US Ethylene - Evolutionary Road
The past 5 years have been major evolutionary ones for the US ethylene market. A sleepy market for the better part of the 20th century, ethylene trading began to change from exchanges of material on an “as-need” basis (mostly between producers) to outright deals between counterparties of all types – producers, consumers and traders. Brokers even entered the market.
In 2004, an average of 40 million pounds of ethylene was trading in the spot market per month. For a market that produces roughly 5 billion pounds per month, this spot market represented less than 1% of material. This itself was a major change from the previous 50 years, in which only several million pounds would trade outside of fixed contract volumes. In 2008, an average of 342 million pounds of ethylene was trading each month, nearly 7% of material. In February 2009, 422 million pounds of ethylene traded in the spot market.
What changed in such a short amount of time — and at this velocity, what’s next?
What changed is that upstream and downstream volatility necessitated more flexibility in how to price the monomer. What’s next could be cleared futures contracts – at least the brokers and the CME are betting on it.
The very foundations of the market have become increasingly risky since mid-2008: credit worthiness and ability to deliver material.
If you owe the bank $100, that’s your problem
If you owe the bank $100 million, that’s the bank’s problem
-J. Paul Getty
In 3Q 2008, ethylene market participants saw liquidity threatened up as major players dropped out along with their creditworthiness. This was painfully apparent in the upstream NGL markets. By the time Lehman Brothers collapsed in September, the previously liquid and transparent NGLs were quickly regressing and the market size was constricting as a result. The credit situation had severely limited
liquidity, and transparency was also challenged. Ethylene producers had come to rely on that transparency, and faced their own credit risks as well. Aside from cash injections or mergers, only a clearing house could restore liquidity.
The well-timed introduction of cleared swaps contracts for natural gas liquids – ethane, propane, butane and natural gasoline – by the CME restored order to the NGL markets. NGLs market players re-entered the marketplace with a roar. Rather than having 12 or 20 creditors, parties now have one: Clearport. The efficiency was immediately apparent to even the most skeptical companies, and brokers estimated that by January 2009 more than 90% of all paper deals for the NGLs market were being transacted through Clearport. That’s a major cultural shift that took less than 60 days to occur.
The credit concerns extended to ethylene majors by 4Q, and several key players were suddenly unable to trade with ease, if at all.
Could a cleared ethylene contract work?
Anyone working in the petrochemical industry understands the perils of scheduling deliveries during hurricane season in the Gulf. Underlying all of the potential profits of any paper market is the transmission of physical gases, liquids, flakes or pellets. The ethylene market is extremely sensitive to delivery issues, and to the fungibility of spot market trade. Unlike ethane, which is a liquid, ethylene is a gas. But unlike natural gas, ethylene’s delivery lacks a common carrier, meaning that ethylene is delivered by companies that produce ethylene, which generally have exclusive rights to the pipelines. Until 2002, only companies that consumed ethylene received deliveries.
The 2002 entrance of traders into the ethylene market was a jarring experience for many producers and consumers. By leasing storage space from ethylene producers, Koch Industries pioneered trading ethylene as a purely financial commodity. Soon followed by Louis Dreyfus and other trading firms, ethylene began to be truly traded in the 21st century. The deliveries for these trades were not from production sites to consuming plants, they were from and to storage wells. The very basis of the market was transformed. No longer was ethylene considered to trade “in the Gulf” – meaning, from any production site in Texas or Louisiana. It traded at Mont Belvieu, the major storage area for ethylene in Texas.
While traditional market participants considered traders disruptive, they did prove to be useful in one significant way: they provided supply when the market was extremely short. Hurricane season was the one time of the year where traders were popular, as they were able to keep the market supplied when plants shut due to a storm.
In addition to smoothing out supply availability, another effect of traders entering the ethylene market was that the increased liquidity smoothed price volatility. This is, of course, a natural effect of liquidity, but the proof of this significantly eased the fear factor that had gripped producers and consumers with regard to traders in “their” market. Delivery was smoother, prices were less volatile, traders hadn’t “ruined” the market – and liquidity increased.
Ethylene is sensitive to delivery issues in a way that most markets are not, and certainly not in the way that any cleared futures markets are. Only two locations available for common storage: at Mont Belvieu, Texas, and at Choctaw, Louisiana. In January 2009, the Mont Belvieu hub was so busy that the Williams Companies alerted its ethylene “tenants” that deliveries scheduled after the first day of the month could not be guaranteed. For a market that still occasionally operated on the premise that today’s trade could be delivered tomorrow, this was as jarring as the entrance of traders into the market seven years prior. But the market adapted and ethylene at Mont Belvieu is a more rigorously scheduled delivery system, like natural gas at Henry Hub or refined products delivered by the Colonial pipeline. Prompt or “wet” delivery would be the exception, not the expectation.
Within a few years, ethylene has evolved quickly and the supply chain has not been destroyed. These evolutions have created efficiencies, including a more efficient pricing chain. NGLs bridge the gap between energy and ethylene. Ethylene, in turn, extends that bridge to most downstream chemical markets, including the pervasive world of plastic resins, itself a direct link to major manufacturing markets. Transparency not only helps commodity markets function more efficiently, but helps define the relative risk level of investment and capital structure.
Markets evolve out of necessity, not out of choice. But within that construct, participants have a choice to steward the market or leave it. The stewardship seen in ethylene has served it well. Clearing is no longer a taboo subject. A futures contract developed with the guidance of market participants requires more vigilance to ensure fungibility for this sensitive delivery-based market. The success of NGL swaps on CME’s Clearport system has held great meaning for the current ethylene market participants, several of whom trade those contracts themselves.
The now-apocryphal tales of the road to the first energy contracts continue to inspire those looking for ways to improve market efficiency, transparency and also to capture more financial opportunity. Could the same lightning that struck 30 years ago strike again for ethylene? This could be the petrochemical industry’s watershed moment.
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Copyright 2009