Summary of the Project Report
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It is difficult to locate value within the conventional notion of the petroleum industry, especially
in the upstream.
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A holistic approach to the much broader petrochemical and petroproduct value chains suggests
that most of the economic value in the petrochemical industry is created and realized
downstream.
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Vertically integrated value chain players are able to source cheap inputs and produce valueadded products with intangible values.
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The value chain analysis framework can be applied to any situation in which raw materials are
liberated from commodity market forces.
The Petrochemical and Petroproduct Value Chains
SA contributor, Chris Aublinger, in his ambitious series “How Much Does It Cost To Produce One Barrel
(MCF) Of Oil (Gas)” has repeatedly noted that the cash flow situations for most upstream businesses are
very dire, in which investing cash flows far outstrip internally generated operating cash flows. In a more
recent piece, Shale Producers Can’t Make Money At An Oil Price Of $60, Chris also carefully models out
how, at current prices, even premier independent producers EOG Resources (NYSE:EOG) and
Continental Resources (NYSE:CLR) are not earning acceptable rates of return. Furthermore, the Carbon
Tracker Initiative, in its 2014 Oil Major CapEx Report, used deep-dive data from Rystad’s UCube
upstream database to demonstrate how the majority of oil majors’ planned and potential capital
expenditures require oil prices above $75 per barrel for economic sanction (i.e., break-even on net
present value plus a minimum required return on investment). Bloomberg analyst Carl Pope recently
echoed this thesis in the article, Why You Should Short Public Oil Companies. In Carl’s view, the majors
continue to invest in uneconomic projects out of a lack of options — “Easy oil had already been found”.
What is normally thought of as the oil business (i.e., upstream, midstream, and downstream) can just be
thought of as a means of producing the raw materials for the entire petrochemical value chain. In fact,
according to ExxonMobil’s (NYSE:XOM) 2014 10-K, the super-major’s refining capacity is well in excess of
its year end oil-equivalent production. In 2014, ExxonMobil’s upstream segment produced 3.969
MMBOE/day (53.2% liquids) while its refining throughput was 4.476 MMBOE/day — the highest
throughput for a single company in the world. Truly, ExxonMobil is as much a chemical company as an
exploration and production company, if not more so.
This concept of a value chain was first described by Michael Porter’s best selling Competitive Advantage:
Creating and Sustaining Superior Performance. Simply, a value chain is a supply chain through the lens of
economic value creation; it is a linked set of value creating activities which transform raw materials to
end-use products.
The petrochemical value chain is immense and truly a source of wonderment. To an extent, referring to
oil and gas refining, but it’s much broader and deeper than that. At some point in this chain, between
where oil is pumped out the ground to where it is used in a myriad of applications, a commodity can be
mystically (i.e. chemically and/or perceptually) transformed into something proprietary and with
intangible value. Figure 1, below, produced by the U.S. Department of Energy’s National Renewable
Energy Laboratory in a publication on value-added organic chemistry encapsulates both the intricacy
and complexity of the petroleum value chain.
Figure 1: Flow-Chart for Products from Petroleum-based Feedstocks
Source: Department of Energy. National Renewable Energy Laboratory. Top Value Added Chemicals from Biomass Volume IResults of Screening for Potential Candidates from Sugars and Synthesis Gas. DOI: August 2004
Take cosmetics for instance, which are usually not much more than petroleum-based hydrocarbons and
ground up minerals. In terms of raw materials, cosmetics are cheap. However, when we add in a little bit
of chemistry and brand differentiation to the mix, these raw materials command much higher value
premiums which are totally dissociated from the prices of the underlying commodities. Think about it:
did the prices of make-up, paints, sealants, tires, water bottles, perfumes, synthetic fabrics, and more
drop at all when the price of the primary raw materials (i.e., petroleum) plummeted 40-50% over the
past eight months? No. While the consumer saves some money on fuel costs, and refineries lowered
their cost bases, consumer petroproducts manufacturers are the overwhelming beneficiaries in times of
lower petroleum prices .
The first task at hand from an investor’s perspective is to find the sweet spot in this chain and invest
accordingly. In general, the more steps between the commodity and the end-consumer, the greater the
mark-up. The greater the mark-up, the more potential there is for value creation. Figure 2, below,
exemplifies a simplified petrochemical value chain in which raw materials (bound to commodity market
forces) are transformed into value-added consumer products whose prices are dissociated from the
underlying commodities.
Figure 2: Sample petrochemical value chain
Source: Petroleum Online. Overview: What are Petrochemicals?
Taking that “sweet spot” notion one step further, the more vertically integrated an enterprise is upon
that long value-chain, the greater the potential to cut out the middle-men and realize that value
creation along those various steps under one roof. Such a conceptual approach to investing in oil and
gas might help investors avoid the pitfalls of investing in commodity driven businesses in which
producers are forced to compete on cost and scale and in which they have virtually zero influence over
the all-important operating lever: price.
However, there is trade-off with traveling too far down the value-chain. Consumers can be a fickle folk
and, as a result, end-products often go into and out of fashion. While commodity producers can always
rely on there being a buyer at a set price, the same cannot be said for an out-of-vague or low value
brand name. To this extent, commodity-driven businesses can offset increased commodity risk with
decreased consumer risk.
Figure 3, below, exemplifies how a small sample of companies fit into this larger value chain. Clearly,
there is a direct correlation between how deep one travels down the value chain spectrum and
management’s focus on either low-cost leadership, product differentiation, or niche focus. Enterprises
which fall into this “sweet spot” are those which are able to source cost advantaged commoditized
inputs, process those inputs into high value products, and still manage to isolate themselves from
cyclical consumer demand. Graphically speaking, the sweet spot lies somewhere near intersection of
integration and the downstream value chain. At this junction, we find the most deeply integrated oil
companies like ExxonMobil and integrated petrochemical companies like BASF (OTCQX:BASFY),
LyondellBassel (NYSE:LYB) and Dow Chemical (NYSE:DOW).
Figure 3: Petrochemical Value Chain
The sweet spot in the petrochemical/petroproduct value-chain is the point at which a staple (i.e. nondiscretionary) product is somehow liberated from the shackles of cyclical commodity market forces.
In the petrochemicals industry, access to low-cost raw materials (or feedstock) is an important
competitive advantage. Since the mid-2000s most low-cost feedstock has been located in the Middle
East. For companies that set up production there, the most significant challenge is physically moving
product to end-users across the globe in a seamless manner.