William R. Young, Ph.D.

Headwaters MB
April 2012 203-622-1044 byoung@headwatersmb.com

Ethylene Profitability Outlook Positive

The Ethylene Business: Supply/Demand
We view ethylene as a global business from a supply/demand viewpoint. While ethylene is a gas and is not subject to a significant amount of import/export activity, the ethylene business is considered worldwide due to the transportability of the derivatives and should be examined on that basis. In other words, major derivatives of ethylene are often destined for the export market. For example, while (1) the Middle East accounts for about 20% of world ethylene production and (2) virtually all of this petrochemical intermediate made there is upgraded locally (usually at the site of production), Middle Eastern consumption of ethylene derivatives represents less than 20% of its own output, meaning the bulk of ethylene equivalents produced in the area are exported from the region. The vast majority of ethylene made in the Middle East is converted either to (1) polyethylene (3 types LDPE, LLDPE, and HDPE -- comprising 60% of global ethylene use) or (2) ethylene glycol (over 10%). This region does not produce meaningful amounts of PVC, polystyrene, or, for that matter, the energy-intensive chlorine and caustic soda. The Middle East is the lowest-cost global producer of ethylene, with the average cash cost of production (as of year-end 2011) being around $300/ton. Alberta production (ethane based) is next, at about $350/ton. The US is the next lowcost producer, with an average cash cost on the order of $625/ton, with ethane-based units enjoying a below-average cost of around $550/ton. Costs in the rest of the world average as low as $750/ton and as high as $1250/ton except for the ultra-high cost output.
Ethylene Supply/Demand Outlook 1

Ethylene Prime Uses

Thermoplastics
Others
59% 59% 8%

Low-Density Polyethylene Ethylene Glycol High-Density Polyethylene Linear LowDensity PE Polyvinyl Chloride Polystyrene Styrene

13%

Ethylene
13% 13% 7%

Ethylene Oxide

Other EO Derivatives

Ethylene Dichloride EthylBenzene

VCM

Source: ChemSpeak

Ethylene Supply/Demand Outlook

The cash costs mentioned above are quite variable, since the most important driver of cash cost is the raw material. The volatility of oil prices leads to sharp ups/downs in naphtha costs in almost a direct correlation. Ethane costs typically depend not only on the cost of natural gas, but, on the US Gulf Coast, by a supply/demand relationship for ethane itself as purchases by petrochemical companies drive variability and therefore the cost of this natural gas liquid. Depending on the state of inventories (for ethane, ethylene, and derivatives) as well as demand for ethane, the price can vary considerably. For example, if there are major ethylene plant closures (unscheduled outages as well as planned maintenance turnarounds), ethane costs could drop meaningfully from the higher levels achieved when ethylene operating rates are high and producers are seeking more ethane to run through their steam crackers (versus historical amounts). Moreover, if co-product values (prices) for key outputs from naphtha crackers (such as propylene or butadiene) are especially high, demand (and prices) for ethane could ease as naphtha use could displace ethane. In 2011, ethane sold as high as 89 cents/gallon and as low as 61 cents/gallon. Nevertheless, on balance, the main conclusions from the cash cost curve still hold. (Please see the Ethylene/Ethane Spreads Chart on page 3.) In Alberta, as in the Middle East, ethane prices are set by contract often fixed in the latter region (perhaps with

escalation formulae) and typically by formula (based on natural gas prices) in the former. Dirt-cheap natural gas-derived ethane provides the advantage in the Middle East. The reason Alberta and the US are next on the cost curve is that natural gas prices are so low (relative to oil) and, as a consequence, ethane (one of the natural gas liquids derived from natural gas production) is relatively inexpensive as well. The bulk of the ethylene produced beyond the Middle East and North America is based on naphtha, whose price is closely tied (virtually directly correlated) to that of crude oil.

As is well known, the low natural gas prices in North America are due to an abundance of the commodity that has materialized with the success of gas discovery and production projects in shale deposits. Major NGL sourcing locations are shown in the accompanying map below. We see this low-price situation continuing, even though incremental demand for natural gas will develop in the electric utility, domestic heating, LNG export, and petrochemical sectors.

Ethylene Supply/Demand Outlook

Ethylene Supply/Demand Outlook

Ethylene - World Capacity and Demand (Assumes modest shutdowns and stretchouts)
(Millions of Tons)
2000 2001 2002 2003 112.5 1.4% 98.8 2.9% 87.8% 2004 113.3 0.6% 104.7 5.9% 92.4% 2005 116.9 3.2% 107.1 2.3% 91.7% 2006 121.7 4.1% 112.0 4.5% 92.0% 2007 127.7 4.9% 118.0 5.4% 92.4% -0.4% 2008 130.2 2.0% 110.6 -6.3% 84.9% 8.3% 2009 132.6 1.8% 111.3 0.6% 84.0% 1.2% 2010 138.9 4.8% 120.2 8.0% 86.5% -3.2% 2011 147.0 5.8% 125.6 4.5% 85.4% 1.3% 2012 150.3 2.2% 131.3 4.5% 87.3% -2.3% 2013 153.7 2.3% 137.2 4.5% 89.3% -2.2% 2014 158.6 3.2% 143.3 4.5% 90.4% -1.3% 2015 163.7 3.3% 149.8 4.5% 91.5% -1.2% 2016 168.6 2.9% 156.5 4.5% 92.9% -1.6%

Average Capacity 98.3 104.6 111.0 Avg Cap Change 6.5% 6.1% Demand 90.5 91.7 96.1 Demand Change 1.3% 4.8% Shipment Rate 92.1% 87.6% 86.5% Capacity Change vs. Demand Change
Source: ChemSpeak LLC, Headwaters Estimates

As mentioned above, internal consumption of ethylene derivatives in the Middle East is less than 20% of production. In the US, which has a large population versus the amount of ethylene produced, a high percentage of production is consumed internally. But, given its lost-cost position versus Europe, Asia, and Latin America, excess production in the US often finds a home outside the country. We estimate that 20-25% of all the polyethylene produced in North America is exported, while 35-40% of the polyvinyl chloride is shipped abroad. Historically, prior to the drop in natural gas costs relative to the price of crude oil, these percentages have been much lower, i.e., in the 10-15% zone. The key markets served by these exports are located in Northern Asia and Latin America. It should be noted that the cost of shipping for these commodities is typically in the range of 5-10 cents per pound. There has been global overcapacity of ethylene in the 2008-2011 time period, with average world plant utilization rates in the 84-86% zone. This has led to below desirable profitability in most regions, specifically in recent times for those facilities that utilize naphtha as feedstock. As noted, the bulk of production in Asia, Latin America, and Europe is based on naphtha. About 30% of North American ethylene is derived from naphtha, although this proportion is declining as producers invest in more flexible production units that can handle more natural gas liquids, especially ethane. Westlake is even considering injecting capital into its Calvert City, KY cracker, to convert the propane feedstock (another natural gas liquid) to ethane, which would be sourced from the Marcellus region.

Since the clearing price of a commodity is based on the cash cost of the least efficient player that can afford to remain open in times of overcapacity, the cost of naphtha is the key determinant of global pricing (typically in the form of derivative netbacks, such as PE). Hence, European and Asian ethylene manufacturers are getting by during this overcapacity period. Meanwhile, low-cost producers in the Middle East and North America which typically utilize ethane -- are generating healthy returns on their ethylene facilities, since the selling price of their ethylene derivatives is also based on the cost of naphtha, which is not that variable across the globe.

Ethylene/Ethane Spreads
$0.80 $0.70 $0.60
Cents Per Pound

$0.80 $0.70 $0.60

Ethylene Spread

$0.50 $0.40 $0.30 $0.20 $0.10

$0.50 $0.40 $0.30 $0.20 $0.10

Ethane

$0.00

$0.00

Source: Credit Suisse, ChemSpeak, Headwaters Estimates

Ethylene Supply/Demand Outlook

Ethylene Supply/Demand Outlook

The following link provides a detailed listing of ethylene facilities and capacity around the world as of 2008.
http://www.icpress.co.uk/etextbook/p702/p702_chap01.pdf

We envision global operating rates gradually advancing from 85 % in 2011 to 90-91% in 2014. Utilization could remain in the low 90s through 2016, depending on possible unforeseen incremental expansions that could come on-stream in 2015 and 2016. During the 2012 2016 timeframe, assuming normal economic conditions, demand for ethylene equivalents should increase at a 4.5% rate, while average capacity growth should be in the 2.5% - 3.0% vicinity. This should lead to higher returns for both low- and high-cost producers as the selling prices increase more rapidly than raw material costs. (Note: 92% is typically considered the highest sustainable industry operating rate over a year given seasonality, normal turnarounds, and unscheduled outages. Also, confidence in projections for 2015 and 2016 is lower vs. the 2012-2014 period, given possible unforeseen circumstances that could occur over the longer term.) From this starting point, where is the new capacity going to be built? In the 2008-2011 period, about 67% of world capacity growth emanated from the Middle East, while we expect this to drop to the 30% area in the 2012-2016 timeframe. Chinas proportion of expansions should remain similar in the 30% range, while in North America with its improved feedstock cost position the contribution to global capacity growth in 2012-2016 should approximate 17% versus virtually none in the 2008-2011 period.

result from a rapid run-up in feedstock costs followed by a notable decline. A good example of this can be found in 2008, when energy prices advanced sharply, peaking in mid-summer; by the fourth quarter and into the first quarter of 2009, a major inventory adjustment materialized, causing a sharp downturn in profitability. Another possibility, although an unlikely one, would be a major drop in oil prices relative to natural gas. This could erode the significant raw material cost advantage that ethane-crackers (based on natural gas) enjoy today. One must also consider the push to develop shale gas deposits in regions that typically crack relatively expensive naphtha: Europe and China. It would take several years to develop these reserves and alter naphtha crackers so that they could manufacture ethylene from ethane. Nevertheless, it is a situation which should be monitored.

Ethylene % of New Capacity by Region

Middle East North America Africa China Other Asia Total Middle East North America Africa China Other Asia 2008-2016 20,400 3,670 48 11,610 6,430 42,158 48% 9% 0% 28% 15% 2008-2011 14,000 0 0 5,150 1,720 20,870 67% 0% 0% 25% 8% 2012-2016 6,400 3,670 48 6,460 4,710 21,288 30% 17% 0% 30% 22%

Source: ChemSpeak LLC, Headwaters Estimates

Our Main Conclusions:

Over the forecast period, all ethylene producers should enjoy higher profitability as global operating rates advance from the mid-80s to the low-90s. What could go wrong? Beyond the normal negative consequences of economic downturns, one must consider inventory corrections (which typically last 6 months) that often
Ethylene Supply/Demand Outlook 4