Prices Falling, Dollar Rising – Stocks Defying Gravity

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

March 9th, 2015

Prices Falling, Dollar Rising – Stocks Defying Gravity

  • US ethylene stocks reflect the unlikely idea that the current commodity market is an anomaly and that things are going to improve quickly. Stock price correlations with polyethylene pricing and margins have completely broken down suggesting downside if fundamentals do not improve. Further, currency is going to be a major headwind in Q1 2015 – LYB, WLK and DOW have downside.
  • An alternative interpretation would be that investors are betting on a recovery in crude oil relative to US natural gas pricing. We would argue that if you really feel that way you should be buying the depressed oil E&P names – see recent work from our colleague Grayson Andersen or shorting natural gas.
  • Spot pricing for ethylene and polyethylene in the US has collapsed, reflecting the need for the US to export more than 15% of its ethylene output as derivatives and the much more competitive position that lower oil prices have created in Europe, Asia and Latin America. This weakness in pricing comes despite Williams continual and ongoing problems restarting its ethylene facility in LA.
  • Spot high density polyethylene pricing for the export market has fallen close to 50 cents a pound in February, from a high of 80 cents per pound as recently as October 2014. On an integrated (ethane based ethylene) basis, margins have fallen from almost 50 cents to 20 cents over the same period.
  • Correlations between share prices for WLK, LYB and DOW and ethylene and polyethylene spot prices, as well as HDPE margins, are generally good, but they have broken down completely in the last few months. The current deviations from normal are at such statistical extremes – especially for LYB and WLK that we see nothing but relative downside for both names, unless fundamentals turn and turn quickly – however, US contract prices for ethylene and polyethylene always follow spot.
  • The weaker Euro in Q1 is also a major headwind for LYB and DOW, and the combination of the currency and pricing headwinds mean that you have to believe in something else – we are not sure what – to own these stocks today. LYB is most overvalued, but both LYB and WLK look to be facing some meaningful near-term negative revisions.

Exhibit 1

Source: Capital IQ, Industry Sources, Wood Mackenzie, SSR Analysis

Overview

Despite continued problems with the Williams ethylene plant, its lack of supply does not appear to be preventing significant and continued price declines for US ethylene and polyethylene pricing, especially if we focus on the leading indicator – the spot market. Spot high density polyethylene for export in the US is hovering above 50 cents per pound, down from 80 cents in October. Because the US has such a significant surplus of ethylene already, export prices have to fall to whatever is needed to move material off shore. Spot ethylene pricing is edging lower almost daily in an attempt to find an incremental buyer who can make the derivative export math work. Ethylene and polyethylene margins alone in Q1 2015, and if sustained through 2015 present US producers with significant earnings headwinds.

Separately, we have a much stronger dollar, particularly versus the Euro. This will present Q1 challenges and 2015 challenges if it continues. The Euro is currently 20% weaker than it was in Q1 2014. In Exhibit 2, we look at the impact of US ethylene and polyethylene as well as the Euro for both Q1 and full year earnings for DOW, LYB and WLK (assuming unchanged averages from Q1 2015 YTD). We estimate the year on year change that they will drive and then compare this with the change currently reflected in consensus. For the companies to meet current consensus they will need to find offsets for these very strong headwinds.

Exhibit 2Source: Company Reports, Wood Mackenzie, Industry Sources, SSR Analysis

In this environment, we have trouble justifying the price that LYB and WLK are trading for today as estimates are likely to come down and generally the stocks do not perform well when that happens – as shown in the early stages of Exhibit 3. The recovery in the share prices since January looks hopeful given the headwinds.

Exhibit 3

Source: Capital IQ, SSR Analysis

The same case can be made for DOW, but the stock is not as far away from its normal relationship with spot ethylene and polyethylene pricing as LYB and WLK.

Estimates look very optimistic in our view for all three companies. This is especially true for LYB where they call for EPS growth of roughly 17% from 1Q14 despite the fact that US HDPE margins have fallen some 43% from their averages in January and February of 2014 and ethylene margins have fallen roughly 35% in the same time frame. In 2014, U.S. olefins & polyolefins comprised roughly 30% of the company’s sales and 55% of EBITDA. Given recent strikes and lower Q1 refinery crack spreads (versus Q1 2014) we are doubtful about the ability of LYB’s other segments to pick up the slack, though we would expect the European business to be better, absent the exchange rate issue. The story for WLK is only marginally better, and DOW’s numbers look too high also. WLK has a gain in Europe from the inclusion of Vinnolit, and this is included in the table in Exhibit 2.

In the past we have seen companies review the first two months of a quarter and either make a public statement or quietly try to guide down street estimates – this is likely to be the case here and while the stocks have fallen from their recent recovered highs we think they could go much lower. The later Q1 reporters did not sound overly optimistic about Q1 and we think this will flow through the quarter. We note that companies in the US are pushing for a polyethylene price increase in March 2015, but we would remind all that the best way to limit a price decline is to announce an increase and the spot market is the one to watch; it is not improving for polyethylene and it is weakening for ethylene.

The stocks are completely out of sync with past spot ethylene and polyethylene pricing – the last time integrated spot polyethylene margins were at 20 cents per pound, LYB traded at $20 per share and WLK traded in the high teens. Both have larger platforms today and more cash plus stronger balance sheets and other products than just polyethylene, but you could make a case for LYB at $40 and WLK at $35 if you went to the negative extreme – 50% downside for both.

For this not to happen, the spot markets for polyethylene and other derivatives have to recover. This will only occur with stronger economic growth or with higher oil prices relative to US natural gas. US natural gas is very weak, given the weather and production in the Marcellus, but it is still not enough of an advantage given lower international prices. If you are betting on oil, you should bet on
the much cheaper E&P names that our colleague Grayson Andersen is talking about
and not an expensive LYB and WLK.

Spot Prices Continue to Weaken

The charts below – Exhibits 4 and 5 – show what has happened to ethylene and polyethylene pricing over the last three years; quite the dramatic change of fortunes. Ethylene, polyethylene and other ethylene derivatives are falling to find the price at which you can export polyethylene or persuade someone to buy more ethylene in order to export more of a derivative. There is still a sizeable margin in the ethylene business – Exhibit 6 – but polyethylene looks fairly bleak given how much lower spot prices are than contract. Note that for polyethylene, there are sizeable US consumer discounts over the contract prices shown below and the gap between spot and contract for large buyers is not as significant as it appears.

Exhibit 4

Source: Wood Mackenzie, SSR Analysis

Exhibit 5

Source: Wood Mackenzie, Industry Sources, SSR Analysis

Exhibit 6

Source: Wood Mackenzie, Industry Sources, SSR Analysis

The concern for the builders in the US right now is that the spot prices based polyethylene integrated margin – the green line in the chart above – does not today, for the first time since 2010, justify green or brown field investment in the US with the plan to export. We have
written recently about whom of the builders might blink first
and late February polyethylene pricing should be a cause for concern. However…

… Investors don’t seem to care!

Stock price correlations with ethylene and polyethylene prices and polyethylene spot margins have broken down, especially for LYB and WLK. In Exhibits 7 through 15, end-February 2015, our most recent point, is marked in red while January is marked in purple. To measure this relationship, we used the share prices vs. margins earned on HDPE, as well as share price against absolute spot prices. DOW has a much weaker relationship with HDPE margins and prices than LYB or WLK. We believe that this is a function of its exposure to other businesses, with polyethylene a smaller proportion of the overall portfolio than for LYB and WLK. We should also take this time to restate that the relationships for LYB and WLK have broken down considerably over the past two months. Excluding the most current point and the point for January, LYB’s R-squared improves to 0.58 (Exhibit 14) and WLK’s improves to 0.49 (Exhibit 15.) In the cases of all three companies, current prices appear too high based on their historical relationships between share prices and HDPE margins.

LYB and WLK have much more interesting stories based on their stronger historical relationships with HDPE margins and the current departure from those relationships. They also appear extremely overvalued whereas Dow appears less overpriced on this basis.

Because of the recent breakdown in relationships for LYB and WLK, we have elected to not include a specific price target today based on this analysis. The trends and current positions in some cases suggest that a close to zero or negative share price would be appropriate for both of these companies using this methodology.

Exhibit 7

Exhibit 8

 Exhibit 9


Source: Capital IQ, Industry Sources, Wood Mackenzie, SSR Analysis

Exhibit 10

Exhibit 11

Exhibit 12

Source: Capital IQ, Industry Sources, Wood Mackenzie, SSR Analysis

 

Exhibit 13

Source: Capital IQ, Industry Sources, Wood Mackenzie, SSR Analysis

Exhibit 14

Source: Capital IQ, Industry Sources, Wood Mackenzie, SSR Analysis

Exhibit 15

Source: Capital IQ, Industry Sources, Wood Mackenzie, SSR Analysis

Exhibit 16

Source: Capital IQ, Industry Sources, Wood Mackenzie, SSR Analysis

While estimates for 2015 earnings have come down, they have not come down to the extent that margins have fallen. This inconsistency corroborates our view above in that shares of each of these companies still seem to be pricing in more optimistic margins. Dow is again notable in that its estimates have not fallen yet due to its comparative diversification and activist involvement and usual Q1 optimism around expectations for the year.

Valuation – Sell LYB!

The case against LYB specifically is made worse when we look at current valuation – Exhibit 17. Not only does the company appear expensive when compared to current HDPE margins, it also appears expensive when using our normalized valuation model. The company trades at a premium when compared to its own history and historical returns on capital as well as a premium to its peers Dow and Westlake. While we generally prefer a larger premium to normal value before getting too bearish, we feel that current dynamics in energy, olefin, polyolefin and currency markets do not justify paying the premium that LYB currently asks.

Also troubling about its current valuation is the skepticism index. This is a result of the company overearning in recent months, likely due to the fact that both ethylene and HDPE pricing lagged the collapse that oil saw over the same months. Please refer to this piece written in December for more insight into our skepticism index methodology.

Exhibit 17

Source: Capital IQ, SSR Analysis

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