turn tied closely to the CFR China styrene market.

Complementing China's role as the driver of global demand has been the emergence of the Middle East as the center of global incremental capacity. Although the Middle East currently accounts for only about 10% of the world's total ethylene capacity, it represents a whopping 78% of planned global capacity additions in 2008. As a result, flow of trade is likely to grow from countries such as Saudi Arabia, Iran, and Kuwait to China, India, and other large Asian consumers.

2. Ethylene Derivatives Supply-Demand Balance, 2005 and 2011. A snapshot of the global petrochemical market: Asia is expected to remain the main driver of global demand, supported by the Middle East as the largest surplus center. Meanwhile, the West is likely to drift toward a moderate deficit position.

M&As Are Back

Given this background, it is not surprising to see renewed interest in mergers and acquisitions. A few headlines illustrate the accelerating activity:

– September 5: Reliance absorbs Indian Petrochemicals Corp Ltd (IPCL)

– September 10: Reliance announces plan to buy Malaysia's Hualong polyester assets

– January 2007: Thai Aromatics to merge with Rayong Refinery

– April 2007: Nippon Oil to absorb Nippon Petrochemical

Given this background, it is not surprising to see so much renewed interest in mergers and acquisitions. "There are companies out there wanting to become the next ExxonMobil of the world," said Robert Bauman, vice president for polymers at consultancy Nexant. "And they're going to do that by focusing on feedstocks, globalization and integration," he added, identifying the holy trinity that is driving recent M&A activities. Of those three, globalization has been the most prevalent this year.

This year has seen a number of high profile petrochemical giants expand through acquisitions: Saudi Arabia's SABIC bought GE plastics for $11.6 billion, on the heels of its acquisition of the European assets of US-based Huntsman for $700 million; Huntsman sold its US polymers business to US refiner and petrochemicals company Flint Hills for $350 million, enabling Flint Hills to expand its downstream activities; the Netherlands-based Basell, which was trumped in its bid to buy Huntsman by US specialty chemicals group Hexion, turned around and bought Lyondell Chemical Co. for $19 billion, giving Basell a strong foothold in the US.

SABIC's acquisitions were said to typify the growth by expansion plan, with the company buying into existing infrastructure to launch itself into a new market. The acquisition was similar to its European acquisition of DSM, which established SABIC as a major player in Europe. With its acquisition, SABIC is not only globalizing its business, but at the same time integrating its technology with Huntsman. In comparison, SABIC's neighbor, Saudi Aramco is choosing to grow via integration, attaching petrochemical plants to its existing upstream assets. In addition, Aramco is growing via the traditional joint-venture method (with Japan's Sumitomo Chemical). Expansion in the Middle East is driven by cost advantage, and has in past years prompted a series of joint ventures between Western or Asian companies and local owners.

Takeovers Competitive

In Europe and the US, there is no discernible pattern in expanding businesses. Here, large-scale mergers are characterized by two principles: mergers are opportunistic, and price is no object. The result is the perception that various companies are paying over the odds. But in reality the price is a characteristic of the market. The Netherlands' Akzo Nobel had to improve its takeover proposal to the board of UK's Imperial Chemical Industries to the level of £6.70/share in cash, plus a second interim dividend payment of 5 pence/share from earlier rejected proposals at £6.00/share and £6.50/share.

Indeed, in 2007, public bidding wars seemed to become the new norm for petrochemical acquisitions. Basell was outbid for Huntsman, UK's Ineos threw its hat into the ring on a number of occasions, and in every case, the transaction value of a sale was driven up until it superseded the market capitalization value of the asset for sale. This meant that 2007 saw big money circulating around the industry. [Ineos is in the process of buying Norway's Norsk Hydro suspension PVC business for around €670 million after a €290 million purchase of Borealis' Norway cracker and polymer assets.]

Buying power is based on a company's ability to access funds, its ability to borrow, not just free cash flows. The company and/or lender have to decide when an asset would see a return on investment. This year is no different from any other year in terms of motivation.

The credit rating of a company now becomes increasingly important. Standard & Poor's Ratings Services expects Basell to finance the purchase of Lyondell largely with debt. This "will result in a very aggressive capital structure with an estimated debt to EBITDA of about 5 times," S&P said in its ratings report. The agency placed its BB- corporate credit rating on Lyondell and its related entities, including Equistar Chemicals also BB-, and Millennium Chemicals, rated B+, on CreditWatch with negative implications, immediately after the sale was announced. S&P, like Platts, is part of the McGraw-Hill Companies.

Outside of the direct industry, mergers and acquisitions redefine the playing field as well. US engineering business CB&I agreed to buy petrochemical and oil process technology company Lummus Global from Switzerland's ABB for $950 million, altering the technology and firms available to build new plants. The IntercontinentalExchange bought ChemConnect's commodity trading business. As a result, ChemConnect's electronic markets for ethane, propane, ethylene, propylene and benzene moved from its former platform to ICE's electronic trading platform.

3. Top 10 Largest Chemicals Deals Announced in 2007 ($-billion). Source: Dealogic

Cycling

Bauman sees this recent activity as part of a two-year cycle, where mergers and acquisitions will reshape the industry. "I expect to see the changes result in maybe a dozen key players," Bauman said. Those players will control feedstocks, have a global presence and be vertically integrated. "If you're not integrated, you're probably going to be acquired," he said.

But what does this spate of M&As mean for the outlook for petrochemicals, and for globalization of the industry? Down the line, more new ventures could enter the business to satisfy niches, and the number of major players in the industry would continue to shrink as globalization takes precedence. Large companies in one market will become large companies in more than one market.

The introduction of smaller niche players are expected to pick up as early as the end of 2007, Bauman said. "These companies need to bring something new to the market, and they'll flourish," he said. After two years, Bauman expects the trend to plateau. During the next business cycle—at least two years from now—some of these new companies could become the targets for future mergers and acquisitions, Bauman said.

At the start of the decade, integrated companies were at the forefront of the industry. However, recent years have seen major integrated producers like Shell and BP sell off their chemical assets. Despite some reintegration of upstream assets in 2007, the motivation of companies is now to be more global. This could have something to do with the changed ownership profile of the chemicals market, as financial institutions increase their market share. One thing is for certain, "globalization" is a historical process, the result of innovation and technological progress, and that is what will define the characteristic of trade and financial flows.

4. Petrochemicals Swaps Trading Growth. As the need to manage the risk associated with high price volatility grows, so has the use of over-the-counter swaps, particularly for Asian aromatics products such as paraxylene (PX). Smaller markets are in benzene, isomer mixed xylenes (Iso-MX), toluene, and styrene monomer (SM).

Risk Management Now a Must

The current environment of sustained high prices and extreme volatility has not only served as an impetus for further consolidation, but has also led to the recognition that risk management is now a necessity. The industry has responded in several ways. Physical forward trading in the active Asian spot markets has grown markedly in 2006 and 2007, and financial derivatives have become more actively traded, particularly in Asia for aromatics products such as benzene.

As a measure of the growing popularity for forward physical trading to manage risk, from early 2006 to mid-2007, trade of Asian aromatics started to appear as far forward as nine half-month cycles, according to Platts data. That means that in June, cargoes were traded for loading or delivery as far forward as November, which was unheard of just a few years ago. Meanwhile, paper swaps trade has taken off due to the more active physical trade, as well as greater trust in the established physical benchmark that underlies the financial derivatives. The average number of bids, offers and deals for Asian paraxylene swaps, for example, has more than tripled from five to 16 over the past year.

In China, there has been a proliferation of both physical forward and paper contracts for petrochemicals. In March this year, for example, the Shanghai Petroleum Exchange (SPEX) started trading in toluene and styrene. Other active exchanges include Ningbo Dupute, Jinyindao, and Zhangjiagang.