LYB and DOW – A Holiday Present From Europe With Interesting Implications

gcopley
Print Friendly
Share on LinkedIn0Tweet about this on Twitter0Share on Facebook0

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629 / 203.989.0412

gcopley@/nlipinski@ssrllc.com

December 8th, 2014

LYB and DOW – A Holiday Present From Europe With Interesting Implications

  • We are recognizing a potential short term opportunity, particularly for LYB and DOW, in Q4 from European ethylene production. We still hold our bearish view on US ethylene margins in the medium term and this analysis could make us more bearish, but Q4 could be a positive surprise for LYB and DOW.
  • As crude prices have fallen globally, feedstock costs for European ethylene have fallen while selling prices, for ethylene and co-products have fallen less quickly, at least for the time being. This has meaningfully increased Q4 margins for the European ethylene chain – by much as $180 per metric ton (8 cents per pound).
  • Though we do not expect ethylene prices in Europe to remain high, (instead they should fall more in line with costs) the supply/demand dynamics for co-products, such as propylene and butadiene is less clear. If these prices remain stronger, these co-product credits will greatly reduce the cost of making ethylene in Europe – as they are today. European cash costs in December are as low as 26 cents per pound, well below what our cost curve analysis would predict at $70 crude.
  • It is our view that LYB in particular has not priced this extra Q4 margin. Both LYB and Dow could see a Q4 boost of $0.10 in EPS versus Q3 from Europe. This does not include any added benefit from ethylene derivative pricing in Europe falling less quickly than ethylene – ethylene costs have fallen by around $450 per ton, which if fully captured would be a $0.25 gain for both over Q3.
  • Estimates for Q4 for DOW have fallen over the last month while estimates for LYB are up only a few cents per share. This corroborates our view that the opportunity is not priced in. It is likely, however, that the market is focusing on negative revisions for 2015.
  • In our most recent piece on LYB, we concluded that the stock was fairly valued at around $79 per share on a normal basis, so there is room for the stock to move up on an earnings surprise. Dow is marginally above normal value and WLK well above with no European ethylene.

Exhibit 1

Source: Wood Mackenzie and SSR Analysis

Overview

Our more negative stance on US ethylene has not changed, and is driven by an expectation that the global cost curve flattens, taking away much of the US margin umbrella and lowering 2015 earnings versus current expectations. We have always expected 2014 to be a very strong year. This view has not changed, with the only difference being that the stocks – especially LYB and DOW – now more fully reflect the possibility of a weaker 2015, even if estimates do not (DOW was never at the valuation extremes shown by LYB and WLK) – see our
LYB and WLK piece from last week
.

The path from where we are to where we expect to be for 2015 was never going to be a straight line and one of the possibilities which we highlighted in a blog a couple of weeks ago is playing out – much lower than expected ethylene production costs in Europe. This is partly because of a feedstock mix change, partly because of the lower cost of crude oil, and partly because of high values for ethylene co-products – all of which we will discuss. The result is ethylene costs in Europe in Q4 that are well below the theoretical “break-even” costs that our cost curve model spits out and which we have shown in recent research.

In December, according to Woodmac, European ethylene production costs are expected to be around $560 per metric ton. This compares to our model output of around $900 per metric ton (using Brent at $70 per barrel as an input). While we do not believe that this is sustainable, there are implications for our model. It should be noted that $900 is also unlikely to persist.

The implications for Q4 are simple – European ethylene producers are going to make quite a bit of money. Our current estimates place average net cash margin in Q3 at roughly $380 per metric ton. This compares with estimates of roughly $560 per metric ton for Q4 meaning that Q4 could see a jump in margin of $180 per metric ton, which is around 8 cents per pound.

As illustrated in the chart below – Exhibit 2 – LYB has European ethylene capacity totaling 1.95 million metric tons while Dow’s capacity amounts to almost 3 million metric tons. Assuming that these plants are operating at roughly 90% utilization rates for 4Q suggests that LYB will have production of 400,000 metric tons while Dow will produce roughly 850,000 tons. Increases in Q4 pretax profit versus Q3 with these levels of production would therefore be roughly $72 million for LYB and $150 million for Dow. LYB has paid an effective tax rate of roughly 27% YTD while DOW has paid 27.6%. Assuming that they will pay similar rates in 4Q, LYB will have after tax profit from its European ethylene production of roughly $52 million while Dow will earn roughly $110 million. This is around 10 cents per share for each company.

Exhibit 2

Source: IHS, Company Reports, SSR Analysis

What about the longer term?

There are some possible longer-term implications from what is happening in Q4 and they are quite negative for the US ethylene names if they play out. As shown in Exhibit 3, the current (December 2014) cost of production of ethylene in Europe is well below what our trusted cost curve would suggest – $560 per ton versus $900! This has nothing to do with the price of ethylene in Europe and while the profitability in Europe in Q4 is a function of prices not falling in line with costs, it is the cost that we need to focus on.

Exhibit 3

Source: SSR Analysis

There are two reasons why the costs are lower than the model would predict. Feedstock costs in Europe, mainly naphtha and propane, have moved away from their traditional pricing relationship with crude. In a very good recent presentation given by Woodmac on the expected future of refined products in Europe, they highlight the growing European deficit of middle distillates (diesel, etc.) and a growing surplus of naphtha. This is because diesel demand is growing faster than gasoline demand in both the US and Europe and because we have a growing supply of light crude in the world – mostly from the US – which naturally favors naphtha production over diesel. Woodmac expects the relative value of naphtha to crude to fall slowly over time, while diesel rises relative to crude and the argument seems reasonable. In Q4 2014, there is a glut of naphtha and prices are lower.

The same thing is happening with propane in Europe as there is now more export availability from the US and other sources than the European can handle and propane has been selling at a discount to fuel value in Europe for a couple of months. We see no reason why this will change materially, though the discount may come down from the current high. Part of the problem for both propane and naphtha are increasing quantities of low cost condensate – partly from the US – which compete with both naphtha and propane for space in a European ethylene unit.

In short, Europe is getting some help with ethylene costs and this is before any import of US ethane – which looks like it will be a loss maker, based on the chart above!

But the co-product side is equally important.

As you displace naphtha with lighter feeds in ethylene units, whether in the US or elsewhere, you reduce the volume of co-products such as propylene, butadiene and butylenes. These are valuable chemical, plastic and synthetic rubber precursors and, in the case of propylene, with demand growing incrementally faster than ethylene (mainly because of the broad utility of polypropylene).

Propylene now sells at a premium to ethylene, after decades of selling at a discount – Exhibit 4. Butadiene pricing is also higher than it has been relative to ethylene. Both of these products materially impact the cost of making ethylene from naphtha, condensate and propane, but do not impact the cost of making ethylene from ethane. The propylene deficit has caused companies like DOW and others to invest in on-purpose propylene production from propane, and while these economics will be improved if propane remains in surplus in the US and Europe and continues to sell at a discount to its historic relationship to crude, this will set a floor under propylene pricing that is likely to be higher than the historic average.

Exhibit 4

Source: Wood Mackenzie and SSR Analysis

While it is likely that the December production costs in Europe are artificially low at around $560 per ton, it is also likely that the $900 per ton generated by our historic relationship based cost model is also wrong. We will do more work on this.

Today’s cost in Europe would make it extremely difficult for US producers of ethylene derivatives to send anything to Europe if it came down to direct cost based competition and it would totally negate any of the US investments that are underway or planned.

Estimates likely do not reflect the better Europe Q4 numbers

Q4 estimates have not changed much over the last couple of months and probably do not fully reflect the significant margin improvement in the US let alone Europe. As also shown in Exhibits 5 and 6, estimates for 2015 do not fully reflect how much we believe ethylene margins will fall in 2015.

Exhibit 5

Source: Capital IQ, SSR Analysis

Exhibit 6

Source: Capital IQ, SSR Analysis

©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.

Print Friendly