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Crude oil prices have fallen recently due to a number of factors including monetary tightening in China and banking regulations in USA apart from easing of winter chill. But even amidst this scenario the Bank of America-Merrill Lynch (BofAML) believews that increased petrochemical demand suggests a recovery ahead for energy complex.

A surge in petrochem demand and a steeply backwardated naphtha market suggest that, in absence of major external shocks, a cyclical recovery for the broader economy is around the corner. Historically, demand for naphtha, a key input into petchem processes, has led demand for other petroleum products. It should be no different this time. With more demand and low refinery capacity utilization, global naphtha stocks are drawing quickly. Currently at $2.10/bbl, front-month NWE naphtha cracks are above the seasonal norm, and backwardation in naphtha and other petchem feeds such as propane or butane could continue in the near-term. Tight now, liquid gas supply is increasing in second half of 2010, BofAML analysis said.

BofAML analysis said that there could be an 8.6 million tons/year increase in ethylene cracking capacity this year, suggesting that the market will be craving for incremental feedstock. However, a potential increase in OPEC NGL supply of 600 thousand b/d this year should temper propane prices, limiting the upside on naphtha as these new barrels enter the petrochemical stream. Thus, with the end of winter reducing demand for liquid gas and petrochemical units going into maintenance in early March, the strength in the very light ends could start to fade as other parts of the barrel like gasoline and middle distillates start to pick up some steam.

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The fiscal situation in Greece is cause for concern but a cyclical upswing in economic activity is likely in Europe led by the need to replenish depleted finished good stocks. Outside the OECD, particularly in China, demand has accelerated in the last few months. In spite of the recent sell-off, BofAML still believes that tighter money supply in China is a net positive for commodities as long as it occurs through a stronger Chinese Yuan (CN)Y and not through higher interest rates.

Historically, petrochemical consumption has led oil demand. BofAML analysis shows that demnad for naptha, a key input into petrochemical processes, has teneded to lead demand for other petroleum products as petrochemical plants rushed to supply plastics and other products to manufacturers in the early phases of an economic recovery.

The surge in petrochemical utilization rates is being partly masked by the rapid increase in petrochemical processing capacity around the world. Global ethylene production capacity increased by 4 million tons/year in 2009 even as other industries contracted. Ethylene capacity around the world is now forecast to grow by 6.5% in 2010, according to CMAI. This newly added capacity is the largest in recent memory and should increase demand for traditional petrochemical inputs going forward, including naphtha as well as liquid gas.

…but capacity utilization is still running very high…
Thus, capacity has already started to increase and will likely continue to expand over the coming weeks and months. But despite the ongoing capacity increases, petrochemical demand continues to run strongly. Global utilization rates at ethylene crackers and other petrochemical units have increased to very high levels in various parts of the world. It is important to note that both advanced and emerging economies are experiencing increased demand for petrochemical products. According to the Fed and Ministry of Economy, Trade and Industry Japan, aggregate chemical sector capacity utilization rates in the US have
recovered to 76%, while in Japan utilization rates have reached 89.5% in the last month.

…as Asian demand for petrochemical products is robust
No doubt, Asian petrochemical demand has increased at a phenomenal rate in recent months on the back of a rapid recovery in orders at early cycle exporting nations such as South Korea and Taiwan. With petrochemical demand on the rise in Asia, demand for naphtha across the region has surged to very high levels. In particular, China’s demand for products related to the petrochemical sector, including LPG and naphtha, surged by 250 thousand b/d or 17.5% in 2009 compared to the previous year. In fact, half of China’s oil demand growth last year was linked to these two very light end product group.

Naphtha, liquid gas and gasoil are a feedstock for petrochems
Petrochemical plants can take a variety of products into their cracking units. In particular, naphtha, gasoil and liquid gas tend to be the fuels of choice for ethylene crackers and other petrochemical units. On average, Asian petrochemical units are more geared towards naphtha as a feedstock and have relatively little switching capacity. Meanwhile plants in Europe and the United States have more flexibility in their choice of feedstock.

Due to the weather-related surge in liquid gas demand…
A key factor driving the petroleum product complex during the last two months has been the drop in global temperatures in North America, Europe and Asia. In effect, the cold winter has pushed up the demand for liquid gas like propane, butane and ethane. The rebound in global demand for LPGs has pushed inventories to very low levels and thrown the propane term structure into very steep backwardation. Of course, these fuels are also utilized for heating purposes in many countries around the world, so increased demand for heating has likely limited feedstock fuel options for petrochemical producers.

…petrochemical plants rotate out of liquid gas into naphtha
In turn, petrochemical margins at propane-geared ethylene crackers have started to narrow with rising liquid gas prices. Of course, petrochemical companies are still enjoying positive margins across the board. But the rising cost of liquid gas has surely contributed to a rotation into other feedstock such
naphtha.

Naphtha stocks heading lower, cracks shooting higher
With increased demand and a relatively low rate of refinery capacity utilization on the back of poor margins, naphtha stocks have started to draw pretty quickly across all OECD regions and are now well below the seasonal average . As a tighter supply and demand balance has driven down inventories, naphtha cracks have continued to appreciate in recent months. Currently trading at $2.10/bbl, front-month NWE naphtha cracks are significantly above the seasonal norm as well (Chart 16). Having said that, the risk of a spike is relatively low as naphtha prices are fast approaching gasoline, a level last observed in January 2008, and spare refining capacity remains plentiful. In our view, if naphtha was to appreciate further from here, refiners would just adjust their
product yields and increase naphtha output.

Near-term, plants could even use gasoil as a feedstock
Generally, low refining margins have likely constrained naphtha production around the world by keeping many refineries off-line in the recent period. In part, this is because the much larger distillate and gasoline markets remain broadly oversupplied. Despite the cold winter, OECD distillate stocks are at very high levels, particularly in Europe and the United States. This large oversupply of distillates has pressed gasoil crack spreads to the low end of the
seasonal range.

Yet, cracker maintenance & liquid gas supply in 2H10…
The rapidly narrowing naphtha to gasoil spreads could force some feedstock rotation at petrochemical units as well as some increased naphtha yields at refineries. But the strength in naphtha demand from petchem crackers could also ease as maintenance kicks in over the coming months (Chart 19). Moreover, we expect a surge of 600 thousand b/d in OPEC NGLs and non-conventionals this year. Part of these barrels will likely head into the petrochemical stream. This increase in the supply of liquid gas in 2Q10 and beyond could limit the upside on petchem feedstock prices. Still, with a projected increase in global
ethylene cracking capacity of 8.6m tons per annum, the market should be able to absorb most of the new liquid gas over the next 12 months.

In short, the backwardation in naphtha cracks could remain firm in the near-term as supply and demand factors continue to put downward pressure on naphtha inventories across the world. But these tensions should ease into 2Q10 as petrochemical units go into maintenance and other feedstock like OPEC NGLs comes on line throughout this year. Moreover, naphtha yields at refineries should continue to increase with the rising prices.

Increased petrochem runs still suggest a recovery ahead
In sum, the ongoing developments in the petrochemical sector should lend some support to the ailing refining sector in the short-run. However, the large surge in OPEC gas liquids over the coming months could act as a drag in any recovery in refining margins. With the end of winter reducing demand for liquid gas and petrochemical units going into maintenance in early March, the strength in the very light ends could start to fade as other parts of the barrel like gasoline and middle distillates start to pick up some steam.