INDUSTRY INSIGHT

COVID-19’s Impact on the Petrochemical Industry

By Mirko Rubeis, Managing Director and Partner, BCG, and Marcin Jedrzejewski, Managing Director and Partner, BCG

COVID-19 is one of the biggest humanitarian and economic crises of our time, with almost 200 countries affected. Since the beginning of March, when it became evident that the pandemic is a global challenge, we have seen frequent updates on the projected global GDP for 2020, provided by the leading international bodies and financial institutions. They show an increasingly negative outlook for the global economy with the mid-May estimations projecting a contraction of global GDP by 3.0 – 3.4% in 2020 (IMF, OPEC).

Not surprisingly, in such a context, the petrochemical industry is severely affected through a combination of demand drop as countries implemented social and travel restrictions, and also a supply reduction of the global petrochemical manufacturing hubs, which are impacted at least partially. The global chemical production index by ICIS has already shown a drop of 7% between the end of 2019 and April 2020.

However, COVID-19 is not the sole factor impacting the sector. We are today faced with an unprecedented scenario, whereby three major developments have hit the petrochemical industry at literally the same time:

  1. The COVID-19 pandemic is expected to lead to a full-year volume demand drop of up to 10% on average, depending on application markets (higher demand reduction in industrial and infrastructure, limited or none for packaging and some of the specialties such as food, health, and hygiene applications; the production continuity and operating rates are also affected).
  2. The oil price drop is dragging the pricing of most of the petrochemical materials down (e.g., PP pricing in China is down on average by 20%, PE is down by 15% on China ex-warehouse prices for Dec 2019 – Apr 2020) and bringing a major feedstock price disruption (naphtha price collapsed by 70% in line with crude oil).
  3. We saw a financial market collapse combined with the fluctuating share prices of oil, gas, and petrochemicals, with the valuation of many players going down by 20-30%

“The COVID-19 pandemic is expected to lead to a full-year volume demand drop of up to 10% on average, depending on application markets.”

These developments are interdependent, and we will explore the demand and supply-side implications in a similar manner.

Demand-side implication

A pandemic development such as COVID-19 typically has a three-phase impact on economic activity:

  • Flatten phase: where interventions such as lockdowns are rapidly introduced to contain the pandemic, and this is when economic activity freezes with drastic short-term impact
  • Fight phase: when the economy begins to recover while certain restrictions remain, impacting the recovery trajectory (e.g., air travel limitations, social distancing, disinfection)
  • Future phase: when the pandemic is gone (due to an effective vaccination, for example) and business conditions are entirely back to normal

Overall, the drop in demand in petrochemicals due to COVID-19 is currently estimated to be up to 10% on average. The situation is still dynamic as most countries are moving from the ‘flatten’ to the ‘fight’ phase. A key question is the duration of the ‘fight’ phase when society will resume economic activity while maintaining some restrictions, which is the most uncertain period, both in terms of duration and depth of impact on economic activities.

The difference in the level of impact and recovery trajectories by major petrochemical application segments are already visible:

  • Structural demand collapse (e.g., automotive, aviation industry)

Multiple negative factors characterize this on the demand and supply side. For example, car sales in China collapsed by almost 80% in the period Jan-Apr 2020 (measured vs. 2019), and in Europe, there was more than a 50% decline on average. Shutdowns in Europe alone led to lost production of 1.5 million motor vehicles. Recovery will be slow due to recession (lower disposable income) and structural changes in behaviors (employees working from home), and recovery to pre-COVID-19 demand levels is expected to take years (deep U-shape).

  • Temporary demand reduction (e.g., in electronics, textile, and construction)

Disruptions that are driven by lockdown and social distancing led to delayed product launches (electronics and global smartphone shipments dropped by almost 40%), demand drop (e.g., in textile by 25-35%), or temporary stoppage of construction activities (which differs by region, but is 5-25% below plans on average). A recovery to pre-COVID-19 levels can be expected in 1 – 3 years’.

  • Temporary demand increase (e.g., in packaging, nutrition, and some personal care segments)

The packaging, nutrition, and some personal care industries thrived in the pandemic due to panic buying in March 2020 but also due to changing consumption patterns and an increased focus on hygiene and disinfection standards. For instance, hand sanitizer demand went up by 1400% in Dec’19 – Feb’20 and global packaged food demand went up by 20% YoY). Demand is expected to go back to the pre-COVID-19 trajectory in the medium term, with an increased demand expected in the coming year (during the ‘fight’ phase).

“Car sales in China collapsed by almost 80% in the period Jan-Apr 2020 (measured vs. 2019), and in Europe, there was more than a 50% decline on average.”

“Naphtha had been structurally oversupplied due to structural changes in the global crude supply, leading to a price discount of Brent, which has increased to almost USD 10/bbl since 2017.”

The above trends imply significant changes in demand and profitability of individual types of material. As demand for industrial and infrastructure applications collapsed significantly more than, for example, in packaging, we observe a shift of production from PP to LDPE. The shift may be a positive message for Middle Eastern producers, especially with those with a historically high share of LDPE in their portfolio.

Supply-side implications

COVID-19’s impact on the petrochemical industry happened during a time of significant capacity coming onstream – as can be seen on ethylene and paraxylene.

  • More than 12 mtpa of ethylene capacity was expected to come on stream by the end of 2020, well ahead of the projected pre-COVID-19 demand of 6-7 mtpa. The current demand estimations hover around 1 mtpa in 2020, and even if some of the new projects are delayed, the structural oversupply will be substantial
  • We have observed the commissioning of new Chinese crude-to-chemical plants in Hengli and Zhejiang (the last one achieving on-spec paraxylene on the 2nd unit in Feb 2020) and construction advancement on Shenghong. Collectively, they will contribute more than 15 mtpa of paraxylene, significantly disrupting the market that is already experiencing a collapse in paraxylene and benzene pricing.
  • Naphtha had been structurally oversupplied due to structural changes in the global crude supply, leading to a price discount of Brent, which has increased to almost USD 10/bbl since 2017.

More important is the oil price collapse in March 2020, which in consequence brought a structural decline of naphtha prices – NWE naphtha dropped more than 70% between Jan and Apr 2020, while US ethane (Mont Belvieu) fell less than 20% (which began to rise in April). As a result, naphtha cracking economics have become very favorable, leading to a paradigm shift in the competitive position of petrochemical producers.

Looking beyond this short-term development, the midterm outlook on the supply side reveals several points of concern:

  • Low naphtha price environment translates to lower pricing of most petrochemical materials and is overall leading to the shrinkage of spreads
  • A crude oil price drop of USD 10/bbl from mid-price range before COVID-19 means at least a margin loss of USD 50-60 USD/ton for a gas-cracking integrated polyolefin producer
  • Recent sector profitability estimations – e.g., Moody’s estimated an overall 20% EBITDA drop for the chemical sector in North America this year
  • This immediately puts pressure on non-integrated polyethylene producers (e.g., starting in April, LyondellBasell had been forced to idle production at several smaller plants) and also puts strong margin pressure on facilities cracking imported US ethane in Europe or India
  • Virtually all players started to revisit the CAPEX pipeline and structure and level of engagement into JV projects, balancing future benefits vs. current liquidity needs; several CAPEX delay announcements have already been made.

While the current situation puts inevitable pressure on the organic CAPEX spent, we may see increasing interest in industry consolidation and M&A activities – in fact, with very low company valuations, inorganic moves may be more appealing than new capital projects.

“In the coming weeks and months, we expect companies with resilient balance sheets to actively look for opportunities and carry-out mergers and acquisitions to strengthen their manufacturing capacity and market reach for selected value chain plays.”

“Digital will be critical, by providing tools to optimize pricing and access to clients, particularly at times of social distancing (e.g., digital/remote inbound/outbound marketing, centralized sales, etc.).”

Impact on M&A and corporate development activity

Globally, stock prices in the chemicals sector have declined by 13% on average in the period between October 2019 and March 2020.

M&A activities need to be selected and executed carefully under all market conditions, as more than half of all M&A deals underperform in terms of expected value across industries and economic cycles. However, BCG analysis shows that value generated by deals carried out during periods of weak macro-economic conditions outperform strong economy deals by more than nine percentage points two years after the deal.

Many chemical companies have already put on hold or delayed their capital spend. At times of low valuations, it could make more economic sense to purchase existing assets than build new plants. The cost of new organic capital projects is somehow inflexible, although we are observing downward renegotiations, so in reality, also capital projects are becoming slightly cheaper. However, the cost of any existing asset or business is determined primarily by its future projected cash flows (rather than being linked to the steel on the ground), and in a downturn, the valuation can be significantly lower.

Therefore, in the coming weeks and months, we expect companies with resilient balance sheets to actively look for opportunities and carry-out mergers and acquisitions to strengthen their manufacturing capacity and market reach for selected value chain plays, while other will be companies rationalizing their assets. In most cases, companies will seek ‘portfolio coherence’ – growing in selected value chain plays, through acquisition or divestments of individual projects or business lines, rather than large corporate mergers. Only in the C1, C2, C3 value chains, we counted more than 1,600 assets or projects worldwide, and it is reasonable to expect that a few tens of them will change hands in the coming months.

We expect M&A deals to focus both on existing assets and new projects, e.g., new ethane-based projects in North America changing ownership.

The new reality beyond COVID-19

The sheer impact of COVID-19 and associated disruptions has immediately directed the attention of virtually every chemical player on aspects essential to the sustainability of the business: cash, liquidity, and strength of the balance sheet. Many organizations have set up a dedicated crisis and liquidity teams to ensure adequate managerial attention.

Looking beyond these, there are a few emerging observations that likely will have a more prolonged impact on the industry:

  1. Traditional growth product-markets segments are not necessarily growing anymore (e.g., aviation or automotive). This implies product and grade shifts (following, e.g., a demand shift from PP to LDPE), re-allocation of volume on markets and channels, and adjustments to go-to-market strategies. Chemical players will have to ‘sharpen’ their ability to sense demand and adapt rapidly to changing patterns. Developing more sophisticated demand models, supported by digital tools, will be necessary as well as adopting more agile and technically advanced sales and operations planning capabilities with a significant focus on scenario testing and optimization.
  2. In a more competitive world, access to market will be increasingly important. Development of strong marketing and sales organizations, with global reach, close to key clients and leveraging the full suite of marketing excellence levers (including more sophisticated pricing models) will be essential to winning volumes and margins. Digital will also be critical, by providing tools to optimize pricing and access to clients, particularly at times of social distancing (e.g., digital/remote inbound/outbound marketing, centralized sales, etc.). Models are still relying heavily on third-parties, and traders will inevitably be challenged.

3- Cost and operational excellence is a key “license to operate” – with an imminent further consolidation in the industry. This is not new to the industry, especially for European players who went through drastic cost reductions to stay afloat in the 2009 – 2011 period. What is new is that players with historical feedstock advantage (including Middle East producers) will activate all cushions, reaching to all possible reservoirs of cost optimization and workforce productivity. An option to consider is to consolidate, especially if there is a good portfolio fit as with the Sipchem / Sahara merger initiated in 2019. We will see more such moves in the region. Digital, again, can provide additional tools to optimize operations and supply chain, among others.

4- For companies with a strong balance sheet, this could be a unique moment to carry-out M&A at record low prices. Companies with such characteristics should set-up ad-hoc M&A teams to look at opportunities very quickly – the window of opportunity will last months, not years.

5- Agility in running the business, with better digital tools for information circulation, scenario modeling, and decision support are becoming critical. Speed is becoming even more essential in capturing opportunities offered by a fast-changing market environment. COVID-19 has demonstrated the relevance and importance of digital ways of working. It is vital to go beyond that, introducing advanced analytics and digital tools for scenario modeling, digital control towers for decision making support, and digitalizing further commercial interactions in the channels.

In essence, the times ahead won’t be easy for chemical players, with challenges both on the supply and demand side. Nevertheless, we believe these challenges may be the trigger for further transformation in the industry – both in terms of the M&A landscape, but also to accelerate changes in ways of working and capture well-known opportunities (e.g., commercial and operational excellence).

As it emerged in many of the recommendations above, digital is a key enabler in many areas, providing the tools to make the changes happen, and improving the ‘clock speed’ of the organization. Players that will leverage this moment of change to make bold moves (internally and externally) will emerge as winners during the economic rebound.