Why the Basic Chemical Investments in the US Will Likely Disappoint

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

March 23rd, 2014

Why the Basic Chemical Investments in the US Will Likely Disappoint

  • It only makes sense for the US to add 50% to its ethylene capacity over the next 5 years, if the competitive advantage offered by US natural gas pricing allows the US to export the bulk of this increased production. Even with a better and improving US economy, domestic consumption growth will be slow and at best will only consume a fraction of the increase.
  • We have always been apprehensive about betting on an energy cost differential 5-10 years in the future, in part because of a consistent history of general failure in predicting absolute and relative energy prices. Now, the increasing number of new ethylene project announcements in the US adds to our fears.
  • If the US adds more capacity to consume ethane than can be made easily available, ethane prices will rise relative to natural gas and cut into the cost advantage that US producers enjoy today. There is an increasing risk that this will happen as the number of projects increase, and we expect further project announcements still to come.
  • If the global competitive playing field is leveled, though whatever mechanism, the industry will be in trouble as the country could have 30% overcapacity and a flat cost curve. In this scenario those with large depreciation and finance charges would lose a lot. Global supply/demand forecasts do not suggest that much of this US capacity is needed.
  • Valuations today discount only good times ahead – which is probably a reasonable medium term bet – 2-3 years. As we approach the wave of new capacity starting in 2017 the smarter company might be a seller rather than one continuing to invest.
  • Today we see little upside in WLK and LYB without a definitive guarantee that most of the free cash flow going forward will be returned to shareholders. Dow is talking more openly about more divestments and monetizing its Ag business – this could drive support or some further upside despite valuation. The chlorine guys – OLN and AXLL – look more interesting.

Exhibit 1

Source: Capital IQ and SSR Analysis

(Skepticism is a measure of how in sync valuation is with returns; a high value indicates returns are expected to fall or valuation is expected to increase)

Overview

As the masses gather for the annual pilgrimage to Houston and San Antonio to talk about all things Petrochemical, we expect another year of record attendance. The US companies can afford to go and the non-US companies can’t afford not to go.

The changes in the world order of basic chemicals have been dramatic – while many of the smaller European companies are skirting bankruptcy, if not already there, Westlake has a 20% return on capital and a share price that has tripled in 3 years. We chose Westlake as an example because of its US pure play characteristics.

The near and medium term for the US ethylene producers looks great as ethylene capacity additions are not enough to change the oversupplied nature of the ethane market, without some major supply disruption, and the margin umbrella should prevail. The harder forecast is what happens after the major wave of investment takes hold three years from now.

Estimates of how much new investment there will be in basic chemicals in the US over the next seven years vary, but they sit in a range from $70-100 billion. This would approximately double what the overall industry has spent over any average 7 year period since 1990 – and the industry data is all chemicals, not just basic chemicals.

Exhibit 2

Source: Capital IQ and SSR Analysis

While the natural question is whether all this investment will spoil the party, it is probably the wrong question. The party was likely always going to be spoilt, as it always has been in the past – the question is whether anyone will work it out early enough to cash out at the peak. There is a herd instinct – or at least a herd behavior – to all commodity industries, and we have no reason to believe that this time will be any different. The herd instinct is partly competitive – “he is doing it so I should do it too” – and partly financial – “I can afford to invest so I should” or “I can’t afford not to invest so I must”.

US ethylene is a great example today – most of the big US companies are building and expanding, or plan to, because it is their turf and (in most cases) they have the lower cost of entry. However, US ethylene economics are perceived as such a threat that we have other jumping in, perhaps with a view that they can’t afford not to.

The risk today is the same as it always is, but with much more serious consequences – overbuilding. If the US builds too much ethylene, two things will happen. First, as the price needed to push each incremental pound into the export market will be lower than the price required for the previous pound, pricing will decline; and second, the US could end up with more capacity to consume ethane than there is ethane available. At that point, ethane would rise in price to the level needed to encourage use of an alternative feedstock or high enough to discourage exports, effectively killing any competitive advantage that the US had – death of the Golden Goose!

In its recently published long-term view of global ethylene, Wood Mackenzie forecasts exactly this problem (Exhibit 3), with the price of US ethane post 2017 bid upwards as the market tries to encourage enough ethane supply to meet demand – or discourage demand. Oversupply and no competitive advantage would take away all of the margin that US producers enjoy today and, given that a future US needs to export to balance production, could be made worse by very low operating rates. Companies continue to build ethylene capacity in the Middle East and China, so the world balance is not dependent on the most of the proposed US capacity.

Exhibit 3

Source: Wood Mackenzie

This of course assumes that everyone builds, and builds approximately on schedule. Any major construction slowdown and/or project cancellations could impact the ethane balance and materially change the outcome.

Separately, we are talking about events 4-5 years in the future and a lot can change in a period that long. One of the issues that we are watching closely is the potential development of shale gas in Europe, and while we understand that consensus opinion is that it’s too hard and will not amount to much, it is worth noting the following:

  • The same thing was said about US shale for years – but a few years at gas prices above $10 per MMBTU was enough incentive to try.
  • The rhetoric in Europe is changing, in our view – the economic incentive is so high, that the environmentalists appear to be changing from saying no to saying what needs to be taken into consideration.
  • Recent events in the Ukraine will only strengthen arguments that Europe should exploit its own oil and gas resources rather than depend so heavily on exports from Russia.

There is significant shale in Europe – in the UK, in Germany and other countries. While there may not be enough to change Europe’s net import position on natural gas, it could be meaningfully reduced, which might impact global pricing. More important for the chemical industry, there appears to be quite a bit of ethane – and this could provide a competitive lifeline for pockets of the chemical industry.

The Rush Is On – New Players Emerge

The world has spent the last two years trying to come to terms with the benefit that is accruing to US based chemical producers as a result of very cheap natural gas and more recently abundant NGLs. While we have seen a slowdown in E&P activity around natural gas itself, because gas prices are low, the activity remains very high for liquid rich natural gas, because of the value of the NGLs and gas/condensate rich crude oil, because of the value of the crude. This activity is increasing the supply of natural gas, but it is more quickly increasing the supply of NGLs. US ethane pricing has increased in the first quarter of 2014 with natural gas prices, but it is bouncing around the marginal cost of extraction from natural gas suggesting a significant surplus.

So the supply wave is real and the competitive advantage enjoyed by US ethylene producers is real – Exhibit 4 shows ethane extraction margins in the US and Exhibit 5 shows Westlake’s net income for the last 10 years.

Exhibit 4

Source: Wood Mackenzie

Exhibit 5

Source: Capital IQ and SSR Analysis

Today, there is no incentive to reconsider already announced investment in new US ethylene capacity and every incentive for those not yet participating to consider joining the party. Consequently we have seen two recent additional indications of interest – one from Axiall in joint venture with Lotte and another from Shin-Etsu. Axiall wants access to low cost ethylene for its vinyls chain and Lotte wants low cost MEG. Shin-Etsu is a major global player in PVC and wants the low cost ethylene to support its global business. Both of these investments make sense for the participants as they are about lowering costs within the US and outside the US. These companies need the cheap ethylene – which is a distinction from many of the others building. In Exhibit 6 we list the builders and put them in three categories – those consuming their own NGL’s; those who need the low cost ethylene to maintain a competitive position in their existing portfolio and those simply expanding because they can.

Exhibit 6

Source: Company Press Releases, Chemical Week and SSR Opinion

Without too much thought and analysis, we can identify another 15-20 companies outside the US who should be looking at something similar. In Exhibit 7 we list a few global ethylene consumers who would love to get their hands on current US ethylene economics and some US companies sitting on ethane supply – note that an ethane based ethylene unit fits the MLP test – with Williams Partners as the operating example. This is an illustrative list only – just to show that there are plenty of companies who could yet provide us with surprises – we have probably missed at least as many as we have listed. Every company on the list should be thinking absolute whether it makes sense to be a participant.

Exhibit 7

Source: SSR Analysis

The US Investments Only Makes Sense If the Competitive Advantage Remains

The US is a net exporter of basic chemicals and has been so for many decades. Since the recent fall in natural gas prices in the US and the increased competitiveness, we have not really seen a meaningful increase in net exports of ethylene (as ethylene or as derivatives) – as shown in Exhibit 8 below that we have borrowed from Wood McKenzie.

Exhibit 8

However, as shown in data from the American Chemistry Council (Exhibit 9), the US has not been a hotbed of domestic demand growth for chemicals either, with recent levels well below the 2007 peak and close to the average of the last 15 years.

Exhibit 9

Source: ACC

The US industry needs to keep its energy and feedstock advantage for two reasons:

  • Relatively low energy prices should lead to domestic manufacturing growth which should in turn lift domestic demand for chemicals and their derivatives.
  • Even with stronger, or any, domestic growth, the expansions in the US need the export market to grow significantly, and the US needs a cost advantage to do that.

US ethylene capacity is expected to increase dramatically over the next six years; at a faster rate than at any time in the last 35 years. Capacity in 2020 could be as much as 55-60% higher than in 2012 – Exhibit 10. However, note that the forecast is very dependent on what happens in the later period rather than the next few years. Every builder today is talking about a 2017 start-up, but we do not expect to see much in 2017 and have pushed some start-ups to late 2019 and early 2020. Companies underestimate the time it takes to get permits and the construction process itself. The scenario below assumes that all who have announced build, but that we have no more surprises. It is more likely that one or two current plans get shelved and a couple of new ones appear. The timing reflected below is conservative – and companies planning to build will insist that they can do better and be on-stream earlier.

Exhibit 10

Source: Wood Mackenzie and SSR Analysis/Estimates

US consumption of ethylene has effectively flat lined for the last 14-15 years, having grown reasonably quickly through the 1980 and 1990s – Exhibit 11. This consumption figure includes ethylene used to make derivatives consumed within the US and used to make derivatives for export. The export balance matters a great deal as low cost natural gas in the US drove increasing exports through the 80s and 90s and higher gas prices since then caused exports to fall.

The lack of domestic demand driven ethylene consumption in the US is partly the result of slow manufacturing growth but more driven by increased offshore production of plastic goods which are then imported into the US – think about the product shelves of cheap durables at Target, Walmart and Home Depot. It is also our strongly held view that there is price elasticity in plastic demand and that high absolute prices – driven by high crude oil prices – have cut into demand growth for several years.

Exhibit 11

Source: Wood Mackenzie

If we combine the data in Exhibits 10 and 11 and assume that US domestic demand grows at the average rate ethylene consumption has grown in the last 23 years – 2.0% – and we assume no export growth, we get a disastrous picture – Exhibit 12. We have included the longer history here to remind readers of how bad things got in the early 1980s. At that time the industry was similarly plagued by overbuilding and a meaningful change in feedstock dynamics with the rapid rise in crude oil prices. Cheap gas in the US allowed US basic chemicals exports to grow quite quickly form the mid-80s, although a significant part of the following operating rate improvement came from plant closures. In 2013 US ethylene cash margins averaged around 35 cents per pound; in 1983 they averaged 3 cents per pound.

Exhibit 12

Source: Wood Mackenzie

To keep 2020 operating rates in the US at 90%, and assuming no improvement in demand growth within the US, annual ethylene exports, either as ethylene or as derivatives would need to rise by around 10 million tons (22 billion pounds). This is not inconsistent with the estimate that IHS published at its World Petrochemical Conference last year, adjusting for the capacity announcements that have emerged since that event. Our estimate of what would need to happen US ethylene equivalent trade is summarized in Exhibit 13.

The important question is – “is this reasonable?”

Exhibit 13

Source: Wood Mackenzie and SSR Estimates

If we assume that global ethylene demand grows at around 3.5-4.0% per annum, which in our view is aggressive given pricing, global demand in 2020 would be around 165 million tons, of which the US would be close to 30 million tons. Consequently the US will be trying to get non-US market share of around 11%, up from around 4% today.

These are not crazy numbers, though the rate of growth over a two to three year period might be challenging. The Middle East built its business through rapidly increasing exports of basic chemicals in the 90s.

However: assuming that the energy advantage is still there we would be concerned about the following secondary/follow-on effects;

  • The world is not short of ethylene nor is it expected to be with investments on-going in the Middle East and Asia – mainly China. There is expected to be no investment in Europe or South America, with the possible exception of Argentina over the next few years.
  • Producers with new US capacity – facing an export market that does not need US product – will instinctively try to sell more domestically, as the netbacks will generally be higher. This will likely increase competition domestically and squeeze domestic margins.
  • Pushing most products into the export market will require lower prices – there has to be incentive for a European or Latin American consumer of polyethylene to buy imports rather than from a local source.
    • Exports where intermediates from the US displace local production in other countries on an agreed basis might not impact local prices. See our recent work on this subject.
  • Lower export prices will inevitably have an impact on US pricing.

It is unlikely that US producers can have all their cake and get to eat it as well. Increased volumes will inevitably lead to lower pricing, but a 20% increase in volumes for a 5% decline in pricing might be a good trade.

But Without the Energy Advantage – Things Get Ugly Quickly

If the US is not a competitive exporter the industry will be in real trouble as it will have a 30% capacity overhang and very slow underlying growth. The competitive battle will turn inward and the higher cost domestic producers will get squeezed out. Margins will likely fall to near zero given that much of the investment planned for the next 4 years is about creating competitive capacity all based on the same ethane feedstock – i.e. a leveling of the US cost curve. We could face a scenario whereby all US demand for ethylene could be satisfied from facilities with essentially the same costs – i.e. large ethane based units. If prices fell close to cash cost break-even – something we have seen in the past in significantly oversupplied markets – anyone with depreciation of finance charges would report losses.

How could the energy advantage go away – some (perhaps far-fetched) scenarios;

  • An event takes place in one of the US shale geographies whereby there is either seismic like damage or serious water contamination, leading to a moratorium on drilling activity while new safety standards are agreed. Costs increase – gas availability is more limited – gas prices rise.
  • Europe develops its shale fields more quickly than expected such that in 6-7 years Europe is closer to natural gas self-sufficiency and global LNG prices fall meaningfully, lowering NGL values in Europe and taking away an export venue for US ethylene derivatives.
  • Fuel consumption conservation as well as increased drilling create an oil surplus globally – oil prices decline.
  • Geopolitical events (topical) encourage the US to ramp up LNG as a way to help European allies meet energy requirements – LNG pricing normalizes global gas prices – US gas prices rise.

This may all sound a little crazy, but no-one saw the run up in US natural gas prices in the early part of the last decade 5 years before they happened and no-one saw the recent fall 5 years before it happened – a great deal can change in 5 years.

Much More Near-Term Comfort

It is worth emphasizing that if the wheels are going to come off this bus eventually, they are likely to be firmly attached for several more years before they do. Scenarios that would destroy the margin story between now and 2017 are more tenuous than the ones listed above – except perhaps the last one – and we would expect the US industry to make good returns for several more years.

From a stock perspective it comes down to just how much money can be made, what companies then do with it, and what is it worth. Today expectations are very high – Westlake is effectively trading at 13x peak earnings. We do not have enough cycles of data for WLK or LYB but in the chart below we show DOW’s PE (12 month forward earnings) against where earnings are in the cycle, defined as actual earnings divided by “normal”. At a peak that ratio is at its highest and the multiple of it is at its lowest, and vice versa. This analysis includes 43 years of monthly data for DOW and so includes several full cycles.

Exhibit 14

Source: Capital IQ and SSR Analysis

Of the commodity names in the US only WLK has earnings that are more than 2x what we would consider normal. Other US ethylene producers have US earnings that are 2x normal, but they have other businesses and other geographies that are not at that level. The ratios for our commodity group are summarized in Exhibit 15. LYB and WLK are just within the band defined by the points in the DOW chart above, but any further increase in estimates or earnings is likely to be matched by a lower multiple based on the curve.

Exhibit 15

Source: Capital IQ and SSR Analysis

Given that current levels of earnings are expected to prevail for a while, notwithstanding the obvious weather related Q1 2014 road bump, WLK and LYB can probably maintain current values and possibly even increase values by returning almost all of their free cash to shareholders – either through dividend or buy-back. WLK looks attractive if you assume that 90% of their expected $10 earnings will be paid as a dividend for example. However, while these actions might support values, uncertainty will potentially undermine values, so both companies need to consider being more definitive about the amount of cash that will be returned to shareholders – or the assumption might be made that the cash is being retained for a big new investment or an acquisition.

©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.

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