Chemicals Monthly – Commodity Chemicals Roll On

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

August 15th, 2014

Chemicals Monthly Commodity Chemicals Roll On

  • Profitability in the Commodity Chemicals space is at a record high, with NGL prices low and on the decline; this is reflected in stock performance, with the group up nearly 5% over the past month in a market that was down 1.3%. Year to date the group has outperformed the S&P by more than 20%.
  • Earnings for the Chemicals group as a whole generally were in line with estimates (surprise of just 0.1%); revenues that grew 2% year over year in aggregate. The Coatings sector saw the strongest sales growth (+9%) while Ag revenues remain weak (-6%).
  • Natural gas pricing has trended downward after ending April above $4.80 per MMBtu and now stands just below $4.00inventories are still in the process of being replenished from the winter, and remain well outside of the 5 year average range. The very mild summer weather has tempered demand, allowing inventories to close a modest portion of the gap created by the very severe winter weather.
  • Recent Chemicals research has included a look at the possibilities for DuPont’s agriculture business, Russia trade, short term US profitability, and our preference of PX relative to APD. We see the combination of DD and DOW’s Ag businesses as a sensible option, while APD in our view has some work to do to justify its multiple premium to PX.
  • Chemical sector preferences are outlined below at the subsector and stock level. DD remains a favorite despite the Q2 guide down. Note that we have moved the Commodity group to underweight, but keep AXLL on our preferred list within the subsector. WLK has been removed from our Commodity concerns following the Vinnolit acquisition and MLP announcement. We remain positive on MON.
  • AXLL may face some further negative revisions because of higher ethylene pricing, but valuation is compelling and a normal 2015 could generate significant upside.

Exhibit 1

Source: SSR Analysis

Exhibit 2

Source: SSR Analysis – See Appendix 1 for background

Overview

Q2 earnings for the stocks in our Chemicals index came in largely in line with expectations (0.1% surprise on average) with revenues that grew 2% in aggregate. Exhibit 3 summarizes year over year revenue growth. The Commodity group was negatively influenced by OLN, which reported a 13% drop in revenue – aside from this, the subsector was +2.4%. Coatings exhibited impressive strength, as sales and earnings continue to grow despite increasingly tough comps. Specialty, Gases and Diversified showed healthy gains from Q2 2013 as well. Ag remains mired in a cyclical swoon, with CF the main culprit for the year over year decline.

Full year revisions came in negative for most, but marginally positive (+0.8%) for the Coatings sector. Revisions have not driven performance over the past month however, as the Commodity group saw the most severe negative revisions yet was the best performing subsector. Near-term we expect a divergent movement in revisions for the commodity group with the ethylene producers seeing positive Q3 and Q4 revisions and the buyers seeing negative revisions – see our report dated August 14th . We believe that the current very short US ethylene market will normalize in 2015 and would be very nervous about, DOW, LYB and WLK if prices are driven much higher on the back of positive revisions for 2015.

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: EIA

Valuation

Exhibit 5 summarizes our valuation work. Negative revisions in the Commodity space primarily reflect the AXLL guide down and the subsector as a whole remains on the expensive side with several constituents (WLK, LYB, and DOW) at multi year highs. DD’s pre announcement contained a less severe revision (-6.6%) but has significantly raised the discount for both the stock and the Diversified group, on which DuPont weighs heavily. We expect earnings for the company to remain strong and believe this short term dip only offers a new entry point into a name where we still see value.

Exhibit 5

The subsector classifications are summarized in Exhibit 6.

Exhibit 6

Exhibit 7 shows subsector discount from normal value in standard deviations.

The discount in the Diversified group is mainly a function of DD. Of the Coatings stocks, RPM (2.14 SDs above normal) screens as most expensive on our framework, but SHW (1.92 SDs) and PPG (1.18 SDs) are elevated well – see Exhibit 8 below. VAL (0.76 SDs) is the most conservatively valued. In the Commodity group, dispersion is extreme, with AXLL and OLN screening as fairly cheap (1.25 and 1.11 SDs below normal) and LYB, DOW and WLK conversely looking fairly expensive.

Exhibit 7

Source: Capital IQ and SSR Analysis

In Exhibit 7 we show company discount from normal value as measured on our valuation framework. The left side of the chart shows RPM, CYT, SHW and LYB highlighted in red – all are at (or in the cast of CYT, within 5% of) all time or ten year valuation peaks. LYB admittedly has a short history but has performed very well of late and the stock continues to make new highs on the strength of strong commodity chemical margins. MOS is near (6%) but not at a valuation low, as agricultural chemicals remain out of favor and we remain negative on the outlook for potash .

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibits 9 and 10 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our July Chemicals Monthly. The Commodity group showed continued strength, as profitability stands at an all time high – year to date the subsector has outpaced an up market by over 20%. The other expensive looking sectors, Specialty and Coatings, have also beat the S&P – momentum has continued in both these recently strong groups, as well as the recent laggards (Ag and Diversified, the cheapest and worst performing Chemical subsectors year to date).

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 11 through 13 show profitability at the sector, subsector, and stock level.

In Exhibit 11 we highlight RPM, IFF, VAL and CYT in green – all are at (or within 2% in RPM’s case) 10 year or all time earnings peaks. RPM and CYT therefore have some earnings support for the valuations noted above, and HUN looks very cheap on earnings.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibits 12 and 13 show the net income margin for the Chemicals sector as a whole and for the individual subsectors, respectively.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13

Source: Capital IQ and SSR Analysis

Portfolio Performance

The July portfolio selections are shown in Exhibit 14. Our portfolios continue to disappoint in 2014, after solid performance in 2013. Our portfolios work as value gains relative to momentum, and year to date in the Chemicals space the expensive subsectors (Commodity, Specialty, and Coatings) have continued to see support, while the cheaper spaces (Ag and Diversified) remain laggards.

Exhibit 14

Source: Capital IQ and SSR Analysis

Exhibit 15

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • In the latest release, personal consumption expenditures were revised back through April 2013 in accordance with the yearly restatement of the national income and product accounts. May’s decline was revised to a gain, and June showed an improvement off of that level – expenditures are not right in line with the trend line from 2012 after some choppiness from Q4 2013 to Q1 2014.
  • The post-recession recovery in consumer spending has been impressively uniform, and year to date in 2014, expenditures have risen at a monthly rate of 0.16%, closely tracking the 0.15% monthly gain seen from 2009 through 2013. Most of the recent revisions were downward but the uptrend remains firmly intact. Wage growth could offer a boost to an American consumer that has largely seen stagnant income. It has been suggested that such a wage boost could be delayed as higher earning baby boomers retire and are replaced in the workforce but younger, cheaper workers.

Exhibit 16

Exhibit 17

Source: BEA

Construction

  • The June construction spending figure was off nearly 2% month over month, but April (+0.5%) and May (+1.2%) figures were revised higher. It was widely assumed that, given the amount of slack in the construction markets, 2014 would see an acceleration in activity but housing markets remain weaker than expected and construction generally lacks momentum and continues to be choppy.
  • The intermediate and long term trends remain consistent, but year to date construction levels are below where they ended 2013. With the revised data, 2013 now shows a stronger year over year growth rate than 2012 (8.9% vs. 8.0%) – previously this had been reversed, with 2012 above 2013 by roughly 100 basis points.

Exhibit 18

Exhibit 19

Source: US Census Bureau

Agriculture

  • Weakness in grain pricing continues. Corn is off 11% since early July, and over 25% from the 2012 highs. Exports are strong but have been countered by record-threatening yields and a very healthy crop in terms of quality. The drop in wheat pricing has been less severe, off 3% since early July and 17% off the peaks, and has started to recover. Soybeans on the other hand had seen relative strength until a rather quick 20% drop in pricing over the past month. The US has seen broad unusually favorable growing weather through the sptring and summer in 2014.
  • These weak farm economics explain some of the lack of support for the Agricultural Chemicals sector. Refer to our blogs on potash – we remain quite negative in terms of the longer-term pricing outlook.

Exhibit 20

Source: Capital IQ, SSR Analysis

ISM

  • There were a lot of encouraging readings in the ISM manufacturing data for July. The overal PMI rose nearly two points to 57.1, the highest level since April 2011. Inventories were drawn down sharply and production ticked up and remains strong. New orders were up nicely as well, to 63.4 from 58.9 – orders had been at this level in December 2013 before the polar vortex put a major dent in this category. Readings bounced back and were strong in Q2 as we had expected.
  • For some time there have been similar indications that the US economy was truly about to gain steam, only to taper off and lose momentum. Domestic manufacturing should be advantaged moving forward given the abundance of natural gas, but to get the economy running on all cylinders we will need to see a pickup in housing and construction activity, as well as wage growth to support the spending trends that have defied stagnant incomes.

Exhibit 21

Source: ISM

Exhibit 22

Source: ISM

Trade

  • We have updated our trade chart to exclude Medicinal & Pharmaceutical products from the broader Chemicals categorization – this more accurately reflects the companies in our coverage. The resulting chart still shows significant volatility, but also a high level of surplus – including Medical & Pharma, the balance has been bouncing between surplus and deficit. The dotted line in Exhibit 23 is a twelve month rolling average. Cutting through the month to month volatility, we see Chemical trade volumes have been flat for the past several years.
  • Year over year, the British pound shows the greatest appreciation versus the dollar among major currencies, up 11%. BRIC currency depreciation has stabilized recently, but the Russian ruble was still off 4.7% versus the dollar in July, while the Brazilian real lost 2.1%. Q3 2014 has seen the dollar 1.7% weaker versus the Euro year over year– Exhibits below.

Exhibit 23

Source: US Census Bureau

Exhibit 24

Source: IMF

Exhibit 25

Source: IMF

Commodity Fundamentals

Supply/Demand

Please see our December piece on US ethylene demand for our recent more detailed perspective. We remain concerned that high absolute pricing for chemicals are constraining growth.

Note that we have made a change to our external data source in 2014 and that we are now using chemical market data from Wood Mackenzie. The supply/demand data for 2013 is very similar to that of IHS and we have not changed our historical data.

Capacity is expected to grow by more than 2 billion pounds in 2014 versus 2013, which means that demand needs to grow by more than 3.5% in 2014 just to maintain current operating rates. However, as is shown in Exhibit 27, the second and third quarter will show quite low operating rates as a number of facilities are closed, not just for annual maintenance, but also to tie in expansions. In addition, production problems have been well above average this year, limiting the available capacity. Operating ethylene facilities are running at maximum rates and we expect the industry to run on that basis through the end of this year to replenish what are now very low inventories. The US is likely to see minimal growth in ethylene production in 2014 because of these operating problems, despite a nominal increase in capacity. What was expected to be a weaker second half market for ethylene because of new capacity is now likely pushed to 2015 or the very end of 2014.

US ethylene inventories are now very low, having dropped quickly from highs at the end of Q1 because of both the planned and unplanned outages. Because of the unplanned production outages and the rapid drop in inventories, US ethylene spot prices have responded quickly in July, rising from a June average of around 56 cents per pound to a recent record of 76 cents per pound. June ethylene contract prices rose from 47 cents per pound to 47.75 cents per pound and July saw another equivalent increase – August prices will likely rise again. Assuming all facilities that have been offline come back on line as expected, it is likely that the pressure will ease and that prices will come down again by late 2014 or early 2015.

Production is summarized in Exhibit 26 and operating rates are summarized in Exhibit 27, we have included Wood McKenzie estimates for 2015 in the analysis for the first time – they show production rising with available new capacity but no real improvement in operating rates.

Exhibit 26

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 27

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

Energy – Exhibit 28

The oil market has cracked in recent weeks, with Brent and WTI falling to levels not seen in a while. This is despite continues unrest in the Ukraine and more trouble in Iraq. We are not oil forecasters, but struggle to see a level of global energy security that would take pricing down much more meaningfully in the near-term.

Natural gas is discussed in more detail in the overview.

Exhibit 28

Source: Capital IQ and SSR Analysis

NGL pricing has moved meaningfully with ethane dropping quickly because of limited demand as a consequence of significant US ethylene plant closures. Ethane extraction margins have revisited the lows of late 2013, as shown in Exhibit 29, and as discussed in recent research . Ethane is weakening in step in both the Mid-West and in the US Gulf – Exhibit 30.

Exhibit 29

Source: IHS, Mackenzie Wood and SSR Analysis

Exhibit 30

Source: Midstream Business and SSR Analysis

Propane and Butane prices are a little weaker in August than in July but have more support than ethane because of alternative markets – Propane exports from the US continue to grow and Butane should start seeing support from the expected start of the winter gasoline blending season. However, Butane may see less support than in prior years because of the volume of light condensate finding its way into the US gasoline pool. The swing in Propane is a function of real oversupply a year ago that has been quickly corrected through exports and current pricing reflects export netbacks – mainly from Europe – Exhibit 31.

Exhibit 31

Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing has jumped quickly in the spot market in the US in response to the ethylene shortage, and the spot price suggests that contract prices for September should increase meaningfully. However, as all producers (that matter) are integrated back into ethylene and are seeing higher margins because of the lower feedstock moves – something which all the major polymer buyers know well – we do not see today a rush to move polyethylene prices dramatically. There are now broad discussion about a 3 cent per pound increase for September. Note that the contract prices shown in Exhibit 32 are “list” against which there are significant discounts depending on customer scale. Today the spot market for HDPE is in the $0.80-0.85 cent per pound range and is at a sizeable premium to “net” contract pricing.

The pressure is going to be much higher on PVC producers to increase prices as so many of them are still buyers of ethylene and will see significant cost increases because of the nature of their contract pricing formulae. Any increase in PVC pricing would likely not impact the top line for companies like AXLL and WLK until October.

Exhibit 32

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 (33) summarizes the results and is a repeat of Exhibit 5.
Exhibit 33

Valuation Charts – Exhibits 3436

Exhibit 34

Source: Capital IQ and SSR Analysis

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36

Source: Capital IQ and SSR Analysis

Skepticism Analysis

We apply the framework from our skepticism analysis on the broader Industrials and Basic Materials sectors to the Chemical space – see our past research for more detail . The primary conclusions are:

  • Diversified Chemicals has the highest skepticism index value of the subsectors – this is driven by DuPont, which has the highest skepticism value of all the companies in our Chemical universe. Ag Chem remains undervalued as earnings are slightly below trend, and expected to worsen. Conversely, Specialty is being granted a premium valuation that is discounting a rise in returns from current levels that are largely in line with trend. In Exhibit 39, note that LYB is again the only stock at its skepticism low.

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

Recent Chemicals Research

August 14, 2014 – US Ethylene: It’s a Record Breaker – But No One Really Wins Quickly Anymore

August 12, 2014 – To Russia, But Not With Love – Right Now

July 28, 2014 – Industrial Gases: APD Must Focus on Costs, But PX the Better Investment

July 23, 2014 – DuPont: Ag-rivating, But Unlikely to Change Without Action

June 16, 2014 – European Basic Chemicals: There Is Life In The Old Dog Yet!

June 2, 2014 – DuPont: A Cost Initiative Could Be Substantial

May 15, 2014 – Chemicals Revisions: Not Positive Enough and Not Supportive of Values for Many

May 13, 2014 – DuPont: The Case for $85 – But Why We May Need to be Patient

April 29, 2014 – Dow vs. Lyondell: Bet on the Company with More Levers to Pull – DOW

April 28, 2014 – US Natural Gas: Not Out of the Woods Yet!

April 25, 2014 – Air Products and Praxair: A Tale of Two Strategies

March 31, 2014 – Petrochemical-Fest: A Summary of the Texas Gathering

March 24, 2014 – Seeding a Better Investment

March 23, 2014 – Why the Basic Chemical Investments in the US Will Likely Disappoint

March 19, 2014 – Peak Valuation in Some Commodity Chemicals – Something to Watch

March 5, 2014 – APD: Time to Move to the Sidelines – PX More Interesting

February 24th, 2014 – Dow: A More Optimal Path, But a Hard Destination to Reach

February 17, 2014 – Dow: Loeb versus Liveris – Watch From A Distance

February 9, 2014 – Rising Natural Gas Prices and Rising Commodity Chemical Company Estimates: How Can This Be?

January 9, 2014 – Chemicals Companies in 2014

December 30, 2013 – DD: Still An Interesting Investment

December 16, 2013 – US Ethylene: The Case for a Better 2014

December 10, 2013 – Exporting Shale: A More Logical Perspective

November 18, 2013 – The Recommendation Signal: Another Reason to Look at DuPont

November 7, 2013 – Lyondell: Growth or Income, Both Have Risk

November 7, 2013 – DuPont: An Unusual Stake in the Ground (blog)

October 29, 2013 – PPG: What Do You Have to Believe

October 21, 2013 – Common Sense Restructuring: Some Money to Be Made

September 23, 2013 – The State of the US Chemical Industry

September 15, 2013 – Optimism and Forecasting in the Chemical Industry

August 5, 2013 – Understanding Transformational Change: The Eastman Example

August 5, 2013 – Potash: Breaking Up Apparently Isn’t That Hard to Do (Blog)

July 25, 2013 – DuPont: Getting Appropriate Value for the Growth Engine

June 19, 2013 – Complexity, Volatility, and a Market Where Neither Extremes Work Well

June 14, 2013 – Ethylene: Unlikely to Be a Quick Fix for Williams

May 13, 2013 – DuPont: Betting the Farm – But Perhaps a Need to Crop the Portfolio?

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 40 to 44.

Exhibit 40


Source: Company Reports and SSR Analysis

Exhibit 41

Source: Company Reports and SSR Analysis

Exhibit 42

Source: Company Reports and SSR Analysis

Exhibit 43

Source: Company Reports and SSR Analysis

Exhibit 44

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 45 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 2.

Exhibit 45A

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 45B

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.

©2014, 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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