North American Commodity Chemicals – Shale Gale Maybe, Windfall More Definitely
As production of natural gas in the US has risen it has increased not just the volume of methane available, but also the amount of associated gases; ethane, propane, butane and natural gasoline. With the exception of ethane, these products have values that are derived from crude oil and as a consequence greatly enhance the value of the gas being developed – this type of gas (wet gas) is being preferentially developed today as a result. There is a limit to how much ethane can be left in the methane gas stream that we burn every day, and when that limit is reached it has one valuable alternative use – as a feedstock for the production of ethylene, one of the major building blocks of the plastics and chemicals industry. Without this use, the ethane would need to be injected into storage or, more likely, flared.
We are at a tipping point in North America, as we have reached the limit of consumption by the chemical industry and ethane is about to slip into a surplus that could last for many years. Ethane prices have been by far the most attractive feedstock for the North American chemical industry since the price of oil increased materially, despite the fact that ethane prices have also risen, generating a very good margin for those extracting the ethane from natural gas. With oil prices expected to stay high and natural gas prices in North America expected to stay low, the very strong margin that US ethylene producers have already seen will expand as ethane prices fall to break-even extraction values – a territory they occupied for most of the period from 1980 to 2005. Ethane availability in the US Gulf is rising steadily today because of developments in the Eagle Ford shale basin in West Texas, but will step change in 2013 when pipelines are completed to bring supplies to the Gulf Coast from the Western Marcellus. By end 2013, ethane supply in the US Gulf could be 20-25% higher than it is today.
Our analysis shows that there is a real risk that in the near-term we are flooded with ethane – possibly through 2016/2017 (and perhaps beyond). Today we have a surplus, but it could get much larger. Ethylene expansions are underway, but the big projects all seem to be “just around the corner” in terms of putting a shovel in the ground or ordering long lead time equipment, almost as if there is a big game of chicken going on. Hardly surprising given that there is no domestic outlet for this new capacity and to drop $1bn for a new plant that takes 4-5 years to build and that could have no market as soon as it starts-up is understandably something you want to think long and hard about.
In the near to medium term, cash flows will be very high and returns on existing and new capital could sit at or above 35% for a prolonged period – as many a 5 or 6 years.
The stocks do not reflect this earnings tailwind – the commodity chemical companies in the US are in aggregate fairly valued on an historic normalized basis, whereas, at the beginning of a significant profit super-cycle we would expect the sector to trade well above mid-cycle values. This suggests as much as 30-40% relative upside as the earnings momentum becomes more obvious.