8 Ways to Win with $30 Oil: “Energy at the extremes”

What works, what struggles, what changes when oil prices head into the tank? Who will feed China’s manufacturing monster?

At Clariant’s “Defining the Future VII” conference in San Francisco, the delegates were leaning forward, straining to hear, as IHS Vice-President Mark Eramo undertook the task of looking at forward trends in energy and chemicals feedstocks at a time of extraordinary volatility in the market.

“Energy at the extremes creates opportunity, creates risk,” said Eramo. As Clariant’s Senior VP for catalysis, Stefan Heuser remarked to the delegates, “feedstocks are shifting. Being nimble is important for continued success, and we all must keep our eye on the environment, and find more sustainable solutions.”

“All lines, all roads lead to China,” Eramo said. “It’s the epicenter of the petrochemical universe right now, whether we are looking at imports coming in or exports coming out. We have to understand China, and how they are feeding their manufacturing machine.”

And it helps to understand energy prices, too. China and energy prices, then. With understanding of these, we’ll move along to the “what can we do?”

Energy prices, let’s replace yesterday’s Inexplicable with today’s Crazy.

This morning, the October 2015 contract for West Texas Intermediate slipped to $39.40, and the futures price doesn’t cross the $50 barrier again until September 2017 — and with China’s devaluation of the yuan and other extraordinary flooding of its economy with currency, there’s ample the roiling in global equities markets over growth concerns.

Citi’s global head of commodities research and managing director, Ed Morse, told CNBC he wouldn’t be surprised to see $20 oil before the tsunami subsides.

Moving to the New Normal

First, what’s happening in energy markets and chemical markets, and in decision-making around the globe? There’s a new normal, as OPEC has moved away from tuning its production with a focus on price. “OPEC has said to the US, you set the volume.”

Which is to say, OPEC has committed to a production volume — the volatile shale production chain determines the extent to which the market is oversupplied or undersupplied with petroleum, and the price will be volatile as a result so long as unconventional production is volatile, and the price will be low so long as unconventionals continue to use technology to drive down cost, and continue to expand production.

That’s the new normal.  With as many unexpected cliffs and strange terrors as the first astronaut might run into on a tumbling, hurtling, unstable comet might experience.

Who’s in Charge of the New Normal?

Nominally, shale producers, if you follow the OPEC thesis. Certainly, not chemical producers and other customers.

“Ethane, for example, has been volatile throughout its history,” Eramo noted. “The floor value is set by the fuel value and the peaks are driven by ethylene markets.”

“When energy markets move, chemical markets will respond,” Eramo said. “Chemicals are price takers, the chemical industry does not influence the floor prices, which are set by energy markets.

The problem of volatility, and uncertainty itself

The volatility is there to drive uncertainty. And how fundamental separation in energy prices — and specific molecules, is driving that volatility.

“When crude oil prices fall, there’s a collective pause in the value chain,” Eramo noted. “People say ‘lets drop our inventory, not buy ahead.’ As Eramo described it, wHat we begin to see is a self-fulfilling prophecy, as fears of a slow-down in demand turn into a slowdown in demand, fueled by uncertainty itself. Meaning that markets will continue to be volatile, retarding decision-making.

Leading us from New Normal to the New Abnormal

As Dow VP, Bob Maughon observed this morning in San Francisco, “6 years ago everyone said we have to have alternative feedstocks because of what we saw then. Today, it’s easy to say we don’t need alternatives because of what we see now. But what is the future going to bring? That’s what we have to figure out, and it has to be cost-effective because that is a key part of what makes sustainable sustainable.”

How the New Abnormal will roil global trade

So, consider this. South Korea is making a lot of propylene and propylene derivatives, which they sell to China, to feed the manufacturing monster. Consider the impact of that big international trade in some of the world’s biggest molecules — on currency, on shipping and ports.

Then, consider the China response to all this energy volatility. There’s a tremendous diversification in building capacity to make chemicals from coal. In many ways, a “Back to the Future” move, since the world mostly made chemicals from coal in the period around 1860 until around 1930. That’s a lot of molecules that won’t be made in the parts of Korea that they used to be.

But they won’t made in the same parts of China, either. As demand increases, and China runs through all the good coal to be found in the East, plants are moving west, towards the mine mouth. So, the infrastructure was built to ship everything south and west, from Korea — but now a lot of material is going to have to ship north and east, from the west of China.

How the New Abnormal will roil biotechnology

OK, you say. This has nothing to do with me. I’m a biotechnologist in the EU or the US, these are dirty coal-based chemicals in China.

But let’s consider this. Why did US natgas prices collapse? Upstream US companies began investing heavily in fractionation, but there was not as much investment in moving molecules to markets, so there’s been a supply overhang — with US natgas prices at as little as 25% of Asian prices for the same molecules. Doubly constrained by ancient rules, written in the Old Normal, that slow down or halt the export of anything made in the US that can be used for energy.

Starting around 2011, making the world’s largest bulk chemical, ethylene, from natgas instead of naphtha, became wildly profitable. You see, prices were being set for ethylene by the large naphtha crackers in Asia, but US-based ethane crackers had access to all that low-cost feedstock. Not only was US natgas way cheaper than Asia, it was way cheaper than petroleum, even the US kind.

The New Onslaught of Capacity

What followed was what IHS’s Eramo described as “an onslaught of new capacity” for US-based ethane cracking. Interrupting a decades-long migration of manufacturing capacity out of the US.

However, it was better than cheap feedstock. When you crack ethane to make ethylene, you get fewer of those “other chemicals” than cracking naphtha. So, investments in capacity building are very efficient at delivering ethylene. But, they deliver less C3 and C4 based chemicals, such as butadiene — used to make all kinds of important products from synthetic rubbers to spandex.

And that’s when biotechnology stepped in, developing technology to convert sugar or carbon monoxide, via fermentation, into chemicals such as Butanediol.

But, then oil prices dropped. Ethane crackers are still profitable, but not so wildly so compared to naphtha as before. As Eramo put it, “Western EU naphtha cracking has recently become very profitable,” and he noted that while approved ethane cracker projects are expected to complete, new projects are expected to fall into the “wait and see” department.

So, the New Normal advantaged a whole class of biotechnologies. And the New Abnormal took some of that advantage away. Not to mention, the problem of market risk as it pertains to building first-of-kind biotechnology projects that already have technology risk, not to mention their own underlying feedstock and supply chain risks.

The China Card

Back to China.

Or maybe, Vietnam. Elsewhere described as “China’s China” for its ability to disrupt Chinese manufacturing as it expands its own manufacturing base. But let’s park Vietnam in Forces that Will Define the 2020s, just for now.

What we can be sure of is this. Energy volatility, food price volatility, huge population and manufacturing capacity will not go away. So, the long-term interest in feedstock security is an ongoing driver.

Expect China to continue to invest in reducing import dependencies. Coal to chemicals, yes. But watch how China’s manufacturing is moving west — there are limits to coal, and you’ll find then before you reach the Amur River. Coal will strain to fill all the feedstock demand. So, biotechnology will play a role in adding local production capacity where biomass is plentiful, and will also may play a role in limiting greenhouse gas emissions.

So, how do you win with $30 oil?

We’ve divided these into three Must-Knowns under “Think, Don’t Panic”, 2 under “Feedstocks; Go Low” and 2 under “Diversify Thy Product Set and Channels to Market”.

Think, don’t panic.

We’ve said it many times before. Good companies do well in good markets. Great companies do well in tough markets. It begins with world-class technology, and continues with world-class people. But it also includes world-class “grace under pressure”, as Hemingway once defined courage.

1. Oil prices are falling much faster than gasoline prices. In the past year, the WTI crude oil price has dropped from $96.42 to $39.40 — that’s a 60% drop.

It’s not so juicy on the consumer side. Conventional gasoline retail prices have dropped from $3.47 to $2.71 per gallon in the same time period. That’s 22%.

What does that mean? It means that retail gasoline prices are behaving, right now, as if $96 oil dropped to $75, not $40. We’ll see how that shakes out — but, keep in mind that higher margins from oil make refiners less in love with renewable fuels, but make strategics that buy finished product, not crude oil, may be not as mesmerized by low oil prices as you’d think.

So, it’s a plunge, but not a rout, when you look at end-user markets. SO far.

2. Volatility, volatility, volatility. Wal-Mart succeeds because of Everyday Low Prices — not “occasionally and completely unpredictable low prices”. Savvy investors know that oil prices are volatile over the long-term. While the days of $130 oil may not return tomorrow, the global market that created them is still out there, and the key word is “volatility” — the upsy-downsy of energy prices is an ineffective platform for corporate or sovereign growth, and long-term decisions will be taken by long-term players based on long-term trends.

So — watch partnerships like Total and Amyris; United, AltAIr and Fulcrum BioEnergy; Reliance and Algenol; various steel manufacturers and LanzaTech; Audi and Joule — to name a few.

3. Your friend, the RIN. When gasoline was $3 and peaking occasionally over $5, many investors pooh-pooh’d the importance of renewable fuel credits known as RINs, some of them chortled to The Digest. “we zero out the RIN value, it’s gravy”. Now that ethanol is trading at $1.46 per gallon, that $0.66 RIN price per gallon has the potential to add a lot of value for biofuels producers, and is more critical than ever in the value chain.

Why make a $3 fuel when you can make a $5 chemical? Now we know.  Chemicals are getting battered more than fuels — unprotected as they are by mechanisms such as the Renewable Fuel Standard that were developed in anticipation of just such a market response.

Right now the D6 (corn ethanol) RIN is trading so close to the advanced biofuels RIN ($0.66 vs $0.76), there’s not much of a premium for investing heavily in ultra low-carbon fuels. But watch this space in coming months.

Feedstocks: go low.

4. Zero-cost and super low-cost feedstocks. Best way to compete with low-cost oil is no-cost biomass. So really odious feedstocks, like carbon monoxide, landfill gas, and municipal solid waste, are becoming more critical. That’s one of the reasons that projects from Fulcrum BioEnergy, LanzaTech and anaerobic digesters generating cellulosic RINs are getting more traction than other developers this year.

But there’s another type to watch. Heard of stranded natural gas? Well, there’s stranded biomass, too. The stuff that’s too expensive to transport to someone else’s biorefinery, for example. That’s what Red Rock Biofuels is counting on for making jet fuel from low-value woodstocks in southeast Oregon: no one else is going to show up, and it costs too much to gather and ship the wood for a competing use.

5. Tough to handle feedstocks. Have a very pure, consistent sugar stream? Sounds to us like you’ll be making chemicals or other higher-value products.

Have an “every bale is a different journey” supply of feedstock? Well, anyone who can handle all the variation is going to be looking at lower-cost feedstocks and a “tough to hit” chemical spec and is going to be looking at the fuel performance spec with a smile — pretty much, all it has to do is burn. So, corn stover sounds like a great feedstock for chemicals until you have to design a process to handle all the natural variables in quality from bale to bale.

Mid-term, think bagasse with Iogen and GranBio; corn stover with DuPont, Abengoa, Iogen and POET-DSM; higher free fatty acid waste oil feedstocks and REG — just to name a few.

Products and channels – diversify

6. Proteins rock. For many feedstocks — soybeans, algae, corn — there are all those lovely proteins, in a world that is getting more and more challenged on exactly how it plans to grow enough fish to feed the world. Those who can get to a fish meal profile can access that $1500 per ton market for the proteins, giving more life to strategies that utilize the non-essential oils and the carbohydrates.

7. High margin products — especially those sold directly to retail customers — allow companies to capture more share from the value chain. Also, feedstock costs pale in comparison to marketing and brand expense, when it comes, for example, to skin creams or fragrances. So, one way to insulate a company from feedstock pressure is to diversify the product line, wherever possible.

8. Build routes to end-users. They are the ones most likely to reward sustainability. After all, companies follow costs and profits. Consumers do all sorts of things unrelated to costs, as part of their own New Abnormal. They build parks instead of buildings. They embrace municipal zoning instead of laissez-faire. They favor eliminating landfills even when confronted by the hub-and-spoke economics of a “last resort for waste.”

Also, retail margins can be substantial, especially with branded materials. There’s 10 cents of corn in a $4 box of corn flakes, and 8 cents of coffee in a $2 coffee of the day at Starbucks.