China's push for self-sufficiency has resulted in structural oversupply for certain commodity chemical and derivative products, with recent expansions driving a growing wedge between nameplate capacity and domestic demand.   Spurred by government initiatives and industrial policies supporting domestic production, the Chinese chemical sector has pursued aggressive expansion, installing new capacity at a rate far faster than the global average, and significantly outpacing buildouts in regions lower down the cost curve, such as North America and the Middle East. Since 2015, China has accounted for the majority of ethylene and propylene supply additions globally, with its olefin capacity increasing at a compound annual growth rate of about 12% for ethylene and 10% for propylene, compared to capacity growth of 6% and 2% in the U.S., and about 2% to 3% in the Middle East (see charts 2 and 3).

China's Unfavorable Cost Position Has Not Hindered its Growth Ambitions

This exceptional supply growth has occurred despite a persistent feedstock cost advantage for North American producers and China's relative positioning at the mid to high end of the global petrochemical cost curve. There remains a wide differential between China's naphtha-based cost of production, on which it relies for about 50% of its ethylene needs (see chart 4), and U.S. ethane cracker cost of production (see chart 1), which is some of the world's most cost-advantaged capacity. The regional cost differential is also significant in propylene, whereby China relies on imported propane as a primary feedstock for its propylene dehydrogenation (PDH) units that account for roughly 30% of its propylene capacity (see chart 5).

Given its higher production cost, domestic overcapacity, and slowing derivative demand, we expect margins for nonintegrated petrochemical producers in China will remain under pressure for the next few years. S&P Global Commodity Insights forecasts Northeast Asian variable production margins for both ethylene and propylene will remain at or below breakeven levels through 2025, even with ethylene cracker operating rates remaining in the low-80% area (from above 90% pre-2020) and PDH operating rates falling into the 60% to 70% range through the latter part of this decade (from nearly 90% pre-2020).

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Capacity Growth Has Far Exceeded Incremental Demand in Recent Years

Structural oversupply could persist for years if Chinese domestic demand remains weak.   Until the past few years, the rapid increase in China's capacity was generally balanced by strong domestic demand growth. From 2015-2019, China was the primary driver of global olefin and derivative demand, accounting for about 28%, 54%, 61%, and 63% of all incremental ethylene, polyethylene (PE), propylene, and polypropylene (PP) consumption, respectively. China's capacity grew alongside this demand, and the country's global share of chemicals demand and industry capacity increased substantially. As of 2023, China accounted for 22% of the world's ethylene capacity, 36% of propylene capacity, 23% of PE capacity, and 41% of PP capacity, up from just 13%, 24%, 15%, and 28%, respectively, in 2015 (see chart 6).

During this period, while Chinese nameplate capacity grew rapidly (compounding at an annual rate of 6.2% for ethylene, 8.5% for propylene, 5.3% for PE, and 8.9% for PP), domestic consumption grew alongside capacity at a relatively similar rate (about 7% for ethylene and PE, 8.5% for propylene, and 7.1% for PP; see chart 7). As domestic demand kept pace with additional supply, operating rates in China remained consistent, with ethylene cracker rates averaging in the 90% area and PDH operating rates reaching the mid-80% area. Additionally, since China entered the period net short petrochemical products, imports remained relatively stable, and the country's lack of self-sufficiency was largely the same.

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Compared to the prior period (see chart 7) between 2019 and 2023 (see chart 8), capacity growth accelerated rapidly, despite sluggish domestic consumption and a weaker outlook for chemical demand as a result of the country's property/construction sector downturn and COVID-related lockdowns. Despite these weaknesses, the rate of demand growth during this period wasn't substantially lower than that experienced during the previous five years: 12% for ethylene (versus 7% previously), 8% for propylene (9%), 5% for PE (7%), and 6% for PP (7%). However, the unprecedented scale of capacity expansion dwarfed incremental demand growth. Nameplate capacity for olefins and derivatives grew at a double-digit rate across most major petrochemical products: 17% for ethylene, 12% for propylene, 15% for PE, and 11% for PP, vastly exceeding incremental demand growth and pushing operating rates and margins lower, and in some chains, even negative.

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On an absolute basis, China's ethylene nameplate capacity increased from about 26,000 thousand metric tons (kmt) per year in 2019 to nearly 50,000 kmt per year in 2023, while demand rose from 26,000 kmt to about 41,000 kmt, resulting in nameplate operating rates falling to 80% from around 90%. Oversupply is even more dramatic in propylene, where we expect capacity, driven by PDH unit startups, to almost double from 37,000 kmt per year in 2019 to over 70,000 kmt by 2025 (or +33,000 kmt) compared to projected demand growth of +17,000 kmt per year, pushing our forecast for regional PDH operating rates down to nearly 60% from about 86% in 2019 (see chart 10). The massive ramp in productive capacity beginning in 2019 is also evident across a wide array of derivative products (see chart 9). This includes compound annual capacity growth since 2019 of 29% for monoethylene glycol (MEG), 21% for styrene monomer (SM), 16% for cumene, 10% for acrylonitrile (ACN), and 18% for propylene oxide (PO).

Given the absolute scale of capacity additions across a wide array of olefins, polymers, and intermediates (see charts 11 and 12), even assuming China's petrochemical demand growth returns to its trend rate over the past decade, something we view as unlikely given our forecast for lower domestic GDP growth over the next decade and property sector headwinds, it would take many years for domestic demand to absorb these recent capacity additions. Additionally, according to S&P Global Commodity Insights and illustrated by the purple bars on chart 9, China's capacity growth is forecast to decelerate, but only to the level of incremental demand growth, preventing the existing supply overhang from being easily absorbed, which could prolong the current period of lower global operating rates and margins.

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Increasing Self-Sufficiency Leads To Drop In Imports

The magnitude of capacity additions over demand growth can be illustrated by China's greater self-sufficiency in various polymers, declining import reliance, and rising exports of certain chemical products.   Although the country remains a net importer of most products, based on forecasted domestic capacity, by 2025, China's domestic producers could (hypothetically) cover about 75% of the country's HDPE demand, 72% of its LDPE demand, 94% of its LLDPE demand, and over 100% of its polypropylene demand (see chart 13). This compares to a ratio of just 43%, 47%, 66%, and 89%, for the respective polymers in 2019. The trend toward greater self-sufficiency is also apparent in the country's net trade balance for a variety of other chemicals (see chart 14). While China's domestic demand growth has remained positive across the vast majority of chemicals and polymers since 2019, the country's reliance on imports has fallen, and with domestic demand growth slowing, more Chinese product has found its way onto the global market. China's net imports of MEG, HDPE, LDPE, LLDPE, PP, styrene monomer (SM), and polystyrene (PS) have generally declined over the past four years, the country is now a net exporter of PVC, purified terephthalic acid (PTA); an intermediate used to make PET), and has become increasingly reliant on export markets to balance new capacity additions in products such as epoxy resins, silicones, and titanium dioxide (TiO2).

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Structural overcapacity globally may mean an extended period of lower operating rates and margins for companies within the North American chemical sector, even as chemical demand returns from a cyclical trough after a period of destocking and weaker goods demand.   Given the impact from destocking experienced in 2023 by North American chemical producers, who saw volumes fall more sharply than underlying end-market demand due to customer inventory reduction measures further down the supply chain, we're projecting a slight cyclical demand rebound in 2024 for most issuers we rate. However, we believe current industry overcapacity, structurally weaker Chinese demand growth, a challenging European operating environment, and additional Chinese capacity slated to come online within the next few years, could cap the upside of any cyclical improvement, and result in a more muted rebound in profitability compared to those seen after previous chemical sector "recessions."

Without significant permanent capacity rationalization within China, or in other higher-cost regions such as Northeast Asia or Europe, we believe it could take many years for demand to fully fill the current supply overhang in many chemical chains. Over the past 12 months, the shutdown of higher-cost capacity has slowly begun to pick up pace, with announced rationalizations targeting Europe in particular. Recent announcements include: EXXON Corp. and Saudi Basic Industries Corp.'s (Sabic) planned closures of separate naphtha crackers (and derivative capacity) in France and the Netherlands, Celanese AG's permanent shutdown of PA66 and high-performance nylon capacity in Germany, Lyondell Chemical Co.'s rationalization of polypropylene assets in Italy, Olin Corp.'s restructuring of its global aromatics and epoxy assets, Sabic and Trinseo PLC's exit from their European polycarbonate businesses, and LG Chem Ltd.'s closure of its Korean styrene monomer unit.

Other producers, with margins pressured by excess product making its way into their domestic market, primarily from China, have sought government assistance through a combination of trade restrictions, antidumping duties, and subsidies. The EU has initiated a review of Chinese TiO2 imports into the region and applied antidumping duties to Chinese PET imports in April, while epoxy imports from China into the U.S., PVC and acrylonitrile imports into India, and styrene imports into South Korea have also been subject to scrutiny. Additionally, some governments have provided financial assistance to improve the competitiveness of domestic producers, including Germany's implementation of energy tax subsidies for industrial companies. Although calls for policy action and subsidies have become more urgent, particularly in Europe, and antidumping investigations increasingly common, thus far, measures have been isolated to a handful of products and certain jurisdictions. However, if the current downturn persists, further threatening production, manufacturing, and domestic jobs in regions outside China, the call for additional government intervention could broaden. Current and future subsidies and trade barriers could improve profitability for certain producers on a regional or product basis; however, they also risk short circuiting the capacity rationalization needed to balance global chemicals supply and demand, which could ultimately result in a more prolonged period of overcapacity. Additionally, the time between policy proposals and trade investigations and the actual implementation of these measures can take years, with overcapacity and margin pressure persisting as companies keep assets online, awaiting the outcome of government policy action.

Key Takeaways And Credit Implications For North American Chemical Producers

• Integrated producers with assets primarily in lower-cost regions, such as The Dow Chemical Co. (BBB/Stable/A-2), Westlake Corp. (BBB/Positive/--), and Olin Corp. (BB+/Positive/--) should see operating rates and margins hold up relatively better than European and Asian peers in the event of protracted industry overcapacity.
• These low-cost integrated producers have historically been reliant on global markets to balance domestic supply and therefore could see volume pressure from slowing exports as a result of greater Chinese self-sufficiency in products such as polyethylene, PVC, and epoxy, or from the imposition of increased trade restrictions.
• Issuers most at risk from China's overcapacity are those with either a higher-cost position or those who are now facing increased competition from low-cost Chinese imports due to weak Chinese domestic demand (or both). These issuers include those in the TiO2 sector: the Chemours Co. (BB-/Negative/--), Tronox Holdings PLC (B+/Stable/--), and Kronos Worldwide Inc. (CCC+/Negative/--), nylon producers: Ascend Performance Materials Operations LLC (B/Negative/--) and Invista Equities LLC (BBB/Stable/--), and silicones producers such as Momentive Performance Materials Inc. (B/Negative/--).
• Albemarle Corp. (BBB/Negative/A-2) is another issuer that has been negatively impacted by policy-driven supply additions in China. In order to secure supply, retain self-sufficiency, and further a key policy initiative of the Chinese government (e.g., the production of battery electric vehicles) producers have brought on significant capacity (both in the mining and upgrading side of the business), contributing to lower global lithium pricing and margins for Western producers such as Albemarle.

A cyclical rebound in goods demand, and an end to destocking that has plagued the sector over the past year, should result in a modest improvement in commodity chemical earnings in 2024. However, we believe the unprecedented scale of China's recent chemical capacity buildout, and additional projects under construction, loom as a structural impediment to sector profitability in the short to medium term. North American chemical producers will be relatively less impacted by overcapacity given their cost position versus European and East Asian peers, but still face risks from a slowing export market and competitive Chinese imports. Regardless of cost position, we expect industry margins and operating rates will remain challenged barring meaningful capacity rationalization in high cost regions, a reacceleration of domestic Chinese demand growth, or a marked reassessment by Chinese producers of their future expansion plans.