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January 2001
Federal Reserve Bank of Dallas
Houston Branch
Petrochemicals
and Natural Gas Prices: Short-Term Pain, Long-Term Concern
Houston and the Texas Gulf Coast are
home to two important oil industries. The upstream exploration
industry, consisting of the oil producing, oil service and
oil machinery industries, celebrates an increase in the price
of oil or natural gas as an incentive to greater exploration.
In contrast, the downstream petrochemical and refining industries
see higher oil and natural gas prices as an increase in the
cost of doing business, since they must pass higher feedstock
costs through to customers to maintain profit margins.
The Texas and Louisiana Gulf Coast is
home to the U.S. petrochemical industry. The industry converts
oil and natural gas liquids into intermediate products that
become plastics or synthetic rubber. The major core facilities
in the petrochemical industry are ethylene plants. Of the
40 U.S. ethylene production sites, 35 (95 percent of U.S.
capacity) are in Texas or Louisiana. For both Houston and
Texas, petrochemicals are always either No. 1 or No. 2 on
the list of annual exports to the rest of the world. In Houston,
chemicals, plastics and refining directly provide 50,200 jobs,
compared with 78,300 in oil production, services and machinery.
The Gulf Coast petrochemical industry
is based heavily on ethane, propane and other natural gas
liquids, which make up 76 percent of the typical feedstock
mix to regional ethylene plants. For most of the rest of the
world the input mix is reversed, with the input slate heavily
weighted to naphtha, gas oil and other oil-based products.
The Gulf Coast petrochemical industry has long been among
the world's most competitive, partly because of the region's
strong infrastructure and immediate access to the world's
largest market for petrochemicals but more fundamentally because
of a plentiful and cheap supply of natural gas relative to
oil.
The recent run-up in natural gas prices,
both absolute and relative to crude oil prices, is causing
tremendous short-term economic pain in the petrochemical industry.
While it is too early to determine how much of the current
natural gas price increases can be ascribed to cold weather
and how much to more fundamental changes in gas markets, it
is widely speculated that future U.S. natural gas supplies
may be priced higher for environmental and other reasons.
Short-Term Pain
The price of natural gas rose steadily
throughout 2000. The spot market at Louisiana's Henry Hub
passed $3 per thousand cubic feet on May 12 and has not looked
back. It surpassed $4 on May 24, $5 on November 12 and $8
on December 12. For methanol and ammonia, products made directly
from natural gas, the impact has been dramatic. As much as
half the nation's methanol capacity and one-third of its ammonia
capacity may already have shut down for economic reasons.
The impact of rising natural gas prices
spills directly over into the natural gas liquids market.
Ethane and some propane have fuel value and can be left in
the gas stream along with methane to sell as natural gas.
Alternatively, ethane, propane and butane can be processed
into liquids to be sold as chemical feedstock. As the fuel
value of methane doubles from $2 to $4 per thousand cubic
feet, for example, the fuel value of liquid ethane doubles
from 13 cents to 26 cents per gallon and propane doubles from
18 cents to 36 cents. Because chemical feedstock prices rise
proportionately with gas prices, an ethylene plant or other
chemical producer clearly has to offer more than the equivalent
fuel value plus processing cost to induce a processor to remove
the liquids and shrink the natural gas stream.
However, as feedstock prices have risen,
the price of the ethylene product has risen much less. In
the first half of 2000, ethylene contract prices rose by about
17 percent and spot prices by 36 percent, helped by strong
demand and a string of ethylene plant outages. In the second
half, ethylene prices reversed course, and by November contract
prices were down 6 percent and spot prices 20 percent. With
natural gas prices marching steadily upward, cash margins
slipped by more than 50 percent between June and November—well
below levels the industry recognizes as encouraging reinvestment.
The ethylene price weakness reflects
problems in both demand and supply. Demand slipped in the
second half of 2000 as the U.S. industrial market (including
such important ethylene markets as autos, housing and consumer
packaging) stagnated. Auto production slipped 11 percent from
June to November, other consumer durables fell 1 percent,
and consumer nondurables and housing starts were flat. Weak
ethylene demand was probably compounded by a long period of
post-Y2K destocking, which pulled inventories back to normal
levels and affected the long supply chain stretching from
ethylene producer to final consumer.
On the supply side, capacity additions
in the United States, the Middle East and Asia are putting
further downward pressure on ethylene prices. An additional
8 million tons of ethylene capacity is expected worldwide
this year, compared with demand growth that typically runs
about 4 million to 5 million tons per year. Excess capacity
is expected to weigh heavily on the market into 2003.
Poor profit margins and new, more efficient
capacity coming on line are taking their toll. At year-end,
plant shutdowns had removed about 5 percent of U.S. ethylene
capacity from production and reduced operations another 5
percent to 10 percent, pulling operating rates under 90 percent.
Long-Term Concern
This winter has so far been marked
by brutally cold weather that arrived early and then lingered
in key natural gas markets in the Midwest and New England.
Cold weather was the primary factor in pushing natural gas
prices to $5 per thousand cubic feet and beyond in November
and December. But this upward pressure on prices also may
be a symptom of more fundamental changes taking place in U.S.
natural gas markets. The deregulation of natural gas in the
late 1980s and early 1990s left substantial surplus production
capacity on U.S. markets, a result common to other deregulated
industries, such as airlines and trucking. This overhang of
production, known as the "gas bubble," lingered through much
of the last decade.
The typical pattern for crude oil and
natural gas prices in the 1990s was a ratio of about 10:1
(for example, $20 per barrel for oil and $2 per thousand cubic
feet for natural gas). Each year winter weather drove seasonal
price patterns, with gas prices peaking in winter and sagging
in summer, when storage was refilled to meet the winter peak.
However, in recent years, the gas-bubble surplus seems to
have yielded to strong demand growth stemming from two main
factors. First, as environmental restrictions have tightened,
particularly under the Clean Air Act, the demand for clean-burning
natural gas has risen relative to oil. Fuel switching for
economic reasons, as between natural gas and fuel oil under
industrial boilers, for example, has become increasingly difficult
as environmental permits have become more stringent. Second,
there has been a dramatic shift in favor of natural gas for
electric power production. Efficient combined-cycle generation
technology, lower capital costs than for other fuels and the
environmental advantages of burning gas have combined to make
natural gas the electric power producer's fuel of choice.
One result was last year's apparent difficulty in filling
storage for the approaching heating season; instead of dipping,
gas prices rose steadily through the summer, presumably as
storage operators competed with growing electric power and
other demands for natural gas.
Simple trends do indicate a potential
long-term shift in the price of natural gas, with prices trending
higher since the late 1980s. Through the first half of the
1990s, the gas bubble kept the ratio higher than the 10:1
rule of thumb. Then, particularly around 1997, the gas prices
moved up, pushing the ratio lower. Winter weather and falling
oil prices now have pushed the ratio from 7.3 on November
1 to under 3 by late December.
Most of the rest of the world relies
heavily on naphtha, a light distillate found in oil, to produce
ethylene. The U.S. competitive advantage in petrochemicals
has been built on abundant and relatively cheap domestic supplies
of natural gas. Oil and naphtha prices are determined in a
global market, while U.S. and Canadian natural gas inherently
has a regional market because of physical limitations in moving
gas over long distances. As the environmental and other demands
for U.S. gas grow, we see the potential for natural gas prices
rising domestically, while oil prices will be determined largely
in a bigger market and by unrelated factors.
When do rising natural gas prices begin
to threaten U.S. advantage? It depends on what is happening
to oil prices at the same time. Table 1 shows the cost of
producing a pound of ethylene as oil and natural gas prices
change. For example, if ethylene made from natural gas feedstocks
costs 7 cents, the natural gas costs $2 per thousand cubic
feet; to produce 7-cent ethylene from naphtha, oil costs $13
per barrel. For oil to have a cost advantage over natural
gas at $2, a typical level in recent years in the United States,
it would have to cost less than $13 per barrel. The $17–$22
crude oil price range in Table 1 matches natural gas prices
at $3–$4, both producing ethylene at 10 cents to 16
cents per pound. The $17–$22 range is typical of U.S.
light sweet crude prices over the past 20 years. Adjusted
for inflation, 35 of the 60 quarters from 1985 through 1999
averaged prices in this range, with only eight quarters below
$15 and six above $25. Table 1 tells us that U.S. natural
gas at $3–$4 would remain just competitive with long-term
oil markets at $17–$22, although the historical profit
advantage the United States has held at $2 would be lost.
| Table 1 |
| Cost of Producing U.S. Ethylene: Oil
Versus Gas as Feedstock |
| |
Two completely different sets of circumstances,
both arising in the last two years, pose a threat to gas-based
petrochemicals, as illustrated in Table 1. Following the Asian
financial crisis, crude oil prices plunged, bottoming out
in December 1998 with light sweet crude at under $10 per barrel
while U.S. natural gas held near $1.80. Naphtha-based ethylene
producers briefly held the energy cost advantage until oil
prices began to rise sharply through the spring of 1999. Currently,
naphtha is seizing the advantage again, this time because
of spiraling natural gas prices. Much of the spike is weather-related,
making it unlikely that naphtha's current extreme competitive
advantage will last much longer than it did in 1998.
The long-term question, however, is
whether the causes of this current gas price spiral—stronger
demand for environmentally friendly fuel and natural gas-generated
electric power—point to permanently higher prices in U.S.
natural gas markets that increase the likelihood of long-term
erosion of the Gulf Coast's competitive advantage in chemicals.
Much of the industry's historical advantage of cheap feedstocks
would be lost with natural gas in a $3–$4 range. The
cost factor, combined with severe impending environmental
restrictions on petrochemical operations in Houston and restrictions
on nitrogen oxides that ultimately may be applied throughout
the Gulf Coast, may cause the region's petrochemical industry
to rethink its long-term viability before making billion-dollar
commitments.
—Mark A. Eramo
Robert W. Gilmer
Arved Teleki
| About the Author
Eramo is director of light
olefins and Teleki is chief economist, Chemical
Markets Associations, Inc., Houston, Texas. |
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Houston
Beige Book
December 2000
The Houston economy continues to expand
at a solid pace. Revisions to employment data, now available
for the first half of 2000, point to 3.5 percent job growth
for the year. Employment growth has been running at a 3.2
percent annual rate over the past three months. While the
U.S. Purchasing Managers Index fell to the lower 40s in November
and December, indicating a near recessionary rate of contraction,
the Houston Purchasing Managers Index reading of 58.8 in November
points to a healthy rate of expansion.
Retailing and Autos
Local retailers saw holiday sales
start slowly, but cold weather, heavy promotion and sale prices
finally cleared the shelves. Advertising costs and discounted
prices hurt profits.
November auto sales slipped behind last
year's by 5.6 percent, although year-to-date sales for 2000
were still running 14 percent ahead of 1999. Dealers expected
December would be another weak month.
Oil and Natural Gas Prices
Spot prices for light sweet crude
peaked in late November and have declined by $10 per barrel.
U.S. crude and product inventories remain low, but Asian and
European stocks have begun to refill and U.S. stocks are expected
to fill soon. Oil product prices have generally followed the
price of crude downward, with the fall of heating oil prices
interrupted by cold weather in the Northeast.
Refiners' margins have also slipped
in recent weeks but remain healthy by historical standards.
Refineries on the Texas and Louisiana Gulf Coast have operated
at full capacity to take advantage of the good margins.
Natural gas prices soared with cold
weather in key markets in the Midwest and New England, pushing
as high as $10 and $11 per thousand cubic feet. Inventories
were about 15 percent below the five-year average in late
December.
Drilling and Oil Field Machinery
In recent weeks, the domestic rig
count flattened out at about 1,100 working rigs, the Canadian
rig count dipped in a normal seasonal pattern and international
work continued to grow. Worldwide constraints on equipment,
services and skills are imposing limits to the number of active
rigs, although the projects undertaken are increasingly risky
and lucrative for service companies. Respondents indicate
an increase in pure exploration activity as less risky development
projects are becoming exhausted. Competition for scarce oil
field resources is driving up service prices and industry
wages.
| About Houston
Business
For more information or
copies of this publication, contact Bill Gilmer
at (713) 652-1546 or bill.gilmer@dal.frb.org,
or write to Bill Gilmer, Houston Branch, Federal
Reserve Bank of Dallas, P.O. Box 2578, Houston,
Texas 77252. This publication is available on
the Internet at www.dallasfed.org.
The views expressed are
those of the authors and do not necessarily reflect
the positions of the Federal Reserve Bank of Dallas
or the Federal Reserve System. |
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