The hole in the hedge: Why petrochemical investments have been a volatile bet

An extract from my book Crude Forecasts: Predictions, Pundits & Profits In The Commodity Casino.

Petrochemical prices are notoriously volatile. Sharp upswings in virgin plastic prices typically incentivise the building of lots more capacity, but because of long lead times this capacity may only come on-stream just as prices plummet. Then, as prices plunge the depths, there is little incentive to cut capacity as long as each plant can be cash positive – further perpetuating the volatile cycle.

One industry expert who has been at the heart of this business is Paul Hodges, chairman of International eChem and author of “Boom, Gloom and the New Normal”. When I interviewed Hodges he explained that the petrochemical industry is in a very challenging part of the supply chain, having to manage both short- and long-term interests:

Business in the middle of the supply chain such as petrochemicals can be squeezed on both sides. You have to be a bit like the Roman god, Janus, looking both ways at once. Because you look upstream at oil markets and you look downstream to consumer markets. There is very little connection between the two. If consumer start to take off with an enormous amount of demand, that doesn’t mean that the energy markets start producing a lot more. Equally if demand from the consumer is slow, that doesn’t automatically mean that the energy market slows. They are working on different timescales – one years or decades, the other weeks or months by and large. So the petchem industry is inevitably the buffer.

Given this unenviable position, the sector has to try to anticipate what prices are going to do in order to try to stay ahead of the competition:

And what makes it more volatile is that the margins, because you are in the middle you are getting squeezed by both of these. And what people do to try to get around that problem is they take a view on how prices are likely to move. If we are a plastics consumer, for example, sometime around the middle of April we ask ourselves will the price of oil go up or down. If prices are expected to rise, then everyone down the chain builds inventory in anticipation of higher prices. And what that does is it gives a very confusing picture of demand.

According to Hodges, even executives in the petrochemical industry don’t spend their days looking at the minutiae of oil price forecasts. They take shortcuts, just like everyone else, assuming that if the oil price is high it must mean that demand is strong. But just because everyone is doing it, doesn’t mean there isn’t a better way. Arguably, they should have paid much closer attention to what oil price forecasts left out back in 2011 and certainly also as late as mid-2014.

Back in 2010–14, forecasts of high oil prices ($100 per barrel plus) continuing long into the future contributed to one of the largest mis-allocation of funds ever seen in the commodity industry. Oil and natural gas prices in the US have historically tracked each other based on relative energy values (oil has approximately six times the energy value of gas). Up until around 2008, any difference in relative values has been rapidly arbitraged away over a period of a few years or so. However, from 2008 the difference in relative values blew out to enormous proportions.

The breakdown in the close relationship between US natural gas prices and crude prices from 2007 incentivised large scale investments in petrochemical capacity built on the assumption that recent history would trump several decades. Natural gas prices would remain low, while oil prices would remain high, maintaining the margin for ethylene producers. Industry consultant, IHS estimates that $160bn of petrochemical investment was built on the basis of a long-standing shale gas price advantage being sustained.

Taken in by the prospect of large margins, ethylene producers also forgot to think about where all this additional ethylene was going to be sold. For while supply was also increasing elsewhere in the world, particularly in places like China, the demand side of the equation was also evolving rapidly. According to Hodges, the nature of demand for products made from polyethylene and other plastics is changing as the population ages. Investors were also worried that many of these investments apparently proceeded without the security of signed off-take contracts. This also mirrors developments in the mining industry, where euphoria over the outlook for China was the key driver.

According to Hodges, the over expansion in ethylene capacity in the US is just yet another example of how investors and businesses can get taken in by extrapolating the recent past, long into the future:

The end result of this is that people have wasted billions of dollars, tens of billions of dollars on new investments to provide more supply which is simply never going to be used. It’s a repeat, if you remember of the final stages of the dot com bubble. People were laying fibre cable everywhere in the world, much of which was never used. On the scale of what’s happening today, it’s two part of bugger all. Because of what’s happening in oil, vast amounts of investments have been made that will never be needed; economies have been completely upended and disrupted, which will have all sorts of major implications for their security further down the track. And consumers have paid an enormous price for something that they didn’t need.

Although over investment inevitably leads to low prices, there is a case for arguing that this isn’t all good news for consumers; for what consumers really want is stability at an affordable price. Hodges claims that:

What makes life really hard is when the price becomes unaffordable, because then you start to do other things to get around that issue, you do more investment and so on. And secondly if you get unnecessary volatility, that has a cost in terms of running your supply chain and in terms of the consumer managing your household budget.

Hodges believes that over the time that he has been involved in commodity markets, the quality of knowledge has gone down because the quantity of information has gone up. “We use to talk about a value chain of data, knowledge and understanding. Nowadays that isn’t thought necessary by many investment banks.” He goes even further and argues, as I do that together investor greed and much of the mainstream financial news media have propagated a system where critical analysis is thought to be secondary to a good story:

You’ve created a system where people who shout loudest attract the most attention, even though what their shouting about is something that requires quiet consideration. The way forward is quiet, balanced discussion. There are quite a few people around the world who think the same way, but unfortunately, common sense is not very common. The danger is that the more educated you are the more you will look down on common sense because you think that undermines your intellectual arrogance.

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