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Olefins: Caught Between Big Oil, Big Retail


Who wins if Wal-Mart and the NYMEX go head-to-head in a boxing match? Thats likely to be a long match. But to see that drama play out, tune into the Gulf Coast olefins market.

Portfolio managers spent the last year explaining to frustrated bosses why their assorted raw material costs – including many lube additives, synthetic products, coolants and packaging materials – fluctuate widely each month or quarter, with increases being the most recent development in the story. The answer lies in a structural change in the ethylene and propylene markets, marked by a sharp increase in spot market activity. In the meantime, downstream consumers are under pressure to create a steady pricing environment for their customers and ultimately the big-box retailers of the world.

The relentless supply- and cost-driven price increases seen in U.S. light olefins have been met with questions about how much more the downstream markets can bear.

For roughly the past 20 years, olefins producers were the shock absorbers of energy prices for the chemical chain. During the late 1980s, olefins feedstocks exploded into liquid spot markets, erasing the comfort level of steam crackers that previously paid a single monthly price for raw materials. Ethane, propane and naphtha prices began to change daily – but ethylene and propylene producers still charged one monthly price to their customers.

Olefins still largely operate the same way, with about 90 percent of pricing set monthly for contract volumes. However, the past few years have shown a significant increase in spot ethylene and propylene trade, and contracts now include spot price averages as a major component. As such, contract pricing has become more volatile, and the spot market can no longer be considered to be of marginal influence.

The supply-side pricing culture has largely kept margins stable for many downstream chemical markets in the United States, some of which still employ quarterly price mechanisms. The influence of mega-buyers such as Wal-Mart, however, has risen in recent years. Such savvy and demanding customers are now pushing back on prices. They are leveling the global field and squeezing the midstream commodity chemical markets, as olefins increasingly pass along the energy shock through their influential spot market trades.

Volatility Rising

Historically, contracts have fluctuated no more than 2 to 3 cents per month. This is no longer the case. For example, November polymer-grade and chemicalgrade propylene contract prices increased by 7.25 cents per pound, to 61 cents/lb. And 62.5 cents/lb., respectively. November ethylene contracts increased 4 cents/lb., to 61.5 cents, now considered a mild gain by many.

The sharp gains in chemical-grade and polymer-grade propylene contracts came as spot prices for feedstock refinery-grade propylene (RGP) – the barometer for the propylene complex – traded up from around 49 cents/lb. to 56 cents/lb. RGP prices spiked as refinery outages tightened supply.

In the lead-up to the November ethylene contract agreement, spot prices rose by about 4 cents to 54 cents/lb. from beginning to mid-October. In addition to rising energy prices, ethylene reacted to a supply crunch, as several steam crackers had unplanned outages during significant maintenance turnarounds at two sites in Texas. But by the end of October, spot prices reversed course, and were trading around 50 cents/lb. as energy futures retreated and cracker restarts increased olefins supply to the market.

The spot price influence on ethylene and propylene contracts in the most recent round of settlements highlights the evolution toward a more liquid spot olefins market. In the past two years, spot ethylene volume has tripled, with 296 million pounds trading in the spot market in September 2007, according to PetroChem Wire data.

Roots of Change

There are two main reasons for this transformation. One is an increase in the number of traders playing in the market. But also, more producers and consumers have begun to trade as a way to manage risk and have more of a say in the outcome of their contracts. In the case of propylene, buyers and sellers have stopped reporting their monthly, freely negotiated RGP contract price, which set the tone in the polymer-grade and chemicalgrade propylene negotiations, placing an even greater importance on movements in the spot market

A stiff debate has ensued regarding the merits of this shifting dynamic. Many derivatives markets are locked into monthly and quarterly contracts, and participants seek stable pricing and predictable margins. Fluctuations in daily monomer values create instability, and inject added challenges to running a business, some argue.

However, others point out that liquidity limits volatility, and a spot market trend is always more gradual than a monthly price spike for all contract volume. By representing the specific market fundamentals each day, some posit that markets become more functional and are able to better communicate their situation downstream.

New for 2008?

So what dynamics will the olefins community be watching as 2008 gets under way? In the case of propylene, fourth-quarter 2007 increases were driven largely by tight supply. Polymers producers said the high monomer prices have begun to erode demand, and propylene is set up for a downward correction.

They point to a similar story at the end of 2006, when a runup in propylene values in October was met with a 9- cent collapse in November. While the derivatives producers argued this was precipitated by demand destruction, producers noted this collapse was caused by falling crude oil prices. The difference this year is that crude oil is still high and margins slim, they said, adding that propylene will stay firm.

Ethylene is likely to be a similar story. The contract price for ethylene has not seen swings as large as the propylene market. But as Wal-Mart and their merry band of big boxers push for low steady prices, and as energy markets weave their way to new highs, spot olefins pricing will feature prominently in the story of chain profitability.

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