Chemicals Monthly – Cautious Guidance Appropriate, But A Drag On Performance

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

graham@/lipinski@sector-sovereign.com

February 15th, 2013

Chemicals Monthly – Cautious Guidance Appropriate, But A Drag On Performance

  • A rare month of underperformance from all of the chemical sub-sectors, in a period of the year in which they normally do well. Earnings disappointments and quite conservative guidance were drivers, but additionally this group is levered to the global economy and forecasts of growth for 2013 are coming down.
  • Anecdotal comments from companies suggest that Europe may have found a bottom in terms of demand, while there are no expectations of a quick recovery. One view is that demand is now so low in Southern Europe that it cannot move the needle down further.
  • Energy continues to move in a direction that favors US natural gas based production, though we argue that it is unlikely that this can get much better on a sustained basis. The margin umbrella for US ethane based ethylene derivative producers is around $1000 per metric ton, versus global oil based capacity.
  • Despite underperformance over recent weeks, most sub-sectors and stocks look fairly valued or expensive. The exception remains the Diversified sub-group generally and DD and HUN specifically.

 

Exhibit 1

Source: SSR Analysis –
See Appendix 1
for background and see
Appendix 2
for a larger version of this table.

Overview

The conclusions from this month’s analysis are as follows.

  • The Chemicals sector (and all its sub-sectors) meaningfully underperformed the market since our last report. The Diversified subsector was the only meaningful loser in absolute terms, though all subsectors failed to keep pace with the S&P.
  • Earnings season created as many positive surprises as negative, but a number of the negative surprises were in the diversified group and this resulted in the worst sector performance.
  • Another contributor was a combination of more conservative company guidance and sliding global economic forecasts. The expectation is now for very limited economic growth in the first half of 2013 and we have highlighted the risk to this group in recent work that stagnant economic growth can mean declining chemical volumes and increased price competition.
  • With the exception of Coatings, which saw an incremental positive revision, the group saw meaningful negative revisions for 2013 over the last 4 weeks, with the most significant cuts for Specialty and Diversified Chemicals.
  • Our model portfolios delivered mixed performances through mid February; the normal value screen posted a 1% loss, the skepticism screen a 1% gain, and the portfolio of the overlap of the two was virtually flat. Everything lagged the S&P500.

Valuation

Exhibit 2 summarizes our valuation work. The extreme in valuations for the Coatings group is something we have written about at length – and we can partly explain the premium to normal with the current very high level of earnings. Where there is a more interesting dynamic is in the commodity group, which moved marginally more attractive in February – despite a widening cost advantage gap for commodity producers in the US – see this Month’s topic.

Here we see the investor dilemma, as the economics in the US are extraordinary and should result in very high earnings and cash flows. These have been further emphasized by recent announcements by LYB and DOW around increasing the return of cash to shareholders. The negative is the global economic picture, as this is a subsector that never does well in a weakening economy as more subdued demand almost always results in price pressure and lower margins. Today that is definitely the case in Europe and Asia, where pricing is bouncing along close to the break-even cost of production for many. Those companies with larger portfolios outside the US are clearly suffering as a consequence and this is offsetting the US advantage.

Note that Axiall (the former Georgia Gulf) is not included in this analysis for commodities as some of the recent history is too volatile and unreliable to derive a reasonable framework for calculating normal earnings

Exhibit 2

The group composition is summarized below.

Exhibit 3

Exhibits 4 and 5 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our
January Chemicals Monthly
. In a complete turnaround from last month, the Chemical space as a whole has meaningfully underperformed the market, as every sector fared worse than the S&P 500. The Diversified subsector was hurt by earnings misses from Ashland and Newmarket. At the same time, DuPont is weighing on this average as it has not kept pace with the S&P500 and is dominant in the average because of its market cap. Most of the other subsectors were flat or marginally positive over the time frame but could not keep pace with the broader market rally.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Monthly Topic : Ethylene Economics in the US – See recent research

Over the last few months NGL (Natural Gas Liquids) prices have fallen to levels that represent notional break-even economics for extraction from natural gas. At the same time natural gas prices bump along break-even F&D economics in the US. This is providing extremely advantaged feedstocks to US basic chemical producers at a time when global crude oil prices have been rising, effectively penalizing everyone else. This is reflected in the profits we are seeing from the US focused ethylene producers, most notably WLK, but also LYB.

While this may be sustainable for some time, it is hard to see how it gets much better. All of the benefit of surplus NGL’s in the US is accruing to the ethylene producers today – with margins close to 50 cents per pound ($1100 per metric ton). Natural gas could go lower for a short period, but below $3.00 per MMBTU the consensus view is that we would see further production cutbacks, and very limited new investment. Current forecasts for this year are in the $3.50 neighborhood. Global crude oil pricing cannot get much higher without a geopolitical event that causes broader economic concerns and perhaps curtails demand or without resurgence in economic growth that would likely lift natural gas prices as well.

Stocks pricing in further profit growth from recent (2H 2012) levels may disappoint unless companies have more capacity available to exploit the economics. New capacity at WLK will help 2013 and 2014 earnings, and the implied earnings growth helps support the higher current multiple. LYB and DOW will be held back by capacity in Europe. HUN, DD and EMN all have US ethylene capacity, but not enough exposure to the opportunity to be meaningful for earnings. Ethylene exposure and performance for the more levered companies are summarized in Exhibit 6, while Exhibit 7 shows valuation metrics for the broader group.

Exhibit 6

Exhibit 7

The Risk To European Margins

In Exhibit 8 we show our estimated view of how the ethylene cost curve looks today, based on delivering ethylene to a local consumer and based on buying feedstocks at local market values.

Points to note:

  • We have more ethylene capacity today than we need – global demand is around 130 million metric tons and capacity is 150 million metric tons. A global operating rate of 87-88%. The world is not adding that much capacity over the next couple of years, but in a slow global economic growth environment, we would not expect much demand growth either.
  • Break-even capacity on the cost curve generates an umbrella of more than $1050 per metric ton over a gas based producers in North America (48 cents per pound).
  • The current ethylene contract price in Europe is around $1700 per metric ton – well above the theoretical global break-even price, while the price in Asia sits very close to the break-even line.
  • This dynamic should continue to place downward pressure on prices in Europe, probably not at the direct ethylene level but at the derivative level, with increasing ethylene derivative imports into Europe and more limited opportunities to export.

Exhibit 8

Source: Capital IQ, IHS, EIA and SSR Analysis

The expected European pressure suggested by this curve will get more intense as we add more low cost capacity in the US, and this partly fuels our concerns for both DOW and LYB. Both companies have “competitive” operations in Europe, DOW more so than LYB, but lower pricing relative to the rest of the world will impact profit or increase losses regardless of where you sit on the local cost curve.

Dow has around 6 pounds of European capacity per share and LYB has around 3 pounds. If we assumed that (in a worst case) pricing in Europe fell to the global break-even level as suggested in Exhibit 6 – we would see a drop in pricing equivalent to around 15 cents per pound. Assuming that both companies operate at 90% of capacity, LYB could be negatively impacted by as much as $0.45 per share, while for DOW it would be closer to $0.90 per share.

This is not a scenario that we expect to play out quickly as there is not enough low cost capacity looking for somewhere to sell. It could be a consequence of higher exports from the US from 2017 as new facilities are built here to consume the surplus ethane.

Price Competition Between Products Could Be Good For US Ethylene

The low cost of ethane in the US is maximizing the production of ethylene at the expense of other co-products, such as propylene and butadiene. Consequently, the price dynamic between the products has changed meaningfully and this is impacting the cost of production of their various derivatives and their competitive positioning in markets where it is possible to substitute one product with another.

Exhibit 9 shows the relative price of High Density Polyethylene and Polypropylene over the last 30 years. As production economics of polypropylene improved and its cost of production fell through the 1980s, it started to gain share from other polymers as it was more durable (an advantage in some applications) and it was cheaper. The competition with Polystyrene was more intense – Exhibit 10 – and Polypropylene took many markets away from Polystyrene in the period from 1980 to 2000, including the dairy product container market and a number of electronic manufacturing and packaging markets also.

With the reversal of these trends we have seen a slowing of growth for polypropylene, partly responsible for the price collapse in late 2012, to contain inventories (prices have since rebounded significantly – lost in the 12 month average in the charts). Polystyrene producers have confirmed that their product is doing better in the US in the light of higher priced Polypropylene.

Exhibit 9

Source: IHS and SSR Analysis

Outside basic plastics, it is fairly clear that other propylene derivatives are seeing slower growth as a result of the higher prices and this may be part of the problem that DOW is seeing with its performance in the Coatings and Infrastructure and Performance Materials businesses, as these are largely based on propylene technology. Competition between ethylene oxide derivatives and ethylene based latexes are likely putting price pressure on DOW’s propylene oxide derivatives and acrylate latexes in some end markets.

Exhibit 10

Source: IHS and SSR Analysis

The bottom line is that in the US ethylene based derivatives are benefitting at the expense of other products. This could increase ethylene demand growth in the US raising operating rates and possibly pricing also.

While global operating rates are bouncing around in the 88% range, US operating rates are not much higher today – see Exhibit 24. However, beyond what has been done by DOW and WLK recently, there is not much expansion planned before 2017, and a step up in demand could push prices to a premium above the global break-even level. While we do not think that the current economy can do much to boost operating rates, substitution of ethylene for propylene could help the US ethylene focused companies – so good for WLK and AXLL. This would be more neutral for LYB and DOW as they would gain on one side of the equation and lose on the other.

Portfolio Performance

The full January selections are shown in Exhibit 11.

Exhibit 11

Source: Capital IQ and SSR Analysis

We have back tested the methodology from April and we show these results and the performance since we created the screens in Exhibit 12. We generated good results for the overlap group through mid-September, and after a period of underperformance from October through November, the portfolio returned to profitability in December and January. Midway through last month our portfolios were underperforming but rebounded in the latter half of January to post solid performances on all three metrics. Results have been mixed thus far in February, and the overlap strategy has been virtually flat to the market.

Exhibit 12

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Spending numbers continued to trend higher in the most recent data from December. Figures for October and November were revised down slightly.
  • The longer-term spending trend remains positive – Exhibit 14.
  • European spending and sentiment numbers continue to drift lower.

Exhibit 13

Source: BEA

Exhibit 14

Source: BEA

Construction

  • The most recent construction spending figures were very encouraging. September, October and November numbers were all revised upward and the December figure showed a marked increase month over month. The trend since 2011 has been strongly positive.
  • Stocks within the chemical space that are exposed to this sector continue to show some resilience (with DD now the only real exception), anticipating a return to a positive trend However, machinery stocks remain well off their highs of the year and appear to be discounting more bad news – there is an inconsistency here with some of the higher valued Diversified and Specialty Chemical companies and the Coatings sub-sector.
  • The picture outside the US has not changed materially.

Exhibit 15

Source: US Census Bureau

Exhibit 16

Source: US Census Bureau

Agriculture

  • It was mainly a quiet month for ag prices. Wheat and corn are little changed since our last report. Soybean pricing has drifted slightly higher.

Exhibit 17

Source: Capital IQ, SSR Analysis

ISM

  • The January PMI number came in firmly above the closely watched 50 level that indicates expansion or contraction – Exhibit 19. The reading has not been this high since May of 2012.
  • The troubling trend of increasing inventories and decreasing production has reversed in recent months – Exhibit 18. In January, inventories shot up sharply, while production increased, but at a slower rate.
  • We still do not see enough positive news here for us to feel any less concerned about 2013 earnings.

Exhibit 18

Source: ISM

Exhibit 19

Contraction

Expansion

Source: ISM

Trade

  • Chemical trade volumes bounced back in December after dipping into deficit territory for the first time since 2011.
  • The dashed line in Exhibit 20 is a rolling 12 month average that cuts through the monthly volatility. If the US is going to get real advantage from its lower natural gas prices, we should expect to see this line trend upwards.
  • The dollar continued to weaken against the Euro since a low in July – Exhibit 21. However, the fourth quarter of 2012 saw the dollar stronger against the Euro year on year by around 4% – Exhibit 22.

Exhibit 20

Source: US Census Bureau

Exhibit 21

Source: IMF

Exhibit 22

Source: IMF

Commodity Fundamentals

Supply/Demand

Overall demand for ethylene remains subdued, and the better Q3 numbers were in part a function of some inventory rebuild post the summer. While we do not yet have final numbers for Q4 2012, IHS has raised its production estimate for the quarter by around 3% and now expects year on year production growth in Q4. Operating rates have recovered from the Q2 lows, partly because of plant availability, post a series of shutdowns in the first half of the year – Exhibit 23.

While the current significant discount in NGL pricing in the US relative to crude oil gives a subset of US producers a meaningful cost advantage over any producer globally using an oil fraction as an ethylene feed, the higher cost producers in the US do not have costs materially lower than the higher cost producers in Europe, Latin America and Asia. While the plans to add NGL based capacity in the US is predicated on the idea that it should displace crude oil fraction based production outside the US, there is a risk that some of the early victims will be crude oil based producers locally. Looking back at the trade figures above – Exhibit 19 – we are not seeing the lower cost base in the US turn into a meaningful improvement in exports. The trade data is volatile but it is hard to see a positive trend and if we do a 12 month rolling average the line trends down is only barely positive.

With the change in Q4 2012 estimates and some more conservative 2013 estimates, industry experts IHS are calling for a 4.8% increase in US ethylene production in 2013 over 2012 (down from 7% a month ago). There are some easy comps in the first half of the year because an unusual level of plant operational problems in 1H 2012, but given the recent trade data and the lack of any real increase in exports from the US in 2012, and ever more cautionary GDP forecasts, it is unclear where this additional production will go. The economics for increasing exports do not get any better than this.

Exhibit 23

Source: IHS and SSR Analysis

Exhibit 24

Source: IHS and SSR Analysis

Pricing

Energy – Exhibit 25

Brent prices have been fairly stable over the last few weeks, but have had a positive trend. WTI prices have been more stable at the gap with Brent has opened further albeit only slightly.

Natural Gas has weakened again in February and while volatile, has been on a clear downward trend since the end of November. Today’s price, at $3.30/MMBTU is marginally lower than the price in the middle of January.

Exhibit 25

Source: Capital IQ

NGL pricing remains very weak; even with improved ethylene production, the increased availability is swamping the market. Supply is rising as more and more new wells are drilled in the “wet gas” regions of the West Marcellus and as logistics help increased crude shipment from the Baaken shale play in The Dakotas, Wyoming and Montana. This crude has high levels of associated gas in many locations. Ethane margins remain below break-even extraction costs for the average producer in January, and have now been negative for three months – Exhibit 26. Part of the problem for ethane producers is the price of propane which remains very depressed and makes propane as attractive to many ethylene producers as ethane – this keeps the squeeze on ethane.

Exhibit 26

Source: IHS and SSR Analysis

One thing that we continue to see is the price of NGLs fall relative to crude – Exhibit 27. In January and February this is coming more from the strength in crude prices, but we are now at all time lows for ethane, propane and normal butane (despite the seasonal benefit that normal butane generally sees at this time of the year from gasoline blending demand).

Exhibit 27

Source: IHS and SSR Analysis

Basic Plastics

Lower input costs in December and possible higher polyethylene prices in January and February have lifted polymer margins further – Exhibit 28. International pricing remains weak.

Exhibit 28

Source: IHS and SSR Analysis

Valuation Charts

The exhibits below show our mid-cycle “normal” valuation framework for the chemical sub sectors and the first exhibit (29) summarizes the results and is a repeat of Exhibit 1.
Exhibit 29

Valuation Charts – Exhibits 3032

Exhibit 30

Source: Capital IQ and SSR Analysis

Exhibit 31

Source: Capital IQ and SSR Analysis

Exhibit 32

Source: Capital IQ and SSR Analysis

Skepticism Analysis

We have updated the charts and tables from the Skepticism work that we completed in May – see
our past research for more detail
. The primary conclusions are:

  • Specialty, Ag Chem and Coatings continue to have valuations that discount an increase in return on capital from current levels but with the underperformance of the last four weeks that expectation has decreased – though only slightly. The other subgroups all have values that anticipate a fall in returns on capital – Exhibit 33
  • The gross margin trend analysis suggests that this expected decline is probably appropriate for commodity chemicals based on historic volatility, but not based on the widening oil and/gas ratio that we see today.
  • Gross margin analysis calls into question whether the coatings sector should be discounting further improvements in returns on capital as the sector is already over-earning. As discussed in previous research, the Coatings sub-sector has consensus estimates for 2013 that do not support the return on capital gains discounted in valuation. Furthermore, the sub-sector has a very good track record of accurate forward earnings projections– Exhibit 34

Exhibit 33

Source: Capital IQ and SSR Analysis

Exhibit 34

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

February 12, 2013 – US Basic Chemicals Economics: It Can’t Get Much Better Than This

January 25, 2013 – DuPont: The Uncomplicated Story and The What If?

January 10, 2013 – A Lesson In Expectations: Is There A Bubble In My Paint?

January 3, 2013 – 13 Attractive, Bad or Overyhyped Ideas for 2013, Assuming No Macro Change

December 10, 2012 – Over-Confidence Destroys Value

November 29, 2012 – Guidance Matters, Even for Chemicals

October 9, 2012 – Commodity Chemicals: Building in the US, An Adventure or An Investment

October 9, 2012 – Coatings Expensive? The Sellers Seem to Think So (Blog)

Appendix 1 – Exhibit 1 Analysis

In Exhibit 1 the following apply:

  • Green is good – Red is bad. The more intense the shade of green or red the more interesting or negative the factor looks for the sector.
  • Length of bar – wider signifies more important
  • Arrow direction – “Up” means the situation is becoming more positive from a stock selection perspective. So a green valuation bar with an upward arrow means that the stocks look cheap from a valuation perspective and they are getting cheaper. A red ISM bar with a downward arrow means that the ISM numbers suggest downside and they are getting worse.
  • Arrow size – how significant the move is.

Input Analysis

In the input analysis bar we attempt to show how important the natural gas/oil advantage is for each sector (length of bar); how positive it is (color of bar); and which direction it is moving (direction of arrow).

Demand Analysis

For each of our industry sub-sectors we have taken company by company data and generated an average segment exposure. For some companies this information is provided explicitly and for others we have taken estimates from presentations, annual reports and other sources. The segment break-downs are summarized in the charts below: Exhibits 35 to 39.

Exhibit 35


Source: Company Reports and SSR Analysis

Exhibit 36

Source: Company Reports and SSR Analysis

Exhibit 37

Source: Company Reports and SSR Analysis

Exhibit 38

Source: Company Reports and SSR Analysis

Exhibit 39

Source: Company Reports and SSR Analysis

We have then grouped the categories into buckets for which we can measure growth drivers. Those groupings are summarized in Exhibit 40 below.

The first table summarizes the data in the pie charts above and then shows which market driver we use to model each end market. The second table then breaks each sub sector into these market driver buckets and then adjusts for how much business is in the US and how much is external. We add a factor which we call “trade” which brings into play the US trade balance and the strength/weakness of the dollar.

This analysis then drives the “Demand” section of the schematic in Exhibit 1.

Exhibit 40A

Source: Company Reports and SSR Analysis

  • Note that for the “trade” component, we have arbitrarily assumed that 25% of offshore sales are influenced by the US balance of trade and by exchange rates, while 75% of offshore sales are influenced by the same factors as listed above. It is more than likely that this is a different split for different sub-sectors and this will be a subject for further analysis.
  • Note also that we have done some initial correlation work to look at the impact of the factors below on revenue growth and it does show that sub-sectors with a greater exposure (in our analysis) to the ISM data (for example) have a greater correlation between the ISM numbers and demand growth. This will also be the subject of future research.

Exhibit 40B

Source: Company Reports and SSR Analysis

Valuation Analysis

The valuation analysis draws from our mid-cycle “normal value” work detailed above and our revisions work also detailed above. We have – for the moment assumed that valuation is 60% of the story and revisions is 40% for each sector. We will test this more empirically in the coming months.


Appendix 2

©2013, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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