A Volatile Energy Backdrop In 2019 – Bad for Valuations

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

FOR IMPORTANT DISCLOSURES 203.901.1629/203.901.1627

gcopley@/asalzillo@ssrllc.com

November 27th, 2018

A Volatile Energy Backdrop In 2019 – Bad for Valuations

  • We take a more comprehensive look at a subject that we touched on in a recent weekly and show that volatility in natural gas and crude oil prices has an inverse correlation with absolute value in most Industrial and Material sectors.
    • The exception is E&C, which appears to have a positive correlation – the more volatile energy (especially natural gas) the higher the EV/EBITDA multiple.
    • The data is impacted by one extreme year of volatility (2008) but in some cases, especially for natural gas, removing the data point makes the best fit line slope even more dramatic.
  • The results are not surprising, as volatile energy drives uncertainty at every level – economic growth, feedstocks, transport fuel costs etc., but even groups like Electrical Equipment have some significant trends.
    • In Exhibit 1 we rank the segments with respect to how negative the correlation is – i.e. how much EV/EBITDA multiples fall as volatility increases. The lowest ranking for E&C and the red background indicates a reverse relationship.
    • We are surprised that Electrical Equipment ranks so highly – i.e. shows the most pronounced slope – we expected Chemicals to be number 1 for both oil and gas. We are also surprised by transports, as we expected a better correlation because of fuel prices.
  • We have also looked at S&P volatility and summarize some of those results at the end of the report – but there is no correlation for any sectors – market volatility is not a factor, although we include it in the summary below.
  • We have produced this analysis because 2018 has seen volatility emerge as the year progressed – although year to date it is one of the least volatile years for crude in the last 13. Natural gas volatility has been higher.
    • Every corporate that we have spoken to over the last month or so believes that 2019 could see more volatility in crude and natural gas than in 2018 – crude because of geopolitics and natural gas because of infrastructure timing in the US.
    • Natural gas volatility may be overwhelmed by ethane volatility, but this is only a risk for a handful of chemical names – DWDP, WLK, LYB and OLN.
  • Just based on this analysis; if we expect 2019 to be volatile we should avoid highly valued electrical equipment, chemical and conglomerate names and buy cheap E&C companies.
    • Stocks to avoid: ECL, PPG, ROP, AME, ROK, WAB, IEX, GGG and DE.
    • Stocks to own: FLR and the rest of the E&C group.
    • Likely unaffected names would be in Transports.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

Crude Oil Analysis

The charts below (Exhibit 2) summarize the sector correlations with crude oil volatility – with volatility defined as one SD of price movement over the year (data is analyzed on a daily basis). The outlier point is 2008 and, in some sectors, if you take it out you get less pronounced slopes and in others more pronounced.

Exhibit 2

Source: Capital IQ, EIA and SSR Analysis

The analysis runs from 2006 as when we try to include more years we see the company sample sets fall off because of M&A and other changes that restrict the number of companies we can use. Later in the report we take a group of companies for which we have longer term data and run a longer data set.

US Natural Gas Analysis

The charts below (Exhibit 3) show the same methodology for US natural gas. If we remove the outlier year in this analysis we get several charts where the decline slope is steeper. The correlations are tighter for natural gas than they are for crude oil in most cases.

As with crude oil we see a positive correlation for E&C and we can only assume that the expectation is that volatility leads to investment. The correlation is slightly more pronounced for natural gas than for crude.

Exhibit 3

Source: Capital IQ, EIA,and SSR Analysis

Valuation – Where Would the Opportunities Lie

If you buy the argument that 2019 could see significant energy volatility, multiples should shrink for Chemicals, Electrical Equipment and Capital Goods and rise for E&C. We plot current values in each segment in the 4 charts below – Exhibits 4 through 7. The more obvious underweights are ECL and PPG in chemicals as the other expensive names are mid restructuring or acquisition integration. In Electrical Equipment all the expensive companies are fair targets, and in Capital Goods all of the more expensive names are worth looking at as shorts but note that we have an underweight on WAB already.

FLR is already an overweight for us so it would be our first-choice long in the space, but a rotation into E&C should lift all.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

Longer History Analysis

We have taken a group of 18 companies from Chemicals, Electrical Equipment and Capital Goods, where we think we have good historical consistency of data and reworked the analysis with data back to 1991. The companies are listed in the table in Exhibit 8 and the correlations are shown in Exhibit 9. The conclusions are mixed here as you get a positive correlation with Crude Oil and a negative correlation with Natural Gas. The sample set has a bias towards Capital Goods, which was negatively correlated on the shorter time frame with Crude Oil. This longer-term analysis would cause us to be more worried about the effects of Natural Gas volatility than Crude Oil in 2019.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ, EIA and SSR Analysis

The S&P Analysis – no real conclusions

The analysis using the S&P as a variable is summarized in Exhibit 10.

Exhibit 10