The petrochemicals industry, always extremely sensitive to shifts in economic activity, is poised for a shake-up. Consolidation could characterise the sector, as it tries to pull itself out of what is expected to be a very difficult downturn. Middle Eastern players are likely to surge into Western markets and fundamentally alter the petrochemicals landscape, according to lenders active in the sector.

LyondellBasell provides the most obvious sign of the trouble to come, after it placed its US subsidiary into Chapter 11 bankruptcy protection. Producers in the Middle East are best placed to weather the combination of low oil prices and shrinking product demand. But the economic downturn will exaggerate this supply overhang, and the trough may be much more severe.

Operational projects in Europe, the US and Asia could become stressed by the current market conditions, and some of the large projects in the Middle East closed when engineering, procurement and construction (EPC) contract prices spiked, like the Saudi projects from the first half of 2007, could also face challenges when they reach completion in what seems likely to be one of the deeper petrochemical down cycles of recent times, says John Dewar, a project finance partner at Milbank Tweed.

Lenders and producers are aware that petrochemicals is vulnerable to cyclicality, and the Middle East and North Africa, which enjoy access to cheap feedstock, have been the most fertile grounds for new projects. Several of these projects, however, are scheduled to come online in 2009, and this increase in supply will test the profitability of competitors working with higher costs elsewhere in the world. The stage is set, at the very least, for a large amount of capacity to change hands.

LyondellBasell breaks down

LyondellBasell's US business filed for chapter bankruptcy in January, after being hit hard by slumps in product demand in late 2008 and near-frozen credit markets. The producer, one of the biggest users of project finance in petrochemicals, is result of the combination of a former polymer joint venture between Shell and BASF, and the refining operations of Atlantic Richfield and Equistar, all under the control of Leonid Blavatnik's Access Industries.

LyondellBasell is the world's third-largest independent petrochemicals company, but its complex history left it a legacy of a complex series of debt obligations. It has said its non-US operations are unaffected by the bankruptcy filing, but despite this Standard and Poor's downgraded its credit rating for LyondellBasell's global business in February, from SD to D, following payment default, on coupons of two European bonds worth $615 million and Eu500 million ($635 million). S&P also said LyondellBasell's Basell Finance subsidiary was unlikely to make a coupon payment for $300 million notes, scheduled for March 15.

LyondellBasell is involved in three petrochemical production joint ventures in Saudi Arabia, which will amount to 2 million tonnes of propylene (PE) and polypropylene (PP) capacity. Two of these, SEPC and SPC, in which LB owns 25% stakes, have encountered slips in their start-up dates (from Q4 08 to Q1 09). Waldemar Olderburger, a spokesman for LB, insists that there are typical technical delays rather than financial fallout.

The last of these projects, Al-Waha Petrochemical Company, is a 25% owned by LyondellBasell and 75% owned by Sahara Petrochemical Company. It was financed in 2006 through a $631 million HSBC-assembled Islamic financing. The complex is to produce 455,000 tonnes per year of PE and 450,000 tonnes of PP and is scheduled to start production in the second quarter of 2009 quarter.

The producer's troubles have also cast a cloud over its ventures elsewhere. LyondellBasell has also signed a project development agreement with the government of Trinidad and Tobago, and contractor Lurgi, to build a 490,000 tonnes-per-year polyolefins plant. LyondellBasell is to provide technology as well as marketing muscle to the project, if it goes ahead.
"As the PDR in Trinidad and Tobago has been signed in December, I can still confirm that our intention, and business strategy have not changed. However given the current economic climate, and the current financial condition of our company, the timing of this project must be carefully reviewed," says Oldenburger at LyondellBasell.

LyondellBasell is also a minority interest holder in Kazakhstan Petrochemical Industries, which plans to build three new petrochemicals plants by 2013, with a combined capacity of 1.3 million tonnes per year of polyolefins. This deal is yet to reach financial close. LyondellBasell is also reviewing the timing schedule of the Kazakhstan project, according to Oldenburger.

However, LB is not alone in facing a difficult outlook for its development prospects. "There are some projects mooted in CIS, which are oil-based, and I know they are basically on hold," said one banking source. "They are projects being done by companies which had lots of cash flow when the oil was at $147 per barrel," he says, adding: "They are [now] saving cash for things which are vital – and expansion into petrochemicals is not something which is vital at the moment."

"In the current debt markets and with EPC prices still to come off the boil in a meaningful way, I would doubt very much whether those [projects] are proceeding very rapidly," adds Milbank Tweed's Dewar. "They are also going to need significant export credit agency participation to get them done," he says.

What fed the trough?

The fall in energy prices since the middle of 2008 provides a serious test for the less competitive petrochemicals projects. Plants tend to be built in waves, every five or six years, and the sector is firmly in the trough of its cycle, following a series of projects that came to market in and around 2006.

The price of naphtha, the main oil-based feedstock for non-Middle Eastern producers, closely shadows swings in crude oil markets. Naphtha is used heavily in European and Asian plants that do not have access to cheap ethane (gas feedstock) like many plants in the Middle East. When oil prices headed northwards in the first half of 2008, so did naphtha prices, and in turn the price of petrochemical products.

Naphtha tends to trade at a modest premium to crude oil, producing a crack spread. The spread changed drastically the latter half of last year, after fuel prices rocketed and the global slump began to bite.

"The crack spread over the last fifteen years has averaged at just over one dollar per barrel," says Andrew Powell, a senior consultant at Nexant, which analyses petrochemicals markets through its ChemSystems arm.

"Slowing demand for gasoline, particularly in the United States, as retail prices hit a succession of record highs, contributed to a reduction of the crack spread in the first half of 2008. Naphtha supplies, which are usually converted into gasoline blending components such as reformate and isomerate, within oil refineries, were released into petrochemical markets," he notes. Meanwhile, he adds, petrochemicals producers were not able to fully pass on the higher feedstock prices from soaring oil, and reduced consumption as operating rates were trimmed in response to severe erosion of margins. Production cutbacks at reformers and crackers in petrochemical complexes across Asia considerably reduced the volume of naphtha imported from Western Europe into Asia.

The downturn in GDP growth in the fourth quarter was accompanied by a slump in the demand for chemicals, as sectors like the automotive and housing industries reined back their order books. "In the second half of 2008, a dramatic reduction in demand for naphtha in the petrochemical industry accelerated the weakening of the crack spread ... Naphtha crack spreads collapsed to historic lows, bottoming out at an all time low of almost minus $20 per barrel in November," Powell says.

"You had a combination of very high price levels for polyethylene, polypropylene, you had a very strong incentive for conservatism amongst [polymer] buyers to stop buying to try and minimise inventories. There was a lack of availability of credit, and there was a huge uncertainty over end-user demand with a negative economic outlook ... that probably resulted in the worst level of petrochemical demand since the early 80s," says Matthew Thoelke, a consultant in olefins and derivatives markets at Chemicals Market Associates, a consultancy.

"Average production rates at European crackers were turned down to just 60% in the final quarter of 2008. The fourth quarter of 2007 saw cracker operating rates at about 88%. This is a much more typical production rate than the extremely low rates in the final quarter of 2008," Powell says. "Towards the end of 2008, many crackers were either operating at minimum technical throughput volumes, or even temporarily idled," he adds.

The naphtha crack spread recovered a little in the first few months of 2009, as lower prices have encouraged producers to top up their inventories. Moving towards the end of February, naphtha still trades at a discount to crude, but much reduced at minus 2.5 dollars per barrel. Naphtha prices typically rise in the summer months as gasoline demand increases, and this should further narrow the feedstocks' discount to crude. "We expect naphtha prices to strengthen relative to crude oil, as consumption in the petrochemical sector is restored, restoring the crack spread to where we were a year ago," Powell says. Demand for naphtha in the European and Asian markets has risen since the start of 2009, but the global economic downturn and credit issues mean that the profitability of plants is likely to be much reduced for several months, at least, and will be highly sensitive to its energy cost element, and thus to the price of crude, says Thoelke.

Lenders to the last batch of projects will wait anxiously to see whether demand recovers. Several new plants are expected online this year, and will meet a much weaker demand than a year ago. "As long as we see an oversupplied market, we would expect the price of petrochemicals to be very much determined by their cost," Thoelke says.

Powell said with new supply set to combine with flat demand during the downturn, the surplus of ethylene supply is forecast to widen by around 27 million tonnes.

"In previous downturns in the industry it's been more of the order of 5 or 6 million tonnes," he says. "Certain projects that were given financing and approved in the last year, expecting oil at around $70 per barrel, and locking in capital costs at a peak, will struggle to deliver anticipated returns should oil prices remain at a much lower 30-40 dollar per barrel range in the long term."

Advantage Middle East

Middle Eastern producers, however, should enjoy one big protection – cheap feedstock. The main advantage that the Middle East has is around ethane," says Thoelke. Prices of ethane in the region were set by governments or government-owned companies to stimulate investment, which resulted in a wave of ethane-based projects sprout up in the region.

Fed by locally-sourced ethane with a fixed price, these projects yielded high profits when oil prices hiked and they remain the most competitive, despite economic slump. Gas-fed plants exist elsewhere, but plants in the US, for example, are at the mercy of local spot gas markets. Since they compete for gas with buyers such as utilities, they do not enjoy the same margins.
But governments like that of Saudi Arabia have also encouraged producers to process LPG and liquid feedstocks using newer steam crackers plants, to support other value-added producers. These projects are likely to be less profitable than the 100% ethane projects, which came online five or ten years ago.

But given how cheap the local feedstock is, developers are still actively pursuing projects in the Middle East. But with no depth to credit markets, many are concentrating on re-bidding EPC contracts in the hope of realising substantial savings. Very few projects are likely to secure any financing commitments this year, bankers say.

This move to squeeze EPC contractors will be complicated enough. The global downturn should bring about lower EPC prices, but with the order books of construction and technology companies relatively full for the short term, there will be some lag before developers can take advantage of lower costs. Other projects, according to market rumours, have freed attempts by lenders to use market disruption clauses to renegotiate margins upwards.

"Some of the projects may need restructuring, in particular, the ones built when EPC prices were at an all-time high. They are going to find debt servicing more challenging even with low feedstock prices," Milbank's Dewar says. The projects completed during the previous cycle, when EPC costs were significantly lower and whose debt has been substantially repaid, are likely to remain very competitive, he says.

The shake out

Saudi Basic Industries Corporation or Sabic, bought GE Plastics from General Electric in 2007, for a price of $11.6 billion, firmly consolidating the position of the Saudi Arabian producer in the downstream market. As Western companies, even those as large as LyondellBasell, are now considered vulnerable, consolidation is preoccupying lenders to the sector.
Sabic's buyout of GE Plastics has given the Saudi company direct access to European and US end-user markets, says one banking source. "It is now starting to fill in the missing links in the chain," he says. "The new big producers which are going to emerge are going to be the Middle Eastern and North African producers which have access to very cheap feedstocks," another banker says.

Those producers with production costs at $2 per million BTU, or below, should be able to ride out the cycle, he says. Based on the assumption that oil prices will rise in the short to medium-term, producers with oil-based crackers in US, Europe and Asia will not be able to compete with the gas based projects in areas like Saudi Arabia, and this will prompt M&A activity in the sector, he says: "I think we're going to see a massive rationalisation of the worldwide petrochemicals capacity."

The state ownership, or at least state support, that predominates in the Middle East will give further stability to these producers as global markets shrink. They are likely to buy technology companies, or those companies offering access to market places like Europe and the US, according to many market observers.

Al Kayan's offtake heats up

Although Sabic has shown a keen interest in expanding abroad, it currently has some issues to resolve on a project closer to home, the $10 billion Al Kayan deal, of which $6 billion is debt financed. The plant is to produce 4 million tonnes of petrochemical and chemical products per year. The financing for the plant closed in 2008 and the facility is currently under construction.

Al Kayan's financing package consists of $727 million in commercial bank debt, a $1 billion Islamic tranche, a $1.5 billion ECA tranche split between ECGD, Sace and KEIC, a $500 million loan from Kexim, a $1.1 billion Public Investment Fund (PIF) facility and $530 million from the Saudi Industrial Development Fund (SIDF). There is also a $635 million Islamic working capital facility lead arranged by Al Rajhi. The commercial loan had a 15-year tenor and a margin of 65bp over Libor, rising to 75bp. Fees on the commercial tranche are 100bp and 25bp on the ECA-backed tranche.

But rumours have emerged that SIDF wants Sabic to reduce the marketing fee it charges the project company, and could end up walking away from the project, says a banking source: "The project is paying a marketing fee for Sabic to offtake the production and place it. SIDF wants this fee negotiated down." BTM is communicating with the sponsors on behalf of the lenders and "there is a negotiation, ongoing," he adds.

There are also press reports that the SIDF is concerned about the terms of the gas allocation agreement and the commercial debt on the project and that Sabic is ready to step in to cover the shortfall if SIDF leaves the project, though the source could not confirm these. The dispute offers a foretaste of the stresses that lenders will need to cope with in the coming months.