US Basic Chemicals Economics – It Can’t Get Much Better Than This

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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

February 12th, 2013

US Basic Chemicals Economics – It Can’t Get Much Better Than This

 

  • Over the last few months NGL (Natural Gas Liquids) prices have fallen to levels that represent notional break-even economics for extraction from natural gas. At the same time natural gas prices bump along break-even F&D economics in the US.
  • This is providing extremely advantaged feedstocks to US basic chemical producers at a time when global crude oil prices have been rising, effectively penalizing everyone else. This is reflected in the profits we are seeing from the US focused ethylene producers, most notably WLK, but also LYB.
  • While this may be sustainable for some time, it is hard to see how it gets much better. All of the benefit of surplus NGL’s in the US is accruing to the ethylene producers today – with margins close to 50 cents per pound ($1100 per metric ton).
  • Natural gas could go lower for a short period, but below $3.00 per MMBTU the consensus view is that we would see further production cutbacks, and very limited new investment. Current forecasts for this year are in the $3.50 neighborhood.
  • Global crude oil pricing cannot get much higher without a geopolitical event that causes broader economic concerns and perhaps curtails demand or without resurgence in economic growth that would likely lift natural gas prices as well.
  • Stocks pricing in further profit growth from recent (2H 2012) levels may disappoint unless companies have more capacity available to exploit the economics. New capacity at WLK will help 2013 and 2014 earnings, and the implied earnings growth helps support the higher current multiple. LYB and DOW will be held back by capacity in Europe. HUN, DD and EMN all have US ethylene capacity, but not enough exposure to the opportunity to be meaningful for earnings.
  • Valuations currently push us to favor DD within this group, despite its limited exposure to this opportunity. DOW remains most attractively valued of the ethylene levered group, but is a much more complicated story than either WLK or LYB.

Exhibit 1

Source: Capital IQ, IHS and SSR Analysis

 

Overview

We are going to devote some time and some research hours this year to the subject of the natural gas advantage in the US and what it means for US industry. There will be an obvious emphasis on the US Chemical industry as it is the most exposed, but we will cover subjects such as possible second and third order effects on trade, investment in the US, global response, unintended consequences etc., which will expand into other sectors.

In 2011, the Brent Crude/U.S. natural gas ratio was about 3.9x on a fuel equivalent basis. In 2012 that increased to around 5.7x. These numbers compare with a 32 year average of 1.75x. The time series is shown in Exhibit 2.

Exhibit 2

Source: Capital IQ, IHS, EIA and SSR Analysis

While the ratio has declined from a high in early 2012, when natural gas prices fell below $3.00 per MMBTU, the situation for the US ethylene producer has improved as NGL prices have collapsed relative to natural gas since the early summer, as a consequence of increasing supplies, mostly from the Eagle Ford shale field in West Texas.

As NGL surpluses have materialized, NGLs have switched from being a valuable co-product of methane to a problematic overhang. This is best expressed in the margin achieved from separating ethane from natural gas, which has now been negative for several months – Exhibit 3. Only limited amounts of ethane can remain in the natural gas stream and consequently, E&P companies will effectively pay to get it removed.

In the immediate term, and for several years, it looks like this is going to get worse for the E&P companies as new natural gas production from the Western Marcellus field as well as new capacity to extract NGLs and move them to the US Gulf are expected early in 2013. This should maintain significant surpluses of ethane and propane and keep pricing very attractive for US Chemical producers.

Exhibit 3

Source: Capital IQ, IHS and SSR Analysis

Combining the natural gas/crude movements and this change in the fortunes of the NGL producer we end up with an opportunity for many North American ethylene producers that is unprecedented. We have never seen a feedstock advantage this extreme; we reached uncharted territory in 2010 and it has become steadily more and more interesting for companies that can exploit this opportunity since then – Exhibit 4. We have focused on ethylene in these charts because it is easy to do the analysis and because it is the dominant part of the story for many companies. However other products that exploit either cheap natural gas or cheap electricity (derived from cheap natural gas) are similarly (though not as extremely) advantaged. Examples include: PVC (and chlorine and caustic soda), Aluminum, Methanol, Acetic Acid and Ammonia.

Exhibit 4

Source: Capital IQ, IHS, EIA and SSR Analysis

Companies exposed to this ethylene opportunity have done very well in 2012 and also in early 2013, and we summarized some of the relevant metrics in Exhibit 1. Our view is that the margin environment cannot get much better and the level of profits generated in this business in 2H 2012, while repeatable, may not be that easy to improve on. If margins are peaking, it comes down to volume and only WLK has a near term meaningful gain on a per share basis. Dow has restarted a facility in Louisiana, but it does not have the same per share leverage as the current expansion does for WLK.

LYB does not have a volume lever to play and like DOW has counterbalancing problems in Europe – see later section. Given valuations in the group, DOW is by far the most interesting on our normalized framework, as it is the only stock trading below normal value and the only one where valuation does not discount a further increase in return on capital. However, DOW is not compellingly cheap and overshadowed today by the discount in DD when compared on the same basis. HUN also looks interesting, though more from a current earnings perspective than a valuation perspective.

Exhibit 5

Source: Capital IQ, and SSR Analysis

However, we do highlight a couple of possible outcomes in the sections which follow, which could be beneficial for US production and companies exclusively focused on the production of ethylene and ethylene derivatives in the US – this would apply to WLK, AXLL and to a lesser extent DD and EMN.

The Challenges with Getting Better Margins From Here – Gas Lower/Oil Higher?

In its analyst day in October of 2011, Dow Chemical talked at length about an expectation that the US would not only have cheap natural gas for a while, but would also move to cheap NGLs relative to natural gas towards the end of 2012. This turned out to be incorrect only in its conservative timing; things started to go poorly for NGL sellers early in the summer of 2012, and NGLs turned quickly from being a very profitable enhancement to the economics of natural gas production to a break-even necessity at best; as shown in Exhibit 3.

Today we see ethane prices bouncing around a slight discount to cash extraction costs and this is where we expect them to remain, volatile by only a few percent around the extraction cost. So ethylene producers have seen all they are going to get from this changing balance in our view – any further gains here will be small.

Absent some sort of global ethylene shortage, which boosts pricing well above marginal costs, the only way that the margin can improve further is for oil to rise relative to gas – so oil goes up or gas goes down or both.

In 2011, as gas prices declined from the $4.5 per MMBTU to $3.5 per MMBTU range, E&P companies talked about the difficulty they had justifying drilling for dry gas in the shale plays across the US. We saw rig count fall and we saw production from new wells slow down. However, investment in the “wet” gas regions of the shale formations accelerated as the higher values for NGLs justified the investment. In one presentation, Range Resources showed an analysis that took a natural gas netback from $4.00 per mcf to $6.34 per mcf based on the value of the contained NGLs. Today this increment has shrunk dramatically and if US Gulf Coast ethylene producers can buy ethane below the local cost of extraction, netbacks to Marcellus on the pipelines once running will be very low – perhaps low enough to question the drilling investment. If the economics change such that the NGLs have negative incremental value – i.e. gas producers have to pay to get them out so that they can sell the natural gas – we could see a slowdown in drilling quite quickly. Consequently, it is hard to see much downside to gas prices without a production correction that would quickly change the market dynamic.

On the oil side, we already have a security premium priced in today. Oil is not short and there is plenty of inventory – the price is high partly because of security fears. The price is high enough to encourage everyone to explore, everywhere. Supply is rising in a slow growth world. For oil prices to go meaningfully higher we either need to see a sharp recovery in global economic growth (not forecast by anyone this year) or we need real security problems such as a meaningful interruption to supply.

If demand increases on the back of a global economic recovery, “low cost” US is going to be a major beneficiary and consequently it would be reasonable to expect US natural gas prices to increase in line with crude. In the second scenario – a major supply disruption – it is unlikely that such an event would occur without economic consequences that would hurt consumption.

We do not claim to be experts on energy pricing, but consensus expectations and the forward curves suggest nothing special on the horizon. The forward curves suggest a closing of the oil/natural gas gap, but they also did this time last year and they were wrong.

Correction Mechanisms/Responses – No 1. Europe

In Exhibit 6 we show our estimated view of how the ethylene cost curve looks today, based on delivering ethylene to a local consumer and based on buying feedstocks at local market values.

Points to note:

  • We have more ethylene capacity today than we need – global demand is around 130 million metric tons and capacity is 150 million metric tons. A global operating rate of 87-88%. The world is not adding that much capacity over the next couple of years, but in a slow global economic growth environment, we would not expect much demand growth either.
  • Break-even capacity on the cost curve generates an umbrella of more than $1050 per metric ton over a gas based producers in North America (48 cents per pound).
  • The current ethylene contract price in Europe is around $1700 per metric ton – well above the theoretical global break-even price, while the price in Asia sits very close to the break-even line.
  • This dynamic should continue to place downward pressure on prices in Europe, probably not at the direct ethylene level but at the derivative level, with increasing ethylene derivative imports into Europe and more limited opportunities to export.

Exhibit 6

Source: Capital IQ, IHS, EIA and SSR Analysis

The expected European pressure suggested by this curve will get more intense as we add more low cost capacity in the US, and this partly fuels our concerns for both DOW and LYB. Both companies have “competitive” operations in Europe, DOW more so than LYB, but lower pricing relative to the rest of the world will impact profit or increase losses regardless of where you sit on the local cost curve.

Dow has around 6 pounds of European capacity per share and LYB has around 3 pounds. If we assumed that (in a worst case) pricing in Europe fell to the global break-even level as suggested in Exhibit 6 – we would see a drop in pricing equivalent to around 15 cents per pound. Assuming that both companies operate at 90% of capacity, LYB could be negatively impacted by as much as $0.45 per share, while for DOW it would be closer to $0.90 per share.

This is not a scenario that we expect to play out quickly as there is not enough low cost capacity looking for somewhere to sell. It could be a consequence of higher exports from the US from 2017 as new facilities are built here to consume the surplus ethane.

We will spend more time on this subject in future research

Correction Mechanisms/Responses – No 2. Pricing Dynamics and Product Competition

This is another topic to be expanded on in future research, but we wanted to introduce the subject in this report.

The low cost of ethane in the US is maximizing the production of ethylene at the expense of other co-products, such as propylene and butadiene. Consequently, the price dynamic between the products has changed meaningfully and this is impacting the cost of production of their various derivatives and their competitive positioning in markets where it is possible to substitute one product with another.

Exhibit 7 shows the relative price of High Density Polyethylene and Polypropylene over the last 30 years. As production economics of polypropylene improved and its cost of production fell through the 1980s, it started to gain share from other polymers as it was more durable (an advantage in some applications) and it was cheaper. The competition with Polystyrene was more intense – Exhibit 8 – and Polypropylene took many markets away from Polystyrene in the period from 1980 to 2000, including the dairy product container market and a number of electronic manufacturing and packaging markets also.

With the reversal of these trends we have seen a slowing of growth for polypropylene, partly responsible for the price collapse in late 2012, to contain inventories (prices have since rebounded significantly – lost in the 12 month average in the charts). Polystyrene producers have confirmed that their product is doing better in the US in the light of higher priced Polypropylene.

Exhibit 7

Source: IHS and SSR Analysis

Outside basic plastics, it is fairly clear that other propylene derivatives are seeing slower growth as a result of the higher prices and this may be part of the problem that DOW is seeing with its performance in the Coatings and Infrastructure and Performance Materials businesses, as these are largely based on propylene technology. Competition between ethylene oxide derivatives and ethylene based latexes are likely putting price pressure on DOW’s propylene oxide derivatives and acrylate latexes in some end markets.

Exhibit 8

Source: IHS and SSR Analysis

The bottom line is that in the US ethylene based derivatives are benefitting at the expense of other products. This could increase ethylene demand growth in the US raising operating rates and possibly pricing also.

While global operating rates are bouncing around in the 88% range, US operating rates are not much higher today – see Exhibit 9. However, beyond what has been done by DOW and WLK recently,

there is not much expansion planned before 2017, and a step up in demand could push prices to a premium above the global break-even level. While we do not think that the current economy can do much to boost operating rates, substitution of ethylene for propylene could help the US ethylene focused companies – so good for WLK and AXLL. This would be more neutral for LYB and DOW as they would gain on one side of the equation and lose on the other.

Exhibit 9

Source: IHS and SSR Analysis

©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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