A strategic overview. Executive summary. KSA petrochemical Thematic report. The following are the key outputs of our strategic analysis; May 2014

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1 Executive summary Petrochemical sector is still among the few options the local and regional governments have to reduce their economic dependence on the exports of crude oil. It is worthy to mention that due to the ample availability of required feedstock, Saudi Arabia continued to dominate the regional industry followed by Qatar. Over the past few years, the local capacity increased at CGAR of 9.9% and recorded at 84.2mn tons by the end of 2012; where, basic chemicals and intermediates constitute more than 50.0% of the overall capacity. However, at present, we believe statements like, petrochemical; a key to diversify the local and GCC economies and undisrupted supply of feedstock gas at highly subsidized rates are not to be taken granted anymore. This does not imply that these factors are irrelevant for growth but the importance of these are fading away which is mainly associated with the rapid changes in the industry dynamics; especially after the developments in shale gas (particularly in USA) with a subsequent decline in the average prices of gas. Consequently, this has started to erode the cost advantage at local and regional petrochemical units, while we should not forget western companies have their own technology and other variations of products. On the other hand, at present, most of the regional capacities are designed to produce basic chemicals and its related derivatives and polymers; which was a suitable product mix a decade ago. But the (i) technological evolution and increase in demand of highly sophisticated products at each level of industrial production process and (ii) no significant change in the regional production mix; caused the regional players the loss of implicit profitability margins to other global producers who are meeting input requirements for industrials. Moreover, such a shift in industry dynamics led to extend petrochemical supply chain with an additional new step i.e. value-added products / downstream more sophisticated chemicals. We, therefore, believe that it is necessary to conduct an in-depth strategic analysis of the existing local and regional petrochemical companies using the academic strategic models to determine the regional industry (i) long-term sustainability, (ii) competitiveness, (iii) strategic positioning. Beside these strategic analyses, it is necessary to identify those areas within the industry; where, the sufficient investment will help to (i) optimize profitability and (ii) realign the regional industry strategy in accordance with the change in industry dynamics. The following are the key outputs of our strategic analysis; Porter-five forces model In the broader prospect, the kingdom petrochemical sector is classified on three petrochemical products (i) basic chemicals, (ii) intermediate chemicals and (iii) polymers and other specialty chemicals. But, to evaluate the industry attractiveness we further reclassify the sector s products in two categories; mainly based on their respective product s industry dynamics and life stage. Moreover, since the kingdom s sector has significant exposure in international market so it is necessary to assess the attractiveness on global basis. Our analysis indicates that basic chemicals and intermediates are approaching at their stabilization stage and starting to become less attractive; but, low cost feedstock is the major factor to keep the local industry intact with growth. On the other hand, polymers and other specialty chemicals are still attractive and in growing stage. where, the suitability of local sector would be to increase focus in (i) technology, (ii) innovations and (iii) diversification. Porter s generic competitive model With the undisrupted supply of feedstock (gas and liquid) at highly subsidized prices USD0.75/mmbtu; and 27.0%-30.0% discount to international market) and limited exposure in downstream petrochemical products; we believe the local sector still have low cost competency. For analysis purpose, we divide local complexes into two categories (i) big complexes; mainly owned by government and (ii) medium to small private complexes. It is worthy to mention that most of the local private medium to small complexes have (a) relatively more exposures in downstream chemicals and (b) utilize more liquid feedstock than big players. We, therefore, believe these private complexes are following segmentation strategy; and, strategically in better position than big players considering the level of exposure these large complexes have in conventional petrochemicals. The key outcomes of our analysis are (i) private small to medium complexes should continue to invest for deepening in their existing product offerings and (ii) the focus of large government based complexes would be on innovations, technology, operational efficiency and backward and forward integration. Furthermore, in order to identify the opportunities in local market; we evaluate the sector on the basis of existing operational structures. Our analysis indicates that the complexes with diversified high-end products are the most operationally efficient in the kingdom followed by the step-ups with diversified product portfolio. Consequently, we believe based on the existing dependence of the kingdom s petrochemical sector on exports; the essence of growth sustainability in the sector is in the investment to establish integrated facilities with wide range of high-end products. Senior Analyst Syed Taimure Akhtar s.akhtar@aljaziracapital.com.sa Analyst Saleh AlQuati s.alquati@aljaziracapital.com.sa

2 Introduction Since the initiation of the kingdom s effort (in the 1970s) to reduce its economic dependence on oil; the sector gained significant importance and witnessed significant development. At present, it is known fact that the local petrochemical sector is heavily dominated by Saudi Basic Industries Corporation (Sabic). However, since the start of new millennium, several private chemical companies started to enter in the local market. According to GPCA 1, the kingdom s overall chemical capacity was recorded at 84.2mn tons; indicating 65.2% of the entire regional capacity. It is worthy to mention that expansions in the local industry (during 2012) along with Qatar remained a key driver for an increase of 6.1% in the regional capacity in GCC chemical production capacity by country (mn tons) CAGR= 12.2% CAGR = 17.2% CAGR = 8% Saudi Arabia Qatar Oman Kuwait UAE Bahrain Source: GPCA 2012 facts & figure It is worthy to mention that the kingdom s petrochemical capacity (by the end of 2012) is mainly based on basic chemicals followed by polymers; while, almost 16.9% of the total capacity is based on intermediates and other chemicals. Based on our observation, most of the local petrochemical capacity is associated with ethylene and its related derivatives and polymers. Where, our assumption, regarding local capacity s composition, is based on the undisrupted supply of ethane gas (feedstock) at highly subsidized price of USD0.75/mmbtu. In addition, expansion in the kingdom s overall petrochemical capacity (as indicated in above graph) during could be categorized in two phases (i) rapid expansion; occurred during and (ii) slowdown in the growth to CAGR of 8.0%. We believe the rapid expansion during was primarily based on the completion of projects; originally started before the crisis happened. However, the decline in growth rate during was mainly in response of global crisis happened in late Furthermore, it is worthy to mention that the expansions planned after economic crisis were mainly focusing (especially) to increase exposures in high-end products (i.e. usually factions of basic chemicals & polymers). 1 Gulf Petrochemical & Chemical Association; 2012 facts & figure 2

3 Saudi Arabia capacity breakdown (product-wise) Others, 25.9% Ethylene, 43.7% Methanol, 18.3% Propylene, 12.1% Intermidiaries & others, 16.9% Fine chemicals, 14.3% Polymers, 20.7% Polypropylene, 24.5% Polyethylene (all grades), 49.3% Fertilizer, 12.8% Other polymers, 26.2% Basic chemicals, 35.4% Others, 41% Ethylene glycol (EG), 41% Ethylene di Chloride (EDC), 11% Propylene oxides (PO), 2% Ethlyene oxides (EO), 5% Source: GPCA & Aljazira Research 3

4 Strategic analysis The kingdom s petrochemical industry is mainly competing in international market; however, on local basis most of the facilities are complementary to each other. Like, several affiliates of Sabic (a local & regional petrochemical giant) are sole suppliers of required feedstock to other Sabic affiliates and local private companies. Hence, there is no rivalry inside the kingdom among facilities which are, on the other hand, getting similar level of treatment in term of required energy and feedstock to run their operations. Consequently, our strategic analysis will continue to focus on the standing of local industry in international market. We used the following two academic competitive models; Porter s five forces Porter s generic competitive analysis Porter s five forces As the products of petrochemical sector is based three broad categories (i) basic chemicals, (ii) intermediate chemicals and (iii) polymers and specialty chemicals; so, we believe it is necessary to evaluate the sector on the pre-determined product categories. Basic and intermediate chemicals Rivalry intensity - Medium to low To evaluate the intensity of competition; on international level, we considered the following factors; Number of suppliers - High Market share (related products) Highly concentrated Price control - Insignificant; although GCC suppliers have capability to sell at lower price (due to lower cost of production) but have no major impact on the prices. As per Bloomberg industry data, in 2012, twenty petrochemical companies around the globe constitute almost 70.0% of the total revenues. Prices of products are determined in open market; where, none of the global players has significant influence on the prices. Threat of new entrants - Low Probability of new entrants is primarily based on the particular country s decision to get exposure in this sector. Where, the decision is based on the availability of feedstock. In addition, we consider the following factors to expand our analysis; Life of industry - Mature Economies of scale - High Specialization - Low Capital intensity - Very high Most of the countries, around the globe, are unable to establish basic chemical plants; which is mainly due to lack of availability of feasible feedstock. Threat of substitute - High to medium We used the following elements to identify the sector s competiveness on this parameter; Competition - Moderate. Commoditization - Several producers with ample capacities. Feedstock availability - Limited As per Bloomberg data*, almost 76.9% of the total petrochemical capacity is based on basic and intermediates**. Availability and pricing of feedstock are the key determinants for any basic chemical producer. *Based on 2012 figures; as there no updated data is available after 2012 for several products. ** We consider name plate capacity of key chemicals; like ethylene, propylene, methanol, benzene, butadiene and Paraxylene. While, for intermediates we consider ethylene and propylene oxides, styrene, purified terephthalic acid and ethylene dichloride 4 Supplier bargaining power - High Source of key input - Sole or few Key input prices Fixed or related with international market Basic chemical producers require (liquid or gaseous) feedstock like ethane gas, propane and butane to run their operation. Generally, the non-governmental suppliers sell feedstock on international prices; while, feedstock supplied by government based entities on predetermined prices. Hence, in either case, the players do not have any significant edge over the supplier. Buyer bargaining power High to medium Options - Several exporters of basic chemicals and intermediaries with limited capacity in importing countries. Availability of substitute - Moderate switching costs. Easy availability of basic chemicals and intermediates; due to ample existence of capacity around the globe. Source: Aljazira Research

5 Polymers and other specialty chemicals Rivalry intensity - High to medium To evaluate the intensity of competition; on international level, we considered the following factors; Number of suppliers - Very high; even countries with no feedstock (gas & naphtha) resources have exposure in polymer market due to availability of basic chemical (a feedstock for polymers) in international market. Market share (related products) - Stagnant and based on the required grades of the product Price control - Insignificant Technology - High Most of the petrochemical complexes (producing basic and intermediate chemicals) have capacity to produce polymers. Rising polymer capacities in importing markets; a significant threat for exporting countries. It also fuels the competition in importing markets. Grades of polymers; a key limitation to the existing producers. Technology a key differentiation factor among the leading petrochemical players. Threat of new entrants - High Unlike basic chemicals and intermediate facilities; setting up of polymer plant does not require the availability of ethane gas or other raw feedstock; but, need basic chemical. Life of industry - Growing Economies of scale - Moderate Specialization - High; exposure to technology is a major limitation Capital intensity - High Developed economies are striving to improve technology. In order to reduce the dependence on exports for endproduct industry feedstock; countries are building up their own polymers capacities like China and India Threat of substitute - Medium As mentioned earlier the demand of polymers varies in accordance with the industry specifications. Competition - Moderate. Commoditization - Moderate High density polyethylene (HDPE) is generally used to produce industrials like bottle caps, ballistic frames and so on. But, low density polyethylene (LDPE) is primarily used to produce households and consumer products. Supplier bargaining power - Medium to low Source of key input - Several; basic chemical producer Key input prices Negotiable or related with international market. Polymer plants are importing basic chemicals from several sources. Hence, switching cost is not too high. Buyer bargaining power - Medium Options - Moderate - Limited when demand is for highly sophisticated polymers. Availability of substitute - Low; due to requirement of different grades of polymers. Specifications of polymers vary from industry to industry. Source: Aljazira Research Factors identified Technology Innovation Diversification Implications Improve operational efficiency, reduce costs and promote integration. High value added & specialized products Expansion in product portfolio and customer Conclusion Based on our Porter s 5 forces analysis we draw the following conclusions; Basic chemical and intermediates product segment is approaching its stabilization stage and start losing its attractiveness. But, low cost feedstock will continue to keep the local sector intact with limited growth. Polymers and specialty chemicals segment is attractive and in a growing phase. Where, the sustainability factor would be the increase in focus on technology, innovations and diversification. In addition, we believe the expansion in operational capacity with limited focus on certain conventional chemicals will eventually erode the existing attractiveness of the sector. 5

6 Porter s generic competitive analysis The analysis focus is to identify the strategic positioning of a company based on cost and differentiation scale. Here, the cost advantage could be due to i) natural undisrupted supply of key input, ii) low input cost like labor and utility and iii) government support through subsidies & other guarantees. While, on the other hand, differentiation advantage created through i) innovations, ii) effective utilization of available resources, iii) technological developments and iv) well-integrated supply chain. In short, these are the factors which will help the industry/business to sustain their competitiveness. Porter s generic competitive model Narrow market scope Segmentation Strategy Useful when the industry/firm has narrow market scope i.e. facilitates selected segment of the target market. Where, the segmentation could be done on the back of several demographic, economic and socio economic factors including locations. Example: The best example for such strategy is the international car industries; where the products are modified to satisfy the demand of consumers like; several variations in Toyota, Honda and Audi cars model found on country by country basis. Broad market scope Differentiation strategy The industry/firm competitiveness is measured on the back of its ability to create differentiation among the products/services. Example: High tech processing equipment leads to increase quality and create differentiation. Cost leadership The industry/firm competitiveness is measured on the back its ability to utilize the input cost advantage. Example: High subsidies on gaseous feedstock make the industrial complexes in KSA more cost effective than the one using liquid feedstock (which is relatively expensive than gaseous feedstock)feedstock) Uniqueness competency Low cost competency Source: Aljazira Research Petrochemical facilities inside the kingdom are enjoying the benefits having undisrupted supply of feedstock at subsidized prices; where, ethane gas is available at highly subsidized rate of USD0.75/mmbtu and liquid feedstock (butane and propane) is provided with a discount of 27.0%-30.0% to the international prices. Hence, all complexes in the kingdom are enjoying the benefit of low cost feedstock; especially those having ethane gas cracker. Within the local sector, mostly the operational structure of private medium-small complexes is based on liquid feedstock with better exposure in high-end and specialty chemicals (although limited) than other complexes using gas feedstock. Therefore, we can categorize these complexes in segmentation strategy. Interestingly, it is worthy to mention that most of the affiliates of Sabic (indirectly, complexes under the supervision of government) are based on gas and have limited downstream products; but the size of these complexes are big. Implication on Saudi petrochemical market Our analysis (based on Porter s generic competitiveness) concluded in the following manner; For private small to medium complexes; we suggest to keep investing to deepen their existing product line. Since, these facilities have limited finance and capability in comparison with government-backed complexes. Moreover, the essence of these complexes would be (i) forward integration, (ii) continue to complement big players and (iii) strengthen & expanding their position in international markets. The big players are mostly government based and have capability to invest heavily in innovation, technology, operational efficiency and backward and forward integration. We, therefore, believe instead of just expanding capacity these complexes should focus on the mentioned areas to sustain growth. Limitations for profit pool analysis Based on the existing operating structure of local petrochemical sector, we believe it is difficult to measure the profitability margins on segmental basis (basic, intermediaries and polymers). In addition, most of the sales among the complexes of same company; like, Sipchem s International Methanol Company (IMC) supply methanol to acetic acid plan which use to produce other chemicals; and several affiliates of Sabic are responsible to supply basic chemical to other affiliates or use in similar complex i.e. Yansab. Thus, sales among such setups are based on cost basis or lower than the market prices. We, therefore, believe segregated margins will not give us true picture. 6

7 Effective operational structure In order to identify the attractive opportunity within the sector; we believe, the most suitable measure would be the comparison on the following basis; Integrated complexes with limited product. Integrated complexes with diversified product portfolio. Integrated complexes with diversified high-end products. Our analysis indicates that the complexes with diversified high-end products are operationally efficient (as indicated in the table below) in the kingdom followed by the step-ups with diversified product portfolio. Saudi Arabian key petrochemical companies EBITDA margin comparison 50.00% 46.07% 45.00% 40.00% 35.00% 30.00% 30.33% 29.79% 25.55% 25.00% 20.00% 16.91% 15.00% 10.00% 5.00% 4.14% 0.00% Sipchem Sabic Tasnee Advanced Sahara Petro Rabigh Source; Bloomberg Implications on Saudi petrochemical sector Considering the ongoing development around the globe and the kingdom s petrochemical sector dependence on exports; we believe the essence of growth sustainability in sector is in the investment to establish integrated facilities with wide range of high-end products. In addition, based on the undisrupted availability of required feedstock; we believe the next growth story for the kingdom s petrochemical would be backward and forward integration. It is worthy to mention that we do not believe Petro Rabigh to be a backward integrated structure; in fact, it is a combination of refinery and petrochemical complexes; where, the dynamics and other profitability measures are totally different. But, here the proposed integrated structure is similar to new oil to chemical project, recently, announced by Sabic (according to MEED). Based on given information, we believe the margins of Sabic new project will be based on the sales of high-end petrochemicals and specialty chemicals; while considering crude oil as a cost (not liquid feedstock; which usually is costlier than crude oil). In addition, the operational structure will give more flexibility to the local sector and hence, reflect positively on growth. 7

8 RESEARCH DIVISION AGM - Head of Research Abdullah Alawi a.alawi@aljaziracapital.com.sa Senior Analyst Talha Nazar t.nazar@aljaziracapital.com.sa Senior Analyst Syed Taimure Akhtar s.akhtar@aljaziracapital.com.sa Analyst Saleh Al-Quati s.alquati@aljaziracapital.com.sa Analyst Sultan Al Kadi s.alkadi@aljaziracapital.com.sa Analyst Jassim Al-Jubran j.aljabran@aljaziracapital.com.sa BROKERAGE AND INVESTMENT CENTERS DIVISION General manager - brokerage services and sales Ala a Al-Yousef a.yousef@aljaziracapital.com.sa AGM-Head of Sales And Investment Centers Central Region Sultan Ibrahim AL-Mutawa s.almutawa@aljaziracapital.com.sa AGM-Head of international and institutional brokerage Luay Jawad Al-Motawa lalmutawa@aljaziracapital.com.sa AGM-Head of Qassim & Eastern Province Abdullah Al-Rahit aalrahit@aljaziracapital.com.sa AGM- Head of Western and Southern Region Investment Centers & ADC Brokerage Abdullah Q. Al-Misbani a.almisbahi@aljaziracapital.com.sa AGM - Head of Institutional Brokerage Samer Al- Joauni s.aljoauni@aljaziracapital.com.sa RESEARCH DIVISION AlJazira Capital, the investment arm of Bank AlJazira, is a Shariaa Compliant Saudi Closed Joint Stock company and operating under the regulatory supervision of the Capital Market Authority. AlJazira Capital is licensed to conduct securities business in all securities business as authorized by CMA, including dealing, managing, arranging, advisory, and custody. AlJazira Capital is the continuation of a long success story in the Saudi Tadawul market, having occupied the market leadership position for several years. With an objective to maintain its market leadership position, AlJazira Capital is expanding its brokerage capabilities to offer further value-added services, brokerage across MENA and International markets, as well as offering a full suite of securities business. RATING TERMINOLOGY 1. 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