By understanding the impact of low crude oil prices, the resulting effect on demand and changing competitive market dynamics, chemical companies can make sound capital investment decisions.

The biggest headlines about reduced oil prices focus on consumers' relief from pain at the pumps. But the impact of lower-priced oil is much larger and far more complex. The decline in crude oil prices at the end of 2014--compared to the 2010 to early 2014 period-has introduced a new set of dynamics for global economic growth and is impacting the operating plans for companies in virtually all industry sectors.

In global energy markets, lower crude oil pricing in 2015 placed the United States-not Saudi Arabia-in the key role of regulating global crude oil supply in response to market pricing. No doubt, consumers in some countries are benefiting from lower energy prices, leaving them with more discretionary income. For example, US consumer spending growth accelerated in 2014 from 2.5% in the second quarter to 4.4% in the fourth quarter as oil and gasoline prices were plunging. Policy makers from importing-oil countries are investigating options to exploit the benefits. However, not all countries are experiencing the benefits of lower crude oil prices. Oil-producing nations such as Saudi Arabia and other OPEC nations are exploring how low crude oil pricing will impact spending on domestic programs and budgets that are reliant on higher-priced crude exports.

Lower crude oil prices are also shaping the planning and operations of chemical companies. Each year the industry invests billions of dollars in new and sustaining capital to keep pace with demand growth. Business leaders decide where to invest in new capacity and how to operate and maintain existing assets based in part on energy market dynamics, as well as trends in the manufacturing and consumption of durable and non-durable goods, and overall market profitability. In light of lower oil prices, executives are now debating the viability of investment decisions that were considered must-do projects just 12 months ago. For example, one US-based, non-integrated ethylene consuming company recently put the brakes on a new ethane-based steam cracker project that last year promised an exceptional return on investment.

The two foundational risks for chemical manufacturers are market supply and demand imbalances, and energy-driven changes in production costs. The development of significant imbalances between available capacity and demand growth can and often does create boom-and-bust cycles in the chemical industry, directly affecting overall profitability. Companies able to align new capacity with global demand growth are less likely to face oversupply or undersupply conditions. In a perfect world, organizations would invest in low-cost capacity with direct access to strong demand growth markets when the global market begins to transition from a period of over-supply to tighter market conditions.

Absent a crystal ball, however, chemicals executives must now make decisions that will impact the future of their companies for decades. To minimize the risks of changing economic trends and energy costs and to maximize profitability over time, chemical companies must develop robust strategic plans that can flexibly adjust to energy market volatility. By understanding the complex and changing dynamics within the petrochemical value chain, firms can more reliably make these adjustments and ensure they produce the right chemical products at the right locations for the right markets. Only then can these companies create business and investment strategies that drive success in periods of extreme cyclicality.

Investing in turbulent times

Chemical companies dedicate a substantial portion of their annual budgets to constructing new assets and maintaining or modernizing existing assets to meet market needs, and conforming to strict regulatory and operational standards so they can compete effectively. Boardroom investment decisions are driven by strategic plans that seek to leverage advantage in three primary areas: energy and feedstock costs, proximity to demand growth, and technology.

Energy and feedstock costs: The differential between oil- and gas-based feedstock prices in the highly competitive markets of the Americas, Asia, Europe, and the Middle East divides cost-advantaged from cost-disadvantaged chemicals producers. Whether the analysis focuses on elementary feedstock choices (such as naphtha, ethane, or propane), power costs, or alternative values for use in crude oil refinery products and heating markets, successful producers must exploit opportunities to create competitive advantage. Cost-advantaged producers can capitalize on these conditions through investments in new multibillion-dollar production facilities. Because as much as 75% of the cost of producing petrochemicals is related to hydrocarbon values, companies with a cost disadvantage may choose to invest in lower-cost raw materials (such as a conversion to ethane cracking in the US market) or attempt to relieve competitive cost pressures through product differentiation.

Proximity to demand growth: Demand can drive or stifle the need for new investment. Today, assets that derive margin from a wide gas-to-oil differential - such as those in North America and the Middle East-are experiencing margin declines. Large, capital-intensive projects already underway will likely continue in these cost-advantaged regions. In energy environments where the supply-curve is lower and flatter, proximity to demand growth can provide a strong competitive advantage, in which companies leverage freight and logistics costs as a barrier to protect or grow market share.

Technology advantage: In commodity chemical markets, competition is driven by cost, service, and reliability. Non-commodity chemicals derive competitive advantage from their product attributes or the functions they serve. Regardless of the competitive differentiator, technology serves as a clear, important variable. For example, the use of on-purpose propylene technology (PDH, propane-dehydrogenation) in North America today allows propylene producers to take advantage of excess propane supply in the region to provide low-cost propylene versus naphtha co-product propylene from a steam cracker. Producers with sustainable technological advantage typically enjoy better performance in terms of volume, profits, and lower margin volatility over the chemical cycle.

Even for the most competitive and strategically placed assets, investment decisions take place against a backdrop of market and political uncertainty. The chemical industry continues to be buffeted by unpredictable and often volatile regulatory, economic, and energy dynamics. For example, 2014 kicked off with continued momentum in North American shale feedstock volumes and record industry profits for gas-based assets and Chinese coal-based technologies. Downstream industries such as converters that produce many finished or semi-finished consumer goods struggled to absorb relentless price increases, squeezed between the chemical producers on one hand, and consumer products and retail industries on the other. A fourth-quarter decision from OPEC to let market forces set oil pricing, in the face of both weak petroleum demand and rapidly rising shale supply, resulted in a dramatic reversal in crude oil and chemical pricing by year's end.

Global economic recovery continues to be uneven. Economic activity in China, Europe, and Brazil, among others, remains sluggish. As a result, chemicals demand is still tepid, and the drop in oil prices has not yet encouraged manufacturers to keep or build inventory. A significant result of lower crude oil prices has been a lower and flatter supply curve. When combined with a stronger US dollar, this flattened supply curve changed the competitive landscape and redistribution of profits, both geographically and throughout the value chain. As a result, downstream markets became more profitable in 2015.

Understanding shifting energy dynamics

Energy is the primary cost factor in the manufacture of chemicals, with crude oil and natural gas the key determinants of production costs. Changes in relative costs of these key energy sources (and the resulting impact on derived feedstocks) play a significant role in the competitiveness of various regions and the willingness of chemicals manufacturers to invest.

For example, from 2010 through the end of 2014, significant price differences between North American natural gas-based raw materials and those derived from crude oil transformed that area into a low-cost region for chemical production. This shift has led to rapid stock equity appreciation in line with growing profits. Accordingly, a large number of domestic and international chemical companies are advancing plans to build or expand facilities in North America.

Change in energy markets creates nearly instant responses in chemical prices. Falling energy prices often translate into a buyer expectation of "lower prices tomorrow." This anticipation creates a collective pause in demand, generating inventory and price reductions as well as market-share battles. Rising energy prices tend to create an opposite expectation of "higher prices tomorrow." What follows are higher inventories, a demand surge, and rising prices. Both movements can dramatically affect overall supply and demand balances, increasing profitability volatility.

The impact of lower-priced crude oil varies. Consider how a $50-per-barrel downturn in oil prices affects global consumers. Petroleum imports are distributed to approximately 90% of the world's population. Unsurprisingly, Asia-Pacific and Europe are the largest petroleum importers, while Central Asia and the Middle East are the world's net suppliers. Shale and oil sands have dramatically increased the self-sufficiency of North America, but the region still benefits from the drop in crude oil pricing.

At approximately 80 million barrels a day in global demand, a $50 reduction in the price of oil creates a significant transfer of wealth-trillions of dollars move from oil-exporting countries to oil-importing countries. In addition, there is a transfer of value between oil producers and downstream beneficiaries such as industry, governments, and consumers. The chemical industry is one of the key beneficiaries of that value transfer. Nearly 10% of the global production of energy is consumed into chemicals-mostly as naphtha, which accounts for approximately 500 million metric tons. Another 400 million tons of coal, oil, gas, and gas liquids are consumed, some of which derive a portion of their value from crude oil via various market relationships. In addition, any stimulus to GDP created by a drop in crude oil prices results in an overall benefit to the chemical industry through an increase in overall demand for durable and non-durable goods.

Correlating low crude oil pricing with investments

A significant change in the price of crude oil impacts not only short- and medium-term demand but also the relative cost structure and cash margins for many chemical value chains. Marginal-cost producers-those that supply the last high-cost increment of production that satisfies the final ton of demand, and whose cost structure sets the lowest possible limit of pricing-often consume oil-derived hydrocarbons as a primary feedstock. Lower-cost producers that use feedstock based on gas, coal, or gas-liquids - such as ethane or liquid petroleum gas (LPG) - are able to capture the difference in feedstock costs as margin. In an environment of falling crude oil prices, low-cost chemical producers experience a reduction in cash margins as selling prices based on crude oil decline more than their own alternative feedstocks.

The flattening of the cost curve-resulting from lower crude oil pricing-causes the cost structures of higher-cost producers to drop faster than the alternative gas- and coal-based technologies. This dramatically reduces the competitive advantage previously enjoyed when oil was near $100 per barrel. For gas-based producers looking to high-cost markets as a source of demand, this shift is significant. For low-cost producers who access the market via exports, freight and logistics costs will play a more significant role in competitiveness, modifying regional trade flows.

Lower crude oil prices are encouraging some chemical companies to delay and further assess investments that were dependent upon a significant oil-to-gas (or oil-to-coal) differential. Producers are re-evaluating their investment returns and testing the robustness of their competitiveness assumptions. Offsetting some of the lower oil-gas differentials, however, is an expectation of lower capital expenditure (capex) escalation. For example, IHS is seeing signs that layoffs and reduced capex budgets originating in the upstream shale-related US energy industries are relieving previously tight conditions for skilled labor as well as demand for engineering resources.

Energy stimulates the upcycle

Given the current oversupply of crude oil, IHS Energy is forecasting crude oil prices to remain well below $100 per barrel (Brent basis) for the next two to three years. During this time, global energy and chemicals markets will respond to the current crude oil oversupply, and market participants will keenly observe how OPEC will adapt to this new energy market dynamic.

While the near-term outlook remains subdued for chemicals demand and margins, low oil prices are expected to positively impact the industry over time - sowing the seeds for better economic conditions, lower petrochemical prices, and improved global petrochemical demand. Since crude oil acts as the primary driver for feedstocks and serves as the marginal production cost and price-setter for many chemicals, plastics, and fibers, a decline in crude oil prices typically leads to lower product prices. Macroeconomic demand-related effects can expand wealth transfer to the greater global population. In addition, the lower prices of petrochemicals relative to other competing materials-such as glass, paper, and metals-accelerate substitution demand. Reduced plastics prices will also cut demand for recyclable material compared with virgin resins, providing further demand stimulus.

The outlook clearly varies by region and value chain, with some specialty sectors benefiting from the lower pricing likely to see a reversal and others simply so oversupplied that additional demand will not matter. For example, the decline in crude oil prices in the second half of 2014 moderated the advantageous competitive conditions in North America. However, some advantage remains and will continue to provide an incentive for planned investments in the region.

IHS also anticipates that a pause in new project approvals-combined with higher GDP and stimulated demand created by lower energy prices-could result in very tight supply and demand conditions in the next five years. Over time, this could lead to a significant upcycle in certain markets, such as the ethylene value chain. Although there will likely be yet unannounced builds, IHS expects investment to slow appreciably from 2017 to 2020 to the lowest levels since the start of the last decade. Underlying trends in capital access, such as the ability for projects to be financed in emerging markets like China, will contribute to the slowdown in capital investment. The slowing in capital programs related to shale may reduce capex inflation concerns experienced in some markets.

For investors, the primary economics of the chemical industry are still attractive in the current market, even if they are not as rewarding as they were over the last three years. Experienced producers recognize that market conditions can and do change. The investment horizon is long and must withstand variability in underlying drivers. Optionality and asset flexibility, superior performance in both operations and construction, and sustainable competitive advantage ultimately provide value to both customers and investors while creating long-term success.

Ideal investment conditions are rare in the chemical industry. Strategic planning lends companies the flexibility and nimbleness they need to make short-term operating plan adjustments that accommodate this volatility. Companies that take action quickly will be able to take the greatest advantage of current market conditions. And wise decisions made in 2015 will result in both productive and profitable facilities coming online three to five years from now.

Mark Eramo is vice president, Chemical Industry Insights, IHS; Dave Witte is senior vice president, IHS Chemical