US Ethylene – Who Blinks First

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

January 27th, 2015
US Ethylene – Who Blinks First

  • US ethylene producers committing significant capital to new US based facilities face a major dilemma; how to react to a current energy environment that was outside the extremes of any planning assumptions considered at the time of the capital decision. We have no idea what energy prices will look like 12 months from now, let alone 5-6 years out, so do you press forward or walk? We expect some to walk, but fewer than should!
  • US ethylene investments are predicated on the assumption that the derivatives can be profitably exported from the US by virtue of cheaper feedstock costs. Current spot ethylene prices – around 35 cents per pound (Exhibit 1) – are where they are because that is what it takes to justify ethylene derivative exports, rather than a reflection of the tightness of the US ethylene market.
  • Even at these lower spot prices, current ethane prices generate a margin that would justify investment, but there is not much room for error. However, the bigger issue is that falling oil has made costs outside the US much lower and prices have not fallen as far as they should or likely will yet – so the 35 cent number in the US will need to go lower if oil stays where it is – see recent work
  • Six US builders are past the financial decision post and five of those have likely already spent as much as $100-200 million. Others, have yet to reach that point and a delay or cancellation decision is both easier and more likely in our view.
  • We would also suggest that those who have already sunk capital consider a change of course rather than plow ahead – either abandon completely and take a one-time charge, or try to combine forces with another – either building or planning to build in order to share the cost/risk.
  • Poor returns on capital in the industry result from poor capital allocation decisions, both around acquisitions and around capital spending. Some companies have been forced into bankruptcy because of such decisions. Committing more capital today because you think oil prices will be higher relative to US natural gas in future years is not an investment; it is a gamble.
  • We believe that the investment community will look favorably on any decision to delay, cancel, JV or otherwise limit the capital risk from any company.

Exhibit 1

Source: IHS, Woodmac and SSR analysis

Overview

As we go into earnings season for the publicly traded US ethylene producers, the top of mind question for many investors will be what happens to all the planned US Gulf investment in basic chemicals in the new oil environment. It is no secret that most of the capacity either under construction of planned is focused on production in the US for ethylene derivative exports to other regions – the US is building and planning to build far more than the domestic market needs. It is also no secret that construction costs in the US Gulf are rising,

Our position is unchanged from when we first wrote on the topic more than two years ago; the investments in the US rely too heavily on the accuracy of oil and natural gas price forecasts some five years forward and beyond. We added the following observation: the collective world of oil experts has not correctly predicted the price of oil forward five years since the mid-60s and at times has been extremely wrong. Today’s oil price is a clear example of how hard it can be to predict these things – the current (January 2015) oil price did not exist in even the most bleak of planning scenarios of any company as recently as six months ago.

In a very competitive global ethylene market (i.e. with a much flatter global cost curve – as we see right now) the landscape could be even worse than it appears today, as the US currently exports the equivalent of around 450,000 tons of ethylene per month, as derivatives, and US surpluses would be made even worse if this flow of product became uneconomic or less economic as it did in the early 2000s when US natural gas was high and oil low – Exhibit 2. Now, one would need to be particularly bearish and have some very non-consensus assumptions to get to that view. It is a worst case, but today’s bull case was the bear case 5 months ago!

Exhibit 2

Source: Nexant, SSR Analysis

At $50/barrel crude and $3.00 per mmbtu US natural gas, you can still make good money making ethylene and derivatives in the US for US consumption, but likely not enough to justify significant new US investment, Given the existing net export position of the US, this option is only open to a few today.

Six companies in the US are past the FID (final investment decision) stage in the US and of these only Sasol is not yet seriously committed in terms of significant capital spending.

So what happens next? We think that those already building probably keep building (though most probably should not), and most, if not all, of those that can delay (including Sasol) do so.

The major issue for the builders is that all have derivative investment plans to accompany the ethylene units. It does not take as long to build a polyethylene unit, for example, as it does to build an ethylene unit, and consequently, while the builders are “all in” on the ethylene units, i.e. past FID and with capital committed, many have not reached this point with the derivatives. However, these points of investment no return are likely imminent.

The US does not need more merchant ethylene and cannot really export large volumes of ethylene – terminal and infrastructure investment would be needed and the economics are not good. Building the ethylene plants and not building (or delaying) the derivatives, may be more palatable from a capital perspective in the current energy environment, but it presents a major problem when the ethylene unit starts up.

One possibility would be to go to the prospective builders who are net buyers and try to stop or delay their projects by offering “condo” type deals. The problem here is that there are not many of them; Axiall, Shintech, Sabic (not a big enough consumer to matter,) Hanwha, Lotte and Indorama are potentially short ethylene outside the US, but the oil/natural gas difference matters here. The second problem is that the major US buyers already have ethylene supply today, and all that any deal would do would be to shift the surplus to someone else. The US market continues to grow, and absent any fall off in ethylene equivalent export the market requires new capacity each year – the less that gets built the quicker the market should absorb it.

While it may be very tempting to delay ethylene derivative investments today, companies would only be creating another problem later – a significantly oversupplied US ethylene market. Consequently, while we would not be surprised to see most move ahead with ethylene and derivatives, one or more of the companies mid-ethylene construction may down tools until they get more comfort around their second wave of associated investment.

Canceling/delaying an Ethylene Plant is not cheap…..

Companies in the process of planning/building an ethylene plant spend tens of millions of dollars at the most getting to the point of a Final Investment Decision (FID), but things change quite quickly thereafter.

The initial expenses are to get a design complete and get permits etc. Once you cross the line the expenses and the liabilities ramp up quickly. Initial physical work is around site preparation, piling, foundations etc., which in itself is not that expensive. However, at the same time you start ordering the long lead-time machinery, such as the compressor(s), main separation towers and furnaces. While these are generally secured with a cash deposit – so some capital outlay – they are also accompanied by a purchase contract and an obligation to pay the rest of the cost over time. The initial liability increase can be bigger than the initial capital outlay. Most E&C companies have progress payments in their construction contracts, but more regular payments as well to cover some if not all of the direct labor costs. E&C companies have cancelation clauses and expenses, as do machinery manufacturers, as one would expect.

Cancelling a project at this point is expensive and will result in write downs in the $100s of millions. Delaying a project is likely much less expensive and today would be a more logical near-term decision. The cost of a delay would be the time value of money already spent or committed and any on-going project oversight

…..But cancelling may be better than throwing good money after bad

A $200 million dollar write down today would certainly leave some egg on the face of the executives at any of the companies building ethylene plants, but making a long-term 4-5% return on a facility that cost you $2.5 billion to build is worse, given possible alternative uses of the cash.

While we do not want to single out Dow Chemical in this analysis, for illustrative purposes we have little choice as DOW has the longest history of consistent data in our system and therefore provides the best example – Exhibit 3. There are lots of other companies who have a poor track record of investment and companies that would have shown a similar profile to DOW for a while but their strategy then resulted in bankruptcy. Clearly a large part of what we see in the DOW chart is the cycle as shown in the ethylene margin chart in Exhibit 4 but margins are not cycling with a negative slope, if anything the recent past would suggest a positive slope.

The negative trend for DOW, as it is for many, is the result of poor allocation of capital – both buying things and building things. To be fair to DOW, although we are not sure this is something to be overly proud of, the data suggests that Dow destroys more capital through acquisitions than through new investments – Exhibit 5.

Regardless, the point we are making here is that companies tend to keep going with decisions, even though the assumptions used in justifying the capital spend no longer exist. They do not cut their losses and move on, when perhaps they should, or they strike deals that limit the ability to exit or change direction, as DOW did with its Rohm and Haas acquisition.

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: Wood Mackenzie, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

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