Commodity Chemicals – Overdone? Maybe Not
SEE LAST PAGE OF THIS REPORT Graham Copley / Nick Lipinski
FOR IMPORTANT DISCLOSURES 203.901.1629 / 203.989.0412
October 16th, 2014
Commodity Chemicals – Overdone? Maybe Not
- If oil goes lower, then the ethylene stocks will go lower as ethylene prices react – LYB remains well above our $66 normal value (which assumes mid-cycle ethylene margins). WLK has fallen much further from its peak and is only slightly above normal value today. Both could fall well below “normal value”, as in the past, when earnings have collapsed or confidence has been lost. AXLL and EMN are at steep discounts and would be our preferred points of entry.
- DOW remains at a premium to “normal value” (which is around $35 per share in our model), but has fallen significantly and given the activist interest in the stock (if it is still there!) and the possible restructuring, is more interesting than LYB and WLK in our view. DD remains our favored name in the sector, but AXLL and EMN are close.
- Since we cautioned on 2015 ethylene profitability it has been a wild ride. Not because we have already been proven correct, but because one of the downside risks we identified appeared almost immediately – falling crude prices.
- For a while many thought that crude was following the stronger dollar but it is possible that the dollar might have been following crude as crude has kept falling despite dollar weakening. This decoupling has, we think, added more fear to the oil market and accelerated the price decline – it is now all about oil supply/demand. See our recent initiation on Energy, where we focus on US oversupply.
- Near-term, the US ethylene market remains in very short supply and while spot pricing has fallen in October, it has not fallen by much – 10% or so. A fair amount of capacity remains off line and we are still awaiting the restart of the Williams unit in Louisiana.
- In an amply supplied ethylene market, US profits are driven by the margin created by the higher oil based cost in the rest of the world and the low gas based costs in the US. In 2014, the US has done much better than that because the market for ethylene in the US has been tight.
- Our premise remains that the world will be amply supplied with ethylene in 2015, as will the US. On this basis, how much money US ethylene producers make in 2015, on that basis, will likely be determined by how Brent crude fairs.
- Leverage to US ethylene margins is highest for WLK and LYB, though also significant for DOW. While it looks high for EMN in Exhibit 1, EMN is selling mostly on a cost plus basis to WLK and has much less price sensitivity.
Source: Capital IQ, Wood Makenzie and SSR Analysis/Estimates
Several weeks ago we wrote about a potential ethylene surplus in the US in 2015 and the need for the US to increase its exports of ethylene derivatives in order to maintain operating rates and expected levels in 2015. We also suggested that the lower the price of Brent, the lower the possible ethylene price that US sellers would have to offer customers in order to support the exports.
Since then we have had many conversations and they have been grouped into a couple main topics:
- The oil price and whether we are simply making an oil call
Since the publishing of our piece in September, we have seen a rapid decline in the price of oil and it is likely that this has fueled the sell-off in the commodity chemical sector, but our earlier concerns were not predicated on oil falling further. They were predicated only on ethylene pricing falling to reflect the “break-even” economics of the target export competitor – prices have been well above that level for most of 2014. The subsequent fall in oil prices simply lowers the cost of the “break-even” competitor and lowers further the potential price decline in the US – hence the stock sell off.
- We would take the other side of the “oil bet” argument and suggest that holders of the US ethylene names – LYB, WLK and to a lesser extent DOW, are/were making an implicit positive bet on the oil price and the margin umbrella provided the high price of oil relative to the US natural gas price.
- Demand growth – is the recent US capacity enough to keep the world oversupplied
The most interesting push back is around growth – there remains a widely held view that not much new ethylene capacity is being added and that a year or two of normal growth could lead to a better global market balance – the recent US expansions are therefore small in the global context.
- Here we have written extensively – we believe that “Plastic is Elastic” to adapt the title of a report published by my friend Hassan Ahmed when we were both at HSBC. Consensus estimates of expected global demand have been revised down every year for the last four years – traditional trend lines and historic correlations to GDP have broken down and leading industry advisors are not asking why – they are simply reverting to the historic average for future years despite four recent years that suggest something has changed.
- What has changed is price – high oil prices mean high plastic prices – mean more conservation in consuming processes – mean more and more recycling and more substitution. Think about the down gauging that has happened with PET water bottles as the best example. Furthermore, we do not believe that a drop in Brent (and therefore ethylene costs) to $80 would change the dynamic at all, as while polyethylene and other polymer prices would fall, recycling would still be profitable. You might get better economic growth with $80 crude and this is likely to be more important
- The 2 million plus tons of capacity added in the US over the last two years is less relevant in a world of 135 million tons of demand growing at 4%, but much more relevant in a world growing at 1-2% when US domestic demand for ethylene derivatives is only growing at 1%.
- We have not seen the effect of this surplus in the US in 2014 because of the planned and unplanned shutdowns this year, which have taken out more than 2 million tons of production. However, assuming 2015 is a normal year, US producers have two options; they either voluntarily cut back operating rates, to accommodate the new capacity – particularly Williams’ expansion – which is going to be a hard sell with incremental costs around 10-12 cents per pound – or they are going to need to export more ethylene derivatives or encourage their customers to export more.
Now, while the stocks have fallen significantly over the last two weeks, there is no obvious floor if crude continues to weaken. Moreover, as we reflected in in the original research, the effect on the commodity chemical market itself from a demand perspective could be near-term very negative, as buyers hold back purchases in the expectation that pricing will be lower tomorrow. This could have a detrimental effect on US ethylene and derivative prices more quickly than we had estimated – so before year-end.
Our rudimentary cost curve analysis suggests that US ethylene prices would need to fall by 15-18 cents per pound to remain as competitive globally under an $84 per barrel Brent world versus a $112 per barrel Brent world. It also suggests that US ethylene pricing (and derivative pricing) would need to fall by at least 15 cents per pound (ethylene equivalent) from average 2014 levels to compete internationally.
In the table in Exhibit 1, we have been intellectually inconsistent as we are using an ethylene margin change versus 2014, but comparing that effect with 2015 consensus earnings. We are assuming that 2015 estimates include incremental volumes from expansions and account for the restart of the Williams unit, but it is possible that they also include higher margin assumptions than 2014, in which case there is additional downside to the 2015 estimates implied in the table.
If we are right with the margin assumption, the question then becomes –“what would you pay for LYB with earnings in 2015 of $6.00-6.50 per share” or “WLK with earnings of $2.25-2.50 per share” or “Dow with EPS of $2.00”? These are not trough numbers, so you would not reasonably apply a trough multiple – at the implied ethylene pricing the industry is still making a 15-20% return on capital – well above the 30 year average.
The downside looks greater for WLK, but our valuation metrics suggest that WLK has fallen much closer to “normal” than DOW or LYB so far – Exhibit 2. However, if oil keeps falling, then the bets are off everywhere. See our recently published monthly for more data on valuation.
Source: Capital IQ and SSR Analysis
The New Cost Curve
As we have indicated in prior research, out global cost curve model is not sophisticated, as it makes lots of necessary simplifying assumptions. However, as the chart shows (Exhibit 3), there has been a meaningful decline in the curve as a consequence of declining Brent prices. We estimated the break-even price at $1150 per ton at the end of September, but Brent has declined by another $13 per barrel since then.
Source: IHS, Wood Makenzie and SSR Analysis
Variables we are not considering:
- Movement in ethylene co-product values relative to normal – i.e. could propylene or butadiene get cheaper or more expensive relative to ethylene. It is possible that butadiene could get more expensive for reasons covered in the next bullet point. This would increase the credit to European and Asian ethylene economics and lower the top end and beak-even point of the curve.
- Other feedstock changes
- Increased propane consumption in Europe – propane was selling at a discount to fuel value in Europe before the recent crude decline as there is more available than can be consumed
- Increased use of condensate – this and propane displace naphtha – naphtha is in surplus in Europe and prices are falling relative to crude. Increased propane and condensate feed likely to reduce butadiene production – see above.
- The points above would also lower the top end and the break-even point of the curve.
- Faster demand growth – however, based on our analysis (and derived from the chart above), demand would need to grow by 10 million tons (8%) to raise the break-even price by the equivalent of 5 cents per pound.
Demand Growth – More Negative Signs Than Positive
The argument that the ethylene capacity additions from 2013 to 2015 in the US are not significant in the context of global demand is fairly powerful. Global demand for ethylene is likely to be between 135-140 million tons in 2014, so the US addition of 2 million tons is less than 2%. However, global capacity is in excess of 155 million tons, so there is plenty of material available, even if some of it is uneconomic to operate today.
Demand growth is key. Part of our very positive stance on Aluminum 18 months ago was driven by very fast demand growth and an expectation that supply would become less of an overhang more quickly than the market expected because of the demand growth. The drivers of faster growth for Aluminum have been low prices and some rapidly growing end markets (automotive and aerospace).
Ethylene has none of this – in fact it has the opposite. Prices are high and markets are generally mature in the developed world. Demand growth in China and the rest of Asia has been very important for this sector, but the recent data from China suggest that all industrial/commercial demand sectors are disappointing.
We have talked about slow growth in the US, with general manufacturing lagging overall GDP and now Europe is getting worse again, with the most recent data from Germany showing very limited growth. For products like polyethylene where there is an annual efficiency gain coming from economies of use and stronger product – slow economic growth can be zero demand growth.
Demand growth is not going to save the day, and even if polyethylene is sold at cost, based on $80 Brent, it is unlikely that the rate of recycling or the incentive to economize will slow down.
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