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html Tough market conditions of rising costs and shrinking margins may mean capacity will have to be idled Dow Chemical's chief executive has highlighted the threat of higher naphtha costs and shrinking margins on crackers in Europe and Asia, warning that units reliant on the feedstock could be under threat. During the US producer's earnings conference call late last month, Andrew Liveris suggested that 2m tonnes/year of cracker production in Europe and Asia could close as a result. Whether those crackers will be temporarily idled or permanently shut down will depend on the direction of the economy and how strongly confidence recovers, Liveris said. VULNERABLE CRACKERS "Right now, as predicted, we are facing trough-like supply/demand conditions in the ethylene chain. We expect high-cost crackers in Asia and Western Europe to begin to feel the margin compression in the very near term," he said. "In Europe and Asia we do believe the industry is at a point where asset decisions will be taken as a result of these current margins," he added. "We've identified about 4m tonnes/year of vulnerable production right now based on pure naphtha plays, mostly in Europe but some in Asia. I think it will be more idling than shut downs." INDUSTRY IN AGREEMENT Tom Crotty, director of Switzerland-headquartered producer INEOS, agreed with Liveris' comments but said this needed to be put in context. Some 48% of the world's ethylene capacity is naphtha based, which amounts to around 55m tonnes/year, he said. An attrition of 2m tonnes/year represents less than 4% of the total. "We have already seen closures of smaller-scale naphtha crackers over the past couple of years totaling some 1m tonnes/year of capacity and I am sure we will see more of this in the next few years," said Crotty. The economy, proximity to the Middle East, dependence on naphtha and the size and age of crackers makes European crackers the most vulnerable. "A reasonable forecast, in our opinion, is around 1m-1.5m tonnes/year," said Daniele Ferrari, CEO of Italy's Polimeri Europa. "It will surely be necessary to arrange reductions of production capacities, with particular regard to the oldest and most inefficient plants." Alexander Keller, global head of chemicals/oil practice group at Germany's Roland Berger Strategy Consultants, also agreed that cracker capacity will need to be closed in Europe, but suggested "it should be more than 2m tonnes/year [rather] than less, looking purely at economics". "We expect a minimum of 1m tonnes/year in Europe. This would stand for two to three crackers. There might be some potential for more in Europe up to 2m tonnes/year, but I do not expect that to happen in the next five years." However, closing units in Europe will not be without its difficulties, mainly because many crackers in the region are partly integrated into refineries. Paul Hodges, chairman of UK-headquartered consultancy International eChem, said that refining economics, as well as petrochemical profitability, needs to be considered: closure would mean the refinery would have to either cut runs, or close down. Also, any

major closures in Europe would adversely affect the continent's ability to rebuild its manufacturing base - a key strategic objective for the future of its economy. Although improvements have continuously been made to ethylene plants, 75% of Europe's capacity was built before 1980 and 35% produces less than 500,000 tonnes/year, according to Paul Bjacek, chemicals and natural resources, research global lead at US management consultancy Accenture. The median plant size in Europe is about 470,000 tonnes/year compared with North America, which is 660,000 tonnes/year, he said. New worldscale naphtha crackers are usually considered to be in the range of 800,000 tonnes/year. CRACKERS AT RISK "Capacity at risk is generally made up of those units that are either subscale, have an expensive logistical feedstock supply, expensive logistical product sales, have poor coproduct capability, or any combination of these shortcomings," said Crotty. "There are a number of e_SDHpcrackers in Europe and Asia that have these problems and I would not be surprised to see more falling by the wayside, as Dow suggests." Strong competition in the important polyolefins derivatives market will also drive European producers to restructure their cracker capacities, added Ferrari. "Furthermore, the competition is sharpened by an increased supply, which is more competitive in terms of costs, coming from other areas of the world, particularly from the Middle East," he said. "This scenario results in unsatisfactory rates of utilization of plants and poor gross margins that do not grant adequate profitability for the sector. "High costs of naphtha during 2011 have penalized the European and Asian crackers with respect to the North American and Middle Eastern ones, fed by gas." In Keller's view, switching to lighter feedstock, and specifically shale gas in the US, is adding pressure to the global naphtha-based cracker landscape. Consequently, he believes that as well as closures, there will be further investment in flexible fuel crackers. This has already happened to a large extent in Europe, in particular the ability to switch between naphtha and liquefied petroleum gas (LPG). Europe is suffering from weak demand growth. Plants that have higher feedstock flexibility and are better located in terms of consumers, such as in Germany or the Benelux countries, are those that will continue to have most advantages in the future. In Western Europe, Italy and the UK are most vulnerable in terms of possible closure, said Keller, because there are some crackers already on the watch list. Furthermore, some capacities in Eastern Europe are at high risk because of ageing assets and their small scale. "Europe needs to take an urgent look at how it can follow the US lead and revitalize its petrochemical industry," Hodges went on to add. "The concept of regional clusters could offer some 'quick wins' in this area. This requires suppliers and consumers to develop plans that will help enable both to prosper in the increasingly difficult world that likely lies ahead in 2012." SHORTCOMINGS Crotty added: "There is no geographic or national guide to which crackers are at risk [in Europe]. The same applies to Asia where there are some crackers in Japan, South Korea and even China that have the same shortcomings. "In terms of where supply will come from to make up any shortfall from smaller units closing; for ethylene and propylene that will be a combination of expansion of the more efficient units in Europe and Asia, alongside growth in Middle Eastern and some North American gas-based units.

"For the longer chain derivatives, Europe will continue to need large, efficient naphtha and mixed-feed crackers." Countries in Asia that rely on more expensive feedstocks and face less favorable conditions, such as labor costs and local e_SDHplegislation are likely to suffer from international competition. Crackers working with advantaged or government-protected feedstocks, especially light feedstocks, are said to be best positioned. Fred Peterson, director of US-based consultancy Probe Economics, said: "On the assumption that China and Japan's crackers will be protected by the government, I suppose you would assume that [South] Korea and Taiwan's crackers are also vulnerable." Opinions differ on the timing of any shutdowns but some e_SDHpbelieve it should happen as soon as possible considering the very weak demand for ethylene and propylene derivatives and a considerable excess of capacity. However, Keller takes a longer term stance, suggesting that this will happen in the next three to five years, and that they are likely to be permanent shutdowns, even if they are not reported as such. "In the short- to mid-term these shutdowns will re-balance the current excess capacity. Therefore we expect an improvement in plant utilization rates as a consequence," said Ferrari. NEW OUTLETS Countries such as China and India are about to build more capacity and will be looking for new outlets, potentially even outside their domestic markets, said Keller. "We expect an increase in ethylene production from approximately 120m tonnes in 2010 to 170m tonnes in 2020, and utilization rates globally going up to more than 90% on average," he said. Crotty thinks it inevitable that there will continue to be changes in olefins production in Europe but expects these to be marginal. Producers that operate large-scale crackers with modern efficient technology, have a combination of gas and liquid capabilities, refinery integration and a broad and differentiated derivative portfolio will thrive and be key to the success of the industry, he said. "Europe shouldn't give up on a business where it retains considerable strengths," said Hodges. "Instead, it should focus on innovation and achieving higher performance, via product development and better site integration." Additional reporting by Al Greenwood in Houston and Franco Capaldo in London CRACKER MARGIN FALL TO 30-MONTH LOW IN EARLY NOVEMBER Asian ethylene variable cash margins have fallen to the lowest level since May 2009, squeezed by high feedstock costs and falling product prices, ICIS weekly margin reports show. Ethylene margins for naphtha and liquefied petroleum gas (LPG) cracking in both Northeast (NE) and Southeast (SE) Asia have been negative since late October, which has prompted ethylene producers to cut plant operating rates to around 80-90% in attempts to minimize losses. NE Asian margins for the first week of November are negative by more than $150/tonne compared with the year-to-date average margin of almost $250/tonne. Margins have been compressed by high feedstock costs while chemical prices are suffering from waning demand, inventory destocking and macroeconomic worries. Spot ethylene prices in NE Asia were assessed at $1,010/tonne CFR (cost & freight) at the start of November, 16.9% lower than the year-to-date average of $1,215/tonne,

while feedstock spot naphtha prices remain elevated, at $880/tonne CFR Japan, only 7.4% below the year-to-date average of $950/tonne. More significantly, cracker co-product credits, such as propylene, butadiene (BD) and aromatics, are fetching almost $1,850/tonne of ethylene produced, almost 20% lower than the year-to-date average of about $2,270/tonne. Author: Andy Brice and Elaine Burridge