Ethylene – Investing In Uncertainty

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

March 12th, 2018

Ethylene – Investing In Uncertainty

  • Ethylene stocks are stuck! Generally discounting neither improving nor declining margins, which is unusual given the predictive nature of the stock market and the historic lack of stability in ethylene margins except at the bottom of the cycle.
    • With capacity (and additions) fixed (and known), demand will be the decider and the stocks are being bought by the economic bulls and sold by the skeptics.
  • Ethylene sentiment tends to set the mood in chemicals – and while price, volume and stock momentum have been good for peripheral segments (gases, materials, TiO2, vinyls), all would be doing better, in our view, if there was positive conviction on ethylene.
    • The ethylene stocks have the leverage – especially DWDP, given valuation – but a rising ethylene tide would add further momentum to others.
  • If you are bullish on the economy globally it is hard not to like materials generally, except where valuations are extreme (as they were for lithium) or where current investment plans are clearly too high.
    • It is, however, hard to find a sector where there is clear current over-building – perhaps in propylene oxide if LYB goes ahead – but that is 2 years out.
  • The risk is demand, requiring an economic surprise, something which could happen, but which looks unlikely. A rapid push (socially driven) to limit waste plastic is a wild card.
  • On the supply side, investment needs to step up everywhere from 2019, but feedstock uncertainty, project execution uncertainty, current margin volatility and trade flow implications are risks to any committing capital.
    • The industry does not have plans to spend at the rate suggested in Exhibit 1.

Exhibit 1

Source: IHS, WoodMac and SSR Analysis

Overview

Every March for the last 30 plus years the basic chemical industry gathers in Houston and then San Antonio for 10 days of forecasts, negotiations, updates, endless coffees and some good parties. My first of these events was in 1988 – a year in which the industry was making more money than it ever thought possible and the forecasts were all bullish and the parties lavish. This year we are more undecided – demand is extremely robust for almost everything in the chemical arena, but we have plenty of capital spending going on now and significant new capacity starting up in some segments this year. At the same time, we have, in our opinion, a growing social conscience with respect to plastic waste – not confined to Europe.

This year is it easy to spin a bull case, but just as easy to spin a bear case and, to a degree, stock valuations reflect the uncertainty or indifference. There are some product shortages in areas that have not seen decent returns on capital in more than a decade:

  • Polyurethanes
  • Epoxies
  • Styrenics (though this has been the case for a couple of years)
  • Polycarbonates
  • Polypropylene
  • Other materials and chemical intermediates

But in the big products that matter most for the major players, there is supply/demand uncertainty because of investment timing and because of idle capacity in China that could – if restarted – lead to a quick oversupply:

  • Ethylene/Polyethylene – uncertain because of capacity wave
  • Urea – improving but at risk from China restarts
  • TiO– improving but at risk from China restarts
  • Chlor-Alkali/PVC – improving but at risk from China restarts

While TiO2 and Urea have had their own cycles over time, generally it has been a case of “as goes ethylene – so goes everything else”. It is likely that stocks like Trinseo, Covestro, Huntsman and BASF (which are doing well) would be doing even better today if there was confidence in the ethylene market and this is definitely the case for DowDuPont, LyondellBasell, Braskem, SABIC, Westlake and others.

The bull case rests on continued strong economic and consumer growth coupled with the law of large numbers – at a 4% growth rate, the ethylene/polyethylene market alone needs up to $25 billion of investment per year globally (more if you assume a mix of ethane and naphtha based ethylene projects).

While we are looking at a large chunk of investment coming on line in 2018, the industry is not planning on spending $25 billion a year on ethylene and polyethylene post 2018. With a low-end construction cost (ethane) at around $1.30 per pound ($2900 per metric ton), you still need $0.29 per pound ($645 per ton) of margin above cash cost to cover depreciation and generate a 12.5% return on investment – Exhibit 2.

As shown in the Exhibit we are very short of those levels of margin today and have been throughout 2017.

Integrated polyethylene margins are better – but have been volatile – Exhibit 3. They are high enough to cover the investment costs for ethylene – just – but not enough to cover the additional polyethylene investment – producers need more than 40 cents per pound to cover deprecation and an acceptable return on polyethylene.

Everyone is generating cash even in the low margin environment of February.

Exhibit 2

Source: IHS, WoodMac and SSR Analysis

Exhibit 3

Source: IHS, WoodMac and SSR Analysis

Demand growth of 4% per annum is the annual average since 1980 – Exhibit 4 – and therefore it is the reasonable working assumption. 2018 could be better both because the consumer economy is expected to be better, but also because polyethylene – the largest consumer of ethylene – is growing at more than 4% and each year its influence on ethylene growth rates increases.

Exhibit 4

Source: IHS, WoodMac and SSR Analysis

The bear case, as always, is demand driven; the economy cools (pick your poison: interest rates, geopolitics, oil price spike) and/or the war on plastic waste heats up, without an adequate and coordinated industry response. It is unlikely that any move on packaging waste will impact demand noticeably in 2018, but it could have an increasing influence thereafter – another reason for producers to question the next round of capacity additions.

Investment Recommendations

So, we are stuck in the middle – margins are good for polyethylene producers, but better in Asia and Europe than in the US, and not good enough in the US to justify new green or brownfield investment – despite the announcements (Total/Nova/Borealis, Exxon/SABIC). Companies are generating a lot of cash and struggling to find things to do with it (LYB buying SHLM as an example), but the JV nature of the next round of ethylene spending suggests that many are looking to limit capital risk.

In Exhibit 5, we show the movement of ethylene prices and margins (the margin assumes a blended spot and contract price) from the time the first wave of investment decisions was made in 2013 until today. While we expect 2018 to be a good year for ethylene and polyethylene, we have said in prior research that volatility is inevitable based on the timing of start-ups of ethylene and derivative units and as we head into March we are at margin lows, based on ethane, since 2010-11, with a step change down in ethylene spot and contract prices in the US in February, based on near-term surplus.

Despite the current level of implied profitability, the IHS conference will likely be bullish and up-beat, because it always is. Whether there is enough data or enough conviction to move the market sentiment out of neutral on ethylene/polyethylene is unclear. We continue to believe that the economic engine will run well, and that despite the volatility, 2018 will be an improving and ultimately good year for global ethylene/polyethylene markets, causing us to be bullish across the entire chemical space in terms of earnings and ultimately valuation.

Exhibit 5

Source: IHS, WoodMac and SSR Analysis

In this market – with this level of momentum and high multiples – no company should be trading at a discount to its historic multiple – especially companies with predicted high earnings growth. In Exhibit 6, DWDP, SHW and FUL are all to the left because of major step changes in capital base and earnings expectations that imply inadequate returns on the investments that caused those step changes. If they were bad investments the stocks deserve some level of discount versus history; if not, they are the real valuation opportunities, and we would use SWK post the Black and Decker acquisition as the appropriate proxy. SWK is up 240% since it announced the Black and Decker deal in 2009.

Otherwise, EMN, WLK and perhaps POL look particularly interesting, but nothing looks expensive. As we have concluded in prior research, HUN looks to be at an extreme, but our model for HUN does not include any years (except 2017) in which the company has made an adequate return on capital – history is a poor guide here – Exhibit 7.

In Exhibit 6, EMN and LYB are the obvious value plays, with LYB far more leveraged to the ethylene cycle and EMN likely a better hedged investment as a consequence. EMN has been on our preferred list for a couple of years – initially just because of valuation, but now because of what we think will be strong earnings momentum – the risk on EMN is a strategy that seems confused and the possibility that the company makes another poor acquisition with its increasing balance sheet flexibility.

LYB is cheap in part because of strategy uncertainty – a switch from cash return to shareholders to capital investments and acquisitions – a move that holders do not like.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

©2018, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. 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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