Chemicals Monthly – Stagnant Demand Undermining Pricing and Confidence

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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

April 16th, 2013

Chemicals MonthlyStagnant Demand Undermining Pricing and Confidence

  • The bubble appears to have burst on the idea of an improving global economy, at least for now. The sector has underperformed meaningfully, particularly in the last 24 hours. Revisions were negative across the board for the last month, but most pronounced in the Specialty sub-sector.
  • The gas/oil difference continues to narrow as natural gas has risen to price levels not seen since 2011. While this might have somewhat influenced the very negative performance of the commodity group, costs remain very low and US oil based fractions are cheaper and NGL extraction margins have fallen further.
  • The concern is pricing, as it should be, given that basic chemical pricing is falling and weaker global demand drives concern about pricing for all products. As we have indicated in prior work, stagnant demand has an undermining effect on pricing and this is a concern for all sectors.
  • The commodity group is expected to have a very strong Q1, but the market is forward looking and while costs are low, prices and demand are weaker.
  • Our valuation screens continue to highlight DD and ROC as attractive both on valuation and on skepticism. We would continue to highlight APD, which looks attractive on our normal value screen – an unusual situation for an Industrial Gas company.

 

Exhibit 1

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

Overview

The decline in the sector broadly over the last 4 weeks generally and on April 15th specifically is likely driven by a number of factors, some reasonable and some less so.

  • Valuations are for the most part high and meetings that we have with institutional clients confirm that many feel the same way, but struggle to find better value alternatives in the material sector.
  • Some of the economic indicators globally have been more negative than expected and the more specialty sectors have high operating leverage and so require volume growth to hit estimates – as mentioned already estimates are falling broadly.
  • The sentiment from the recent petrochemicals gatherings in Texas, while quite bullish for the near-term, painted a bleaker picture of the longer term as we have highlighted in recent research.
  • Natural gas prices are rising and this brings concerns about production cost for commodity companies in the US. In reality, crude prices are lower and NGL’s are lagging the price of natural gas and consequently costs are little changed.
  • Weaker demand domestically and internationally has driven pricing incrementally lower for ethylene and more so for propylene
    • We have highlighted this latter risk to this group in recent work; stagnant economic growth can mean declining chemical volumes and increased price competition.
  • Every Chemical subsector saw its 2013 EPS estimate revised downward over the month, though the revisions were most pronounced in the Specialty, Diversified, and Commodity groups.
  • As was the case in March, our model portfolios have delivered mixed performances through mid-month; unlike last month, however, our short picks are driving the returns, while the long side stocks have underperformed.

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.

The commodity group shows the investor dilemma, as the economics in the US are extraordinary and should result in very high earnings and cash flows – we expect to see some record as Q1 numbers are released. 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 – prices have fallen in April. 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.

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
March Chemicals Monthly
. Negative revisions to each of the subgroups drove widespread underperformance. All subsectors, with the exception of Specialty Chemicals, trailed the broader market by more than 3% (the S&P itself was down 0.5% over the month). The Commodity subsector was the most extreme laggard while the Specialty group was best insulated to the mid month sell-off, bolstered by solid gains for ECL.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Monthly Topic: US Energy Advantage

For some time we have been exploring the implications of the abundance of cheap natural gas in the US. Our
most recent piece on the topic
, published earlier this month, highlighted the possibility of overbuilding and the corresponding impact of such overexpansion on prices and margins. Highlights from the report are presented below.

In the report we cover three issues; the first being whether consensus/consultant demand growth forecasts for basic chemical demand growth are realistic – and the second, whether both the offensive and defensive reactions to cheap US natural gas will combine to create significant overcapacity for basic chemicals for the next several years. The third issue was an introduction to the idea that we are thinking about the cost curve incorrectly when we are trying to decide the likely candidates for closure and their closure economics in an oversupplied market.

We also looked at earnings estimates for 2015 versus current valuation, taking the view that consensus estimates are based on the same raw material assumptions for each analyst and Exhibit 6 shows the different multiple and earnings growth rates that fall out of the analysis. On the margin this would direct you towards LYB, AXLL and EMN rather than the rest of the group.

Exhibit 6

Source: Capital IQ and SSR Analysis

Looking at ethylene demand growth assumptions, we question the 4.5-5.0% growth assumptions in some consultant estimates. The chart in Exhibits 7 supports our expectation that demand growth will struggle to exceed 3.5% per annum – the 30 year trend would suggest that demand growth should be closer to 3.0%. The possible surplus capacity that emerges from the lower growth assumption is shown in Exhibit 8 and is a cause for concern.

Exhibit 7

Source: IHS and SSR Analysis

Exhibit 8

Source: IHS and SSR Analysis

Our examination of the economics of ethylene production suggest that we are thinking about the cost curve incorrectly when we are looking at the price levels needed to shut down uncompetitive units. Companies do not close facilities once they get to cash cost, they close once they are losing more on the ethylene facility than they are making – the chart in Exhibit 9 seeks to compare the current “cost curve” with a future “break-even” curve and is used to illustrate that break-even pricing may be significantly lower than is assumed today. As long as US natural gas prices remain discounted versus global crude oil, a margin umbrella will exist for those investing in the US, but the decline in global pricing could be destructive in other higher costs regions.

Exhibit 9

Portfolio Performance

The full March selections are shown in Exhibit 10. DuPont and Rockwood are the most interesting names as they screen on both valuation and skepticism – both partly as a result of uncertainty in the TiO2 market. All three TiO2 exposed stocks appear in the skepticism index suggesting that in all cases investors expect earnings and returns on capital to fall near-term. It is very unusual to see an Industrial Gas company screen attractive in the normal value framework and APD has now been there for a couple of months.

Our shorts have finally begun to capitulate year to date after holding up well throughout most of 2012 while our long picks had registered solid gains prior to this month. It has been our contention for some time that our sectors are not cheap, and the normalized value work supports that. In a rising S&P world, we would expect Industrials and Materials to underperform.

Exhibit 10

Source: Capital IQ and SSR Analysis

We have back tested the methodology from April 2012; we show the results for the current year in Exhibit 11. 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 through February. Results were mixed in March and returns continue to vary across the metrics midway through April.

The overlap portfolio has been essentially flat to the market; our normal value screen has been the most robust with relative outperformance of 3.5%; while the skepticism screen was hamstrung by the poor performance of ROC on the long side.

Exhibit 11

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Personal consumption expenditures continued their strong trend higher, and are up over 2% year over year. December and January figures were revised up, making for a pronounced near term uptrend.
  • Data is only out through February, and it will be interesting to monitor the effect of the payroll tax hike and government spending cuts as we move further into 2013.

Exhibit 12 Exhibit 13

Source: BEA

Construction

  • Construction spending ticked back up in February numbers, but December and January figures were revised down. The trend remains positive but could be rolling over after plateauing at the end of 2012.
  • This area has been a bastion of strength in a weak and tenuous economy; spending is still well off peak pre-crisis levels and there remains a good deal of optimism in forecasts.

Exhibit 14 Exhibit 15

Source: US Census Bureau

Agriculture

  • Goldman slashed its corn price target, and the commodity dropped 10% since our last report. Soybean pricing was also off considerably, down 7%, while Wheat was little changed month over month.

Exhibit 16

Source: Capital IQ, SSR Analysis

ISM

  • PMI fell off in the most recent reading after rising solidly into expansionary territory last month – Exhibit 17.
  • Production dropped in tandem with inventories following a month where inventory levels flattened while production increased – Exhibit 18.

Exhibit 17

Contraction

Expansion

Source: ISM

Exhibit 18

Source: ISM

Trade

  • Chemical trade volumes popped back up into positive territory in February and remain volatile – Exhibit 19.
  • The dashed line in Exhibit 19 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 Euro continued to give back the early year gains it had made on the dollar. Q1 2013 saw the dollar weaker versus the Euro by 0.7% year over year.

Exhibit 19

Source: US Census Bureau

Exhibit 20

Source: IMF

Exhibit 21

Source: IMF

Commodity Fundamentals

Supply/Demand

Ethylene production is increasing in the US and while the first quarter of 2013 is an easy compare because of plant outages last year, the production numbers are the best we have seen since the economic downturn in 2008. Part of the production story is new capacity from DOW and WLK, but these are small increments relative to the total – Exhibit 22. Given the better consumer spending numbers and the better housing numbers in the US we do see some support for the better production levels and without this spending increase we would be concerned that the extra production is going into inventory. Trade data does not suggest an increase in US exports.

Operating rates are also up, even with the higher capacity – 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, at this time. 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 is only barely positive.

Exhibit 22

Source: IHS and SSR Analysis

Exhibit 23

Source: IHS and SSR Analysis

Pricing

Energy – Exhibit 24

Prices for both Brent and WTI have fallen off recently, while Natural Gas has risen to pricing levels not seen since 2011.

Exhibit 24

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 and have fallen slightly again in April. They have now been negative for 6 months in a row – Exhibit 25. 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 25

Source: IHS and SSR Analysis

One thing that we continue to see is the price of NGLs fall relative to crude on a rolling average basis and while they may be up incrementally in April, the longer-term trend remains negative – Exhibit 26. In April 2013, while crude prices are lower and natural gas prices are higher NGL prices have moved down relative to natural gas.

Exhibit 26

Source: IHS and SSR Analysis

Basic Plastics

While HDPE pricing has remained flat in April, the pricing direction for polyethylene is down, both in the domestic market for other grades and more generally in the export markets (export pricing generally leads domestic pricing). PVC export prices are also weakening, but domestic demand is robust. International polyethylene pricing remains weak (and weaker than US pricing), but above break-even for most local producers. Unless we see some sort of pick up in global demand we would expect the price and margin lines in Exhibit 27 to start moving down.

Exhibit 27

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 (28) summarizes the results and is a repeat of Exhibit 1.
Exhibit 28

Valuation Charts – Exhibits 2931

Exhibit 29

Source: Capital IQ and SSR Analysis

Exhibit 30

Source: Capital IQ and SSR Analysis

Exhibit 31

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 Chemical 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 further for Ag and Coatings– though only slightly. The Commodity and Diversified subgroups both have values that anticipate a fall in returns on capital, while valuation and ROC seem to be fairly aligned for the Industrials Gas companies – Exhibit 32
  • 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 33

Exhibit 32

Source: Capital IQ and SSR Analysis

Exhibit 33

Source: Capital IQ and SSR Analysis


Recent Chemicals Research

April 10, 2013 – US Energy Advantage – Unintended Consequence; Global Overbuilding of Petrochemicals

March 6, 2013 – R&D in Industrials and Basics: Just Not Effective

March 5, 2013 – Low Cost US: The Shift is Underway, SLOWLY Reversing a 40 Year Trend
(Blog)

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 Overhyped Ideas for 2013, Assuming No Macro Change

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 34 to 38.

Exhibit 34


Source: Company Reports and SSR Analysis

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

We have then grouped the categories into buckets for which we can measure growth drivers. Those groupings are summarized in Exhibit 39 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 39A

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 39B

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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