Life in Plastics
By: Brittany Girling & Tanju Dutta
The Ivey Business Review is a student publication conceived, designed and managed by Honors Business Administration students at the Ivey Business School.
Encana Today
Since the fall of natural gas prices, pure natural gas producers like Encana have been struggling to achieve profitability and improve share prices. Encana has recently been producing gas at an average production cost of $4.37 per million Btu (MMBtu). With average prices currently at ~$4.50/MMBtu and prices expected to stay between $3.50 and $6.00 over the next few years, production should continue to be marginally profitable. As such, Encana has focused its investments on five core liquids and oil plays to increase margins and improve the profitability of its asset portfolio. While moving towards producing oil and natural gas liquids (NGLs), which contain hydrocarbon products such as ethane, helps improve short-term profitability, other diversification strategies such as expansion into the petrochemical industry would provide long-term profitability growth. This strategy would be a natural way to hedge the risk of volatile natural gas prices, while diversifying Encana’s asset portfolio.
Stuck in the Pipe
During the winter of 2012/2013, (natural) gas prices averaged $3.47/MMBtu in North America due to the abundance of resources made available from new technological advances in gas fracking. Since the supply of natural gas in North America is expected to remain significantly higher than demand, natural gas prices are expected to remain low. Prices for ethane in Alberta closely follow Alberta natural gas prices, which is why it is expected that ethane prices will remain low as well. With low ethane prices, many companies are finding it more profitable to “reject” ethane by leaving it in the natural gas or liquids stream, instead of selling it and transporting it separately. Although this results in marginal profitability, it is more profitable than any alternatives.
Ethane and Encana
North American companies that use natural gas and ethane as a feedstock (petrochemicals and fertilizers) have profited immensely over the past few years, as costs have remained low while revenues have stayed constant or increased. Since Encana plans on increasing its NGL production rapidly over the next few years, its ethane production will also increase rapidly. Although Encana’s current strategy to increase NGL production will improve profitability in the short term, diversifying by moving downstream and using cheap ethane as a feedstock for plastics could turn a seemingly low value ethane stream into an immensely profitable one.
Positive Demand in Producing Plastics
Currently, 36% of the US plastics production is devoted to High Density Polyethylene (HDPE) and Low Density Polyethylene (LDPE), both of which are made using ethane. The global market for these products is projected to grow rapidly, with North America forecasted to be a major net exporter over the next six years. In particular, shipments of HDPE are set to increase dramatically, showing the potentially willing and able HDPE demand market.
Demand is projected to increase in many developing economies in Asia and South America. Specifically, most of the export growth for HDPE is expected to come from increasing demand from China, which is estimated to grow 8% annually from $14 billion in 2008 to $36 billion by 2020.
Petrochemical Production Process
Ethylene Expansion
Both HDPE and LDPE are produced through the conversion of natural gas and other chemicals as seen in the process below. As Encana has excess ethane, the company should focus on building the later stages in the plastics production process. With most profits in the value chain coming from the final product, Encana should build a facility that converts ethane to ethylene. The ethylene can then easily be transported via rail to other facilities in Canada or the US Gulf Coast for processing into HDPE or LDPE. Considering that ethylene is required as feedstock to produce polyethylene, Encana can expect that the worldwide industry growth rates for both products will be similar.
Some Canadian and US petrochemical companies have already taken advantage of low natural gas and ethane prices by becoming more involved in the ethylene and polyethylene production process, which has significantly increased their profitability. In Canada, the majority of the facilities producing ethylene are large chemical companies, like Nova Chemicals and Dow Chemical. Both of these companies have spent significant capital to build large facilities that have the capacity to produce from 300,000 to 1.3 million tonnes of ethylene per year.
The Natural Advantage
Since ethane prices follow natural gas prices, it is assumed that ethane prices have dropped by 43%, in line with natural gas prices also dropping the same amount. These price changes have made it possible for Encana to hedge its own natural gas and ethane price exposure without the use of complex futures and option contracts. Currently, the ethylene gross margins are slightly over $1,000/tonne, which is significantly higher than the $300/tonne from 1990 to 2010.
The margins for plants that use ethane as a feedstock increased substantially from 2011 to 2012, while the margins for plants that use Naphtha in both Europe and Asia actually decreased over the same year as feedstock costs increased in those parts of the world. This justifies why many petrochemical companies are actually moving ethylene and polyethylene plants back to the US and Canada, and why Canadian players would have a competitive advantage through higher margins in producing ethylene over international players.
Potential from Plastics
Based on Encana’s projected liquids growth for 2014, and assuming liquids production splits in the US and Canada remain similar, Encana is estimated to produce ~53,000 bbl/d of liquids from its Canadian plays, 14% or ~7,500 bbl/d of which will be ethane. Encana’s planned growth rate for liquids production and ethane is estimated to be approximately 30% per year, potentially resulting in ~21,420 bbl/d of ethane production by the end of 2016. This volume of ethane would provide adequate feedstock to supply a petrochemical plant that produces ~270,000 tonnes per year of ethylene.
While purchasing a petrochemical plant would allow Encana to capitalize on the price differential quickly, there are only two major ethylene plants, owned by Nova Chemicals and Dow Chemical, and neither are likely sellers. The alternative is building a new facility.
For Encana to build a plant that would convert ethane to ethylene with the capacity to produce 270,000 tonnes per year, it will cost approximately $1 billion, taking an estimated 4 years to design and build, based on estimates from plants currently being built in the US. With ethylene gross margins around $1000/tonne, this opportunity could represent an increase in gross margin of $270 million; a 9.2% increase over Encana’s 2013 gross margin. This substantial increase clearly shows the ability for the petrochemical industry to increase the profitability of low value products like ethane.
While the upfront capital investment is large, the project will likely prove profitable, as feedstock prices are expected to remain low and the world demand for polyethylene and ethylene, is expected to grow rapidly over the next few years. Due to high margins in the business, the payback period would be approximately four years.
Petrochemicals Partnerships
The main constraints preventing Encana from moving into the industry is a lack of short-term cash flows, low share price, large amounts of debt, and inexperience in the petrochemicals industry. Encana’s current share price is low, relative to its pre 2010 value, at approximately $20 per share, limiting its ability to raise equity. The company has over $7 billion worth of debt, which is similar to Encana’s historical debt levels; however, losses make it difficult to continue borrowing large sums of debt. Nonetheless, Encana has a large capital expenditure program and invested $3,476 million in 2012, indicating its ability to continue to fund exploration and development.
To finance and take advantage of the current opportunity in petrochemicals, Encana should expand its current joint venture with Phoenix, a subsidiary of PetroChina, in the Duvernay. PetroChina is a Chinese company with operations in oil and gas production, refined products and petrochemicals. Although PetroChina has the money and expertise to enter the ethylene market itself, current foreign investment rules regulated by the Investment Canada Act encourage companies like PetroChina to invest with local Canadian companies. Partnering with a foreign firm like PetroChina could provide Encana with the expertise and assistance in financing required to build a petrochemical facility.
Construction in Canada
The Alberta petrochemical industry is strong and competitive globally, due to ease of market access by rail and captive suppliers that can provide low cost feedstock. Alberta is an attractive business environment for petrochemical production because the business policy environment allows for better returns. Additionally, from a regulatory perspective, Alberta has one of the most progressive professional regulatory processes in North America for siting and certification of such facilities.
While diversification into petrochemicals differs from Encana’s immediate goal of focusing on growth in oil and liquids, it adds another lever for long-term growth and provides a natural hedge against low natural gas prices. Moving downstream into petrochemicals does not require Encana to change its current strategy; it supplements it by significantly improving the profitability of its soon-to-be increasing ethane production. While this opportunity is not within Encana’s core competency, and still exposes it to commodity risks similar to other operations, the expected growth in the ethylene industry globally provides an opportunity for companies like Encana to turn its ethane into a higher value product and increase its bottom line.
