Chemicals Monthly – A Mixed Month Midway Through 2013

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

June 17th, 2013

Chemicals MonthlyA Mixed Month Midway Through 2013

  • A month of mixed performance for the group, with the more pure play commodity names reacting positively to the supply interruption created by the tragic Williams fire and explosion on Thursday of last week. AXLL, WLK and LYB gained on both Thursday and Friday, but others with exposure were mixed.
  • The Oil/Natural Gas delta has opened again, with Middle East tensions impacting oil, as well as a tighter WTI balance, and oversupply impacting natural gas. The ethane/Brent ratio is moving back towards the lows seen in Q1 2013. Prior to the Williams outage, there appeared to be downward pressure on product pricing.
  • Outside and within commodities, performance has been mixed for the last 4 weeks and our commodity chemical index would have looked much worse on Wednesday of last week than it does today. WLK was the only company to gain over 5% on the month.
  • A strong month of outperformance from the Industrial Gas companies, focused in the two larger US companies, PX and APD. This is likely driven by relatively attractive value as much as anything company specific or economic.
  • We would continue to focus on DuPont as the best combination of current valuation and leverage to an economic recovery; however, DD is penalized by its complexity, a subject we will cover in more detail this week.  

 

Exhibit 1

Source: SSR Analysis –
See Appendix 1
for background and see
Appendix 2
for a larger version of this table.

Overview

The Williams incident drove gains in the focused names (AXLL, LYB, WLK) while more diversified companies saw mixed effects. The Commodity subsector on the whole was nearly flat in a down market. Industrial Gases posted the biggest gains on the month.

Natural gas fell firmly below the $4/mmBTU mark as supply outstrips demand heading into the summer season. With crude oil up as conditions remain tenuous in the Middle East, the gas-oil difference is at its highest level in several months.

Indicators are mixed. Consumer and construction spending were up marginally in the latest releases but appear to be decelerating off of very strong upward trends. The May PMI reading was the lowest since June of 2009; inventories rose and production dipped, all disquieting readings on economic activity. We would continue to focus on DuPont as the best combination of current valuation and leverage to an economic recovery; however, DD is penalized by its complexity, a subject we will cover in more detail this week.

Valuation

Exhibit 2 summarizes our valuation work. The extreme in valuations for the
coatings group is something we have written about at length
– and we can partly explain the premium to normal with the current very high level of earnings, but the sector continues to discount rising returns on capital from already very high levels.

Despite the most bullish revisions in the Chemicals space the Specialty subsector was among the biggest laggards on the month. The only other subgroup to see positive revisions was Coatings, which declined nonetheless as the group’s already premium valuations struggle to attain further gains in a suddenly middling market. The premium shown in the Diversified group comes despite cap leader DuPont showing a discount.

Exhibit 2

Exhibit 3

Source: Capital IQ and SSR Analysis

The group composition is summarized below.

Exhibit 4

Exhibits 5 and 6 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our
April Chemicals Monthly
. Coatings, Diversified, Specialty, and Agricultural Chemicals were bunched together near a 4% absolute loss over the month. The Commodity group was flat in absolute terms but outperformed a declining market. Industrial gases were the big winners on the month among the Chemical subsectors.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Monthly Topic:

We did not white on any topics relevant to the chemical sector over the last 4 weeks, but did publish a
short blog on the Williams situation on June 14th
.

Portfolio Performance

The full June selections are shown in Exhibit 7. It has been our contention for some time that our sectors are not cheap, and the normalized value work supports that. In a rising S&P world, we would expect Industrials and Materials to underperform.

Exhibit 7

Source: Capital IQ and SSR Analysis

We have back tested the methodology from April 2012; we show the results for the current year in Exhibit 8. Results have been mixed in recent months, and thus far in June all three screens have produced negative returns. The overlap has traditionally generated the strongest performance, and this month was no different. Our long side picks have had a tough June to date, as only Monsanto has enjoyed an absolute gain.

Exhibit 8

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Personal consumption expenditures flattened out a bit in the latest data. The actual number trailed estimates but February and March figures were revised up slightly. This is a key area to watch as indicators remain mixed and sentiment is still rather skittish.
  • The trend is still strongly upward but there is concern that the consumer will not be able to continue to keep the larger economy afloat.

Exhibit 9

Exhibit 10

Source: BEA

Construction

  • Construction spending was up slightly in the latest data but has now been flat-lining for several months. February figures were revised down 1% and March numbers were up marginally.
  • After a peak in late 2012, spending could just be experiencing a short term pullback. There is still plenty of upside to pre-crisis levels but near term economic uneasiness could be hindering a continued uptrend.

Exhibit 11

Exhibit 12

Source: US Census Bureau

Agriculture

  • Ag prices saw some sharp declines over the past month. The anticipation of record crops has been driving corn prices lower; they were down 16% since our last report. Soybeans were also off about 8% while Wheat saw a more modest 2% decline.

Exhibit 13

Source: Capital IQ, SSR Analysis

ISM

  • The PMI reading for May came in at 49, the lowest level since June 2009. The index has fallen off sharply after peaking at 54.2 in February, which is particularly uninspiring given the stagnating spending numbers.
  • Inventories rose and production dipped, and the two appear to be at a critical crossing over point.

Exhibit 14

Expansion

Contraction

Source: ISM

Exhibit 15

Source: ISM

Trade

  • Chemical trade volumes continue to be extremely volatile. After several months of strong increases in the trade balance, volumes fell off sharply and the balance turned negative.
  • The dashed line in Exhibit 16 is a rolling 12 month average that cuts through the monthly volatility. The effects of the much discussed US natural gas advantage are indecipherable, as trade volumes remain erratic.
  • The Euro has been relatively flat on the year; the currency story of note has been the devaluation of the yen – Exhibit 17. The Japanese currency is up nearly 25% year on year and ended May above the 100 yen/$ mark.
  • Q2 2013 has seen the dollar weaker versus the Euro by about 2% year over year – Exhibit 18.

Exhibit 16

Source: US Census Bureau

Exhibit 17

Source: IMF

Exhibit 18

Source: IMF

Commodity Fundamentals

Supply/Demand

Ethylene production estimates the second quarter were revised down again by industry experts IHS, following a recent prior negative revision. While prior negative revisions have been accompanied by increases for later quarters, this one has not, supporting our view that demand growth expectations for this year are too high and will be revised down as the year progresses. As
we have discussed in recent research
, demand is disappointing consistently, which we think that it is as much a function of high prices as it is a weaker economy. In both of the charts that follow we include Q2 2013, and the recent uptick is more a function of eliminating a very weak Q1 and Q2 2012 in a 4 quarter rolling average than it is an improving market. We would not expect production in Q3 and Q4 2013 to be meaningfully impacted by Williams as the whole system has room to make up the gap – Exhibit 19. Given the better consumer spending numbers and the better housing numbers in the US we do see some support for the better production levels and without this spending increase we would be concerned that the extra production is going into inventory. Trade data suggests that US production should be getting a boost from demand offshore, but it still appears to be insufficient to drive very high operating rates.

Operating rates are summarized in Exhibit 20.

While the current significant discount in NGL pricing in the US relative to crude oil gives a subset of US producers a meaningful cost advantage over any producer globally using an oil fraction as an ethylene feed, the higher cost producers in the US do not have costs materially lower than the higher cost producers in Europe, Latin America and Asia, at this time. While the plans to add NGL based capacity in the US is predicated on the idea that it should displace crude oil fraction based production outside the US, there is a risk that some of the early victims will be crude oil based producers locally. Looking back at the trade figures above – Exhibit 16 – we are not seeing the lower cost base in the US turn into a meaningful improvement in exports. The trade data is volatile but it is hard to see a positive trend and if we do a 12 month rolling average the line trend is only barely positive.

Exhibit 19

Source: IHS and SSR Analysis

Exhibit 20

Source: IHS and SSR Analysis

Pricing

Energy – Exhibit 21

Prices for both Brent and WTI have fallen off recently, Brent much more so than WTI, but averages for May are marginally above averages for April at this point in the month. Natural gas has retreated from its April high as inventories have surprised a little on the upside in recent weeks.

Exhibit 21

Source: Capital IQ

Natural gas is weak and NGL pricing continues to track down with natural gas, at economics that cover variable costs for extraction facilities but do not cover cash costs. The Williams incident may cause ethane prices to fall more quickly, as while the ethylene industry may be able to make up the volume difference we would be surprised if that can be done from ethane. Ethane margins remain below break-even extraction costs for the average producer and have fallen slightly again in June (prior to any impact from Williams), and have now been negative for 8 months in a row – Exhibit 22. Part of the problem for ethane producers is the price of propane which remains very depressed and makes propane as attractive to many ethylene producers as ethane – this keeps the squeeze on ethane.

Exhibit 22

Source: IHS and SSR Analysis

One thing that we continue to see is the price of NGLs fall relative to crude on a rolling average basis and while they were up incrementally in April and May, they are falling quite quickly in June and have closed much of the gap back to the all time lows we saw in January and February. The longer-term trend remains negative – Exhibit 23.

Exhibit 23

Source: IHS and SSR Analysis

Basic Plastics

Polyethylene remained flat in May, with sellers postponing announced price increases in the face of weaker feedstock and ethylene pricing. Markets are not significantly oversupplied, but the overall demand picture remains weak, more so overseas than domestically. Unless we see some sort of pick up in global demand we would expect the price and margin lines in Exhibit 24 to start moving down from relative stability so far this year.

Exhibit 24

Source: IHS and SSR Analysis

Valuation Charts

The exhibits below show our mid-cycle “normal” valuation framework for the chemical sub sectors and the first exhibit (25) summarizes the results and is a repeat of Exhibit 1.
Exhibit 25

Valuation Charts – Exhibits 26-28

Exhibit 26

Source: Capital IQ and SSR Analysis

Exhibit 27

Source: Capital IQ and SSR Analysis

Exhibit 28

Source: Capital IQ and SSR Analysis

Skepticism Analysis

We have updated the charts and tables from the Skepticism work that we completed in May – see
our past research for more detail
. The primary conclusions are:

  • Specialty and Coatings continue to have valuations that discount an increase in return on capital from current levels. The Commodity and Diversified subgroups both have values that anticipate a fall in returns on capital, while valuation and ROC seem to be fairly aligned for the Ag Chem companies – Exhibit 29
  • Gross margin analysis calls into question whether the coatings sector should be discounting further improvements in returns on capital as the sector is already over-earning. As discussed in previous research, the Coatings sub-sector has consensus estimates for 2013 that do not support the return on capital gains discounted in valuation. Furthermore, the sub-sector has a very good track record of accurate forward earnings projections– Exhibit 30

Exhibit 29

Source: Capital IQ and SSR Analysis

Exhibit 30

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

June 14, 2013 – Ethylene: Unlikely to Be a Quick Fix for Williams
(Blog)

May 13, 2013 – DuPont: Betting the Farm – But Perhaps a Need to Crop the Portfolio?

April 10, 2013 – US Energy Advantage – Unintended Consequence; Global Overbuilding of Petrochemicals

March 6, 2013 – R&D in Industrials and Basics: Just Not Effective

March 5, 2013 – Low Cost US: The Shift is Underway, SLOWLY Reversing a 40 Year Trend
(Blog)

Appendix 1 – Exhibit 1 Analysis

In Exhibit 1 the following apply:

  • Green is good – Red is bad. The more intense the shade of green or red the more interesting or negative the factor looks for the sector.
  • Length of bar – wider signifies more important
  • Arrow direction – “Up” means the situation is becoming more positive from a stock selection perspective. So a green valuation bar with an upward arrow means that the stocks look cheap from a valuation perspective and they are getting cheaper. A red ISM bar with a downward arrow means that the ISM numbers suggest downside and they are getting worse.
  • Arrow size – how significant the move is.

Input Analysis

In the input analysis bar we attempt to show how important the natural gas/oil advantage is for each sector (length of bar); how positive it is (color of bar); and which direction it is moving (direction of arrow).

Demand Analysis

For each of our industry sub-sectors we have taken company by company data and generated an average segment exposure. For some companies this information is provided explicitly and for others we have taken estimates from presentations, annual reports and other sources. The segment break-downs are summarized in the charts below: Exhibits 31 to 35.

Exhibit 31


Source: Company Reports and SSR Analysis

Exhibit 32

Source: Company Reports and SSR Analysis

Exhibit 33

Source: Company Reports and SSR Analysis

Exhibit 34

Source: Company Reports and SSR Analysis

Exhibit 35

Source: Company Reports and SSR Analysis

We have then grouped the categories into buckets for which we can measure growth drivers. Those groupings are summarized in Exhibit 40 below.

The first table summarizes the data in the pie charts above and then shows which market driver we use to model each end market. The second table then breaks each sub sector into these market driver buckets and then adjusts for how much business is in the US and how much is external. We add a factor which we call “trade” which brings into play the US trade balance and the strength/weakness of the dollar.

This analysis then drives the “Demand” section of the schematic in Exhibit 1.

Exhibit 36A

Source: Company Reports and SSR Analysis

  • Note that for the “trade” component, we have arbitrarily assumed that 25% of offshore sales are influenced by the US balance of trade and by exchange rates, while 75% of offshore sales are influenced by the same factors as listed above. It is more than likely that this is a different split for different sub-sectors and this will be a subject for further analysis.
  • Note also that we have done some initial correlation work to look at the impact of the factors below on revenue growth and it does show that sub-sectors with a greater exposure (in our analysis) to the ISM data (for example) have a greater correlation between the ISM numbers and demand growth. This will also be the subject of future research.

Exhibit 36B

Source: Company Reports and SSR Analysis

Valuation Analysis

The valuation analysis draws from our mid-cycle “normal value” work detailed above and our revisions work also detailed above. We have – for the moment assumed that valuation is 60% of the story and revisions is 40% for each sector. We will test this more empirically in the coming months.

Appendix 2

©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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