Elsevier

Energy Economics

Volume 32, Issue 6, November 2010, Pages 1435-1444
Energy Economics

Price dynamics of crude oil and the regional ethylene markets

https://doi.org/10.1016/j.eneco.2010.03.009Get rights and content

Abstract

This paper is the first attempt to investigate: (i) is the crude oil (WTI) price significantly related to the regional ethylene prices in the Naphtha intensive ethylene markets of the Far East, North West Europe, and the Mediterranean? (ii) What drives the regional ethylene prices? The paper is motivated by the recent and growing debate on the lead-lag relationship between crude oil and ethylene prices. Our findings, based on the long-run structural modelling approach of Pesaran and Shin, and subject to the limitations of the study, tend to suggest: (i) crude oil (WTI) price is cointegrated with the regional ethylene prices (ii) our within-sample error-correction model results tend to indicate that although the ethylene prices in North West Europe and the Mediterranean were weakly endogenous, the Far East ethylene price was weakly exogenous both in the short and long term. These results are consistent, during most of the period under review (2000.1–2006.4) with the surge in demand for ethylene throughout the Far East, particularly in China and South Korea. However, during the post-sample forecast period as evidenced in our variance decompositions analysis, the emergence of WTI as a leading player as well, is consistent with the recent surge in WTI price (fuelled mainly, among others, by the strong hedging activities in the WTI futures/options and refining tightness) reflecting the growing importance of input cost in determining the dynamic interactions of input and product prices.

Introduction

In the last decade, prices of petrochemicals have become very sensitive to movement in crude oil prices. There is also a debate among researchers and policy makers as to what factors might be driving up crude oil prices. Some blame it on geo-political events, while others point the finger to the booming economies of India, China and Korea. While some studies have tested the price dynamics of crude oil and refined petroleum products such as heating oil, gas oil, diesel and gasoline, the market dynamics of petrochemical prices and crude oil has never been tested before.

Markets for petrochemicals remain small and opaque compared to oil but the trade flow concentrated between Middle East swing producers and the giant consumers of Asia is on the increase. Since the 1997 Asian financial crisis, there has been a surge in demand for petrochemicals from Asia, in particular amongst the Far East (FE) economies of China, Korea, Japan and Taiwan. The demand has also increased in other major centres like North West Europe (NWE) and the Mediterranean (MED). The increase in sensitivity of petrochemical prices to crude oil prices has resulted in firms taking price risk management very seriously in a bid to reduce their costs. Some analysts have stated that there is as much as an 80% correlation between crude oil and petrochemical products. In addition, there is an ongoing debate as to the drivers of crude oil prices in addition to the speculation and geopolitical tensions in the Middle East and constant supply disruptions in countries such as Nigeria and Venezuela. In addition to demand from refined petroleum products (heating oil, electricity and transportation fuels) policy makers are also interested in having a better understanding of the dynamics of crude oil prices and demand for petrochemicals (mainly olefins and aromatics), which are key feedstocks in the production of final products such as plastics, polymers, nylon and rubber.

There are two issues that need testing in the petrochemical and crude oil chemistry; firstly we need to model the dynamics between crude oil and petrochemicals which has been largely ignored in the literature (excepting some petrochemical industry consultancy reports). Secondly, the transparency and availability of petrochemical prices gives us an opportunity to assess the dynamics between major petrochemical markets by using ethylene, which is the barometer for the petrochemical market.1 Our research is in line with studies that try to capture price dynamics between various commodity spot prices and in particular major between crude oil barometers like the United States West Texas Intermediate (WTI), U.K North Sea Brent (Brent) and the Middle East Dubai (now constituted of Dubai/Oman blend) in a bid to determine the lead lag structure in the crude oil market.2

Our research is important to policy makers on various fronts. Information on the degree of sensitivity in major ethylene spot markets by incorporating the role of crude oil prices is important. If the analysis shows a strong relationship in the intra-ethylene price dynamics and not with crude oil price, then firms should not hedge against oil prices movements, but if crude oil prices play a significant role in explaining ethylene prices then appropriate risk management policies have to be implemented by ethylene producers and consumers. Unlike oil markets, petrochemical markets (ethylene and propylene) do not have derivative instruments like futures contracts although in recent times contracts in further downstream products like polyethylene and polypropylene are available for hedging and inventory requirements. These contracts are still very illiquid and firms are still dependent on heating oil and crude oil prices in attempting to manage their risk.3

The varying degree of sensitivity of different ethylene markets to crude oil will also help crude oil suppliers in strategic locations like the Middle East to swing their shipments from one region to the other. If shocks to the variance of ethylene in a particular market are explained greater by crude oil then there is a possibility of a drop in demand for ethylene in that particular market if oil prices continue to rise. This is of interest to oil producers as they can increase their focus to petrochemical markets that are less sensitive to crude oil increases. This also gives suppliers of crude oil opportunity to forecast market conditions based on movements in prices in various markets and if favourable conditions prevail, refiners can adjust their output by producing more naphtha which is the main feedstock in the petrochemical process. Our focus is on the European and Asian markets because production of ethylene in Europe and Asia is about 80% geared towards using naphtha (product of crude oil), while in the United States majority (70%) of its ethylene is from ethane and propane (product captured mainly from natural gas).

The analysis is also important to traders in commodity plastics such as polyethylene (which is three times removed from crude oil in the production chain) and according to Platts (Insight magazine, Dec 2005) traders now track spot-market prices of polyethylene against crude oil prices. The old saying that petrochemical prices are derivative driven (downstream demand), i.e., petrochemical prices are determined mostly by the prices of the finished products they go into, has been replaced by the realization that the price of crude oil may have a big impact on petrochemical prices.

Our study is organised as follows. In Section 2, we give a brief overview of the petrochemical process. Section 3 looks at the role of Asian demand for petrochemicals using China as a case study. The literature review in Section 4 is followed by the methodology employed in Section 5. The data, empirical results and discussions take place in Section 6. The study ends with the conclusions and policy implications in Section 7.

Section snippets

The petrochemical process

Before we explain the petrochemical market, a brief discussion on how petrochemicals come about or rather what happens to the oil when it is extracted from the rocks (carbonates) and oil wells is warranted. In most cases, crude oil is extracted together with pockets of associated gas. After some application of heat to crude oil in a distillation unit, products such as heavy oil, fuel oil, naphtha, off gases, propane and liquefied petroleum gas (LPG) are produced and these are classified as

Petrochemical demand from China

China's entry into the World Trade Organization (WTO) in September 2001 has enabled the country's chemical industry to harness the benefits of globalization. Its growing role as a producer and consumer of chemicals and petrochemicals is having a profound impact on the global industry. China is the third largest producer of chemicals and petrochemicals globally with growth rates of 10% annually since 1994 and 9% through 2005. Throughout 2005, China led growth in the Asia–Pacific chemical sector.

Literature review

To our knowledge, no study has looked at the relationship between crude oil prices and olefins products. However, several studies model the dynamics between crude oil prices and refinery products. Using VAR techniques with a single equation framework, Serletis, 1994, Grima and Paulson, 1999, Gjølberg and Johnsen, 1999 find long run relationships between crude oil prices and refinery products but they assume weak exogeneity of the explanatory variables. The problem with such methodology is that

Methodology

It is now well known that the traditional regression analysis that has been applied for many decades in time-series studies either estimated a spurious relationship (if the original ‘level’ form of the variables was non-stationary) or estimated a short-run rather than a long-run theoretical relationship (if the original level form of the variables were ‘differenced’ to make them stationary).

This damaging limitation of the traditional regression analysis (i.e., either spurious or not testing

Data, empirical results and discussions

In this study, we use monthly data from January 2000 to April 2006 sourced from Thomson Reuters Datastream. The series used in the study are ethylene prices for NWE, MED and FE. The NWE prices are CIF (cost, insurance and freight) and for shipment to any ports in Amsterdam, Rotterdam, Antwerp, and the MED CIF prices are for shipments to any ports on the West Mediterranean in particular the west coast of Italy and Southern France. The FE prices are CFR (cost and freight only) shipments to Japan,

Conclusion

This study made an initial attempt to investigate the following two questions: (i) is the crude oil (WTI) price significantly related to the regional ethylene markets of the FE, NWE and the MED? (ii) what drives the regional ethylene prices ? The paper is motivated by the recent and growing debate on the lead-lag relationship between crude oil and ethylene prices.

We investigated the above questions by applying the error-correction and variance decomposition techniques based on the approach of

Acknowledgement

The authors are deeply grateful to the editor (Professor Richard Tol), two anonymous referees for their very helpful comments and to the Center of Research Excellence in Renewable Energy, King Fahd University of Petroleum & Minerals, Dhahran, Saudi Arabia, for the generous support. Financial support from Macquarie University is also acknowledged. We would also like to thank Ronald Ripple and Stefan Trück for their helpful comments and suggestions.

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