Chemicals Monthly – A Volatile Market But Stable Energy

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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

April 15th, 2014

Chemicals Monthly A Volatile Market But Stable Energy

  • Some Chemical stocks are off their recent highs, along with the market, but valuations in Coatings, Specialty and Commodity Chemicals are still elevated. This is heading into what could be a Q1 earnings season filled with weather-driven weakness and perhaps some negative guidance for those levered to natural gas.
  • The group as a whole has underperformed the market over the past month, with the exception of relative strength in the Diversified subsector. Coatings and Industrial Gases were the two sectors most impacted by the market downturn, with APD and SHW most negative.
  • While the winter is behind us in the US, natural gas prices are supported by the very low level of inventory and the need for more production to replenish inventories. Q1 earnings will provide some color on the impact of higher energy costs throughout the winter months – natural gas prices were $1 per MMBTU lower in Q1 2013 than in Q1 2014.
  • Since our last Chemicals monthly, we highlighted peak valuations in some commodity chemical names, noted our opinion on the basic chemical investments in the US, explored the global agricultural complex in depth and with specific respect to Ag Chemicals, and summarized our takeaways from the recent IHS World Petrochemical Conference.
  • Chemical sector preferences are outlined below at the subsector and stock level. Note that we have moved the Commodity group to underweight, but move AXLL to our preferred list within the subsector – see recent research referenced above. Our agriculture related work has also made us more favorable on MON.

Exhibit 1

Source: SSR Analysis

Exhibit 2

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

Overview

As we wrote earlier in the month, unmatched optimism from the US companies and unmatched pessimism from the Europeans. This is probably the best way to describe the IHS industry gathering (an event that I have been attending in Texas off and on for the last 26 years). The Americans are more optimistic than they were in the late 1980s. That was a period of misplaced confidence because the US did not have much of a cost advantage and the Middle East was emerging. Today, even taking into account the lessons of the past, it is hard to poke holes in the optimism – which in our mind makes it far more dangerous.

We remain very concerned that the consensus view of forward demand is incorrect, with consensus choosing to use an historic ratio to GDP growth which has clearly been incorrect for the last three years. As we have written now ad-nauseam, price elasticity explains the breakdown of the relationship and all forward estimates have pricing as high as it is today or higher for many years. This will continue to encourage recycling and down-gauging and cut into organic growth. Consensus views do not have high operating rates at any point in the future and if demand growth is out by 100-150 basis points a year, the operating environment will look increasingly poor as new US capacity is commissioned. In such an outcome, you could see North America, the Middle East and possibly China trying to move incremental molecules to Europe and Latin America.

None of this will happen without real price pressure, everywhere, and it is unreasonable and naïve to assume that European higher cost producers will simply roll over to accept imports. In the chart we show our base case for operating rates and how they would look in a 2.5% growth environment – versus the historic average of 4.15%. Note that the global operating rate does not decline to the lows seen in the early 80s even in a lower growth environment. As we indicated in research last month, if the US loses its competitive feedstock position, much of the surplus would be in the US and US operating rates could return to their lows of the early 1980s.

The exhibit below shows the impact on global operating rates of a lower longer-term growth rate for global ethylene demand – in line with what we have experienced for the last three years.

Exhibit 3

Source: IHS, Wood Mackenzie and SSR Analysis

We appear to be through the winter in the US, but natural gas prices are being supported by the very low level of inventory and the need for more production to replenish inventories. Exhibit 4 where US natural gas inventories are today versus recent history – roughly half of the low end of the five year range. A great deal of faith is being placed in the industry’s ability to ramp up production as previous significant lows in inventory have driven prices much higher than they are today.

As we stand, Q1 2014 natural gas prices averaged more than a full dollar per MMBTU higher than they did a year earlier – $4.55 versus $3.51. This has put significant upward pressure on costs and we still expect some disappointments as companies report their first quarter earnings. We think that investors for the most part are expecting some earnings shortfalls, but if current natural gas prices cause companies to be more cautious for the second quarter, we could see a more significant stock reaction.

Exhibit 4

Source: EIA

In addition, we will see some Q1 sales pushed into Q2 because of the severe weather and some sales lost altogether. Again, many of the companies have done a reasonable job of telegraphing the issue and the stock market does not seem to care.

Our view of the world has not really changed and while we might be a little bit more bullish on demand in the US for the rest of the year, we could go either way in Europe depending on whether the issues with Russia escalate or are resolved. We are marginally less bullish on Asia (China) and the concern here is the balance of trade swings here can have meaningful impact on the rest of the world – China as a marginal (occasional) exporter of surplus commodity chemicals would be destructive for pricing in the region and this would have knock-on effects for Europe and possibly the US.

As we stated last month, we still believe that the commodity chemical industry in the US is in for a bit of an earnings shock this year and given the lofty valuations, there could be trouble ahead.

Finally, we highlight the outperformance of PX since we noted its
relative attractiveness to APD
. We still see further upside in this trade.

Exhibit 5

Source: Capital IQ, SSR Analysis

Valuation

Exhibit 6 summarizes our valuation work. Revisions have been modest in the month leading up to earnings announcements. Coatings companies are most likely to respond poorly to an earnings miss and/or lowered guidance, due to the valuation premium of the group as a whole and its constituent members. Commodity names are
not cheap
either, and we have noted
our cautious outlook for Q1
.

Exhibit 6

The subsector classifications are summarized in Exhibit 7.

Exhibit 7

Exhibit 8 shows subsector discount from normal value in standard deviations.

Coatings and Ag Chem remain the expensive and cheap outliers, respectively, and Diversified remains inexpensive by virtue of DuPont’s relative attractiveness. Of the Agricultural stocks, MON and MOS are each roughly 1 SD below normal, SMG is the polar opposite at 1 SD above norm, and CF is about fairly valued.

Exhibit 8

Source: Capital IQ and SSR Analysis

In Exhibit 9, reproduced and updated from
our past comprehensive Chemicals report
, we show company discount from normal value as measured on our framework. The left side of the chart still has a fair amount of red, even as several companies have retreated from their all time or 10 year valuation highs. These include SHW, WLK and PPG. LYB has a short history but has performed well lately and remains at its highs.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibits 10 and 11 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our March Chemicals Monthly.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 12 through 14, also repeated and updated from
our state of the industry report
, show profitability at the sector, subsector, and stock level.

In Exhibit 12 we have highlighted those companies at or near earnings highs – no companies screen at earnings lows on these time frames. High valuations in Coatings are to some measure supported by above normal earnings.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibits 13 and 14 show the net income margin for the Chemicals sector as a whole and for the individual subsectors, respectively.

Exhibit 13

Source: Capital IQ and SSR Analysis

Exhibit 14

Source: Capital IQ and SSR Analysis

Portfolio Performance

The April selections are shown in Exhibit 15. DD is now just outside the top five in the long side valuation screen. The short side screens predictably reflect high valuations in Coatings and Specialty chemicals.

Exhibit 15

Source: Capital IQ and SSR Analysis

Our portfolios have recovered from a rough first two months of the year. March was a solidly positive month, and April performance is mixed thus far through the month.

Exhibit 16

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Consumer spending continues to rise, reocvering from the first even slight decline in some time – Exhibit 17. December, November and October estimates were also marked up marginally. January’s preliinary estiamte was little changed and February showed a climb higher.
  • With December revised up, consumption expenditures were up 2.2% January through December 2013 versus a similar 1.9% gain in 2012. The post crisis trend has seen PCE rise at a 2.4% compound annual growth rate, compared with a 3.6% CAGR from 1999 to 2007 – Exhibit 18.

Exhibit 17 Exhibit 18

Source: BEA

Construction

  • Construction spending has plateaued in recent months. December (+0.5%) and January ( +0.2%) figures were revised up.
  • After bottoming out following a long period of decline in the aftermath of the housing crisis, construction rebounded at a 6.4% annual clip over 2011 and 2012 – most of this growth came in 2012 when spending rose 8.1%. The upward lift for December brought 2013’s growth to 7.1%, and the solid uptrend remains intact. At a 7% annual growth rate, we would not reach the 2006 construction spending peak until fall of 2017.

Exhibit 19 Exhibit 20

Source: US Census Bureau

Agriculture

  • Ag pricing was up sharply after the USDA released data on prospective plantings. Corn rose to $5 per bushel as intended acres planted came in lower than estimated, at the lowest level since 2010 – this will still be the fifth largest corn crop since 1944. Pricing has encouraged farmers to shift acreage away from corn and towards soybeans, and indeed soybean acres came in at a record level, though also below consensus.
  • See our colleague Rob Campagnino’s work on the implications of the EPA’s renewable fuels mandate with respect to ethanol.
  • Also see our blogs on potash, where we remain quite negative in terms of the longer-term pricing outlook.

Exhibit 21

Source: Capital IQ, SSR Analysis

ISM

  • US PMI continued to improve from a sharp dip down to start the year. The March figure was up slightly to an expansionary level of 53.7. New orders were stronger as well.
  • Production bounced strongly off of recent lows that had dipped the sub-index into contractionary territory. Inventories held stable. We would expect indicators to remain strong in Q2 given the pent up demand that the notably harsh winter likely fostered.

Exhibit 22

Source: ISM

Exhibit 23

Source: ISM

Trade

  • Note we have updated our trade chart to exclude Medicinal & Pharmaceutical products from the broader Chemicals categorization – this more accurately reflects the companies in our coverage. The resulting chart still shows significant volatility, but also a high level of surplus – including Medical & Pharma, the balance has been bouncing between surplus and deficit.
  • Year over year the Russian ruble has been the hardest hit of major currencies, down 14.5% versus the dollar – continuing sanctions in the aftermath of the Crimea grab have exacerbated this decline. Fellow BRIC currencies, the Indian rupee and Brazilian real, have also devalued by over 10%5 each over the past year. Q1 2014 saw the dollar 3.8% weaker versus the Euro year over year – Exhibit 26.

Exhibit 24

Source: US Census Bureau

Exhibit 25

Source: IMF

Exhibit 26

Source: IMF

Commodity Fundamentals

Supply/Demand

Please see our December piece on US ethylene demand for our recent more detailed perspective. We remain concerned that high absolute pricing for chemicals are constraining growth.

Note that we have made a change to our external data source in 2014 and that we are now using chemical market data from Wood Mackenzie. The supply/demand data for 2013 is very similar to that of IHS and we have not changed our historical data.

Capacity is expected to grow by more than 2 billion pounds in 2014 versus 2013, which means that demand needs to grow by more than 3.5% in 2014 just to maintain current operating rates. Note that Wood Mackenzie expects almost no production growth in 2014 and declining operating rates.

US ethylene inventories remain very high and this is keeping downward pressure on spot ethylene prices.

Production is summarized in Exhibit 27 and operating rates are summarized in Exhibit 28.

Exhibit 27

Source: IHS and SSR Analysis

Exhibit 28

Source: IHS and SSR Analysis

Pricing

Energy – Exhibit 29

Russia now dominates the energy headlines, but there has not been much of a reaction in the crude markets – Brent oscillating between $105 and $110 per barrel. If there is any direction in March it is slightly negative. WTI is also slightly lower in March, but the gap with Brent has reduced. Natural gas’ recent spike based on cold weather and lower inventory numbers has eased, but prices remain well above last year’s levels. The US will need to rebuild a great deal of inventory over the next few months and prices may not slide back to lows of last year for a while as a result.

Exhibit 29

Source: Capital IQ and SSR Analysis

NGL pricing continues to track natural gas, at economics that cover variable costs for extraction facilities but do not cover cash costs. Ethane margins remain below break-even extraction costs for the average producer. While there has been a recovery from the low in June of last year, margins have now been negative for a year and a half and there is no expectation that this will change, as those operating fractionators are driven by the need to move ethane out of the gas stream rather than the economic benefit of the process itself – Exhibit 30.

Exhibit 30

Source: IHS, Mackenzie Wood and SSR Analysis

Propane prices have reversed quickly in the last month, dropping as much as $30 per gallon. Despite higher ethane pricing and lower propane pricing, ethane is still the preferred feedstock for ethylene by a wide margin. The chart below is a rolling average and the much lower march price for propane is still higher than the moth it replaced in the calculation, hence the continuing upward trend. The blending season for winter gasoline is coming to an end and butane prices are also lower, despite higher natural gas, though not as dramatically as propane. The propane value in the US continues to create incentive to export US propane to Europe as an ethylene feed, despite better prices in the US, where logistics and feedstock flexibility exist – this is expected to continue and put a floor under US propane prices well above its break-even as an ethylene feedstock in the US versus ethane. The longer-term trend relative to crude remains negative, but is turning and is unlikely get much lower – Exhibit 31.

One recent change that is relevant is the significant increase in ethane prices at Conway – tis impacts the mid-west cost for the units operated by LYB and WLK. March ethane prices in Texas are around 22% higher than December, whereas Conway looks like more than 75% higher. This is a small share of ethylene capacity for LYB and WLK, around 20% or US capacity for both. Conway ethane price remain higher through April and are at parity with the gulf coast

Exhibit 31

Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing has risen in the US with a 4 cent increase pushed through in February, bringing integrated margins back to the level seen in November of 2013. The price increase was helped by weather related supply disruptions and may not last long if Q1 consumer demand was also weak because of the weather. High inventories at the customer will generally result in price weakness going forward. Further attempts to increase prices appear not to been successful.

It looks like polyethylene demand in the US and Canada barely increased in 2013 (see our views of on plastic demand and absolute levels of pricing. The overall demand picture remains weak, more so overseas than domestically.

Exhibit 32

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 (33) summarizes the results and is a repeat of Exhibit 6.
Exhibit 33

Valuation Charts – Exhibits 3436

Exhibit 34

Source: Capital IQ and SSR Analysis

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36

Source: Capital IQ and SSR Analysis

Skepticism Analysis

We apply the framework from our skepticism analysis on the broader Industrials and Basic Materials sectors to the Chemical space – see
our past research for more detail
. The primary conclusions are:

  • Diversified Chemical companies are over-earning by roughly one standard deviation, yet are some of the cheapest in the Chemicals space, giving the group the highest Skepticism Index value – most of this is driven by DuPont. Agricultural Chemical stocks are only slightly under their historical earnings trend but investors are discounting a fall in returns. The Specialty group is being afforded a high valuation premium despite earnings that are actually slightly below the long term trend. See Exhibits 37 and 38.
  • POL joins LYB as the only companies at all time lows on our Skepticism Index; investors are discounting further improvements in already strong returns.

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

March 31, 2014 – Petrochemical-Fest: A Summary of the Texas Gathering

March 24, 2014 – Seeding a Better Investment

March 23, 2014 – Why the Basic Chemical Investments in the US Will Likely Disappoint

March 19, 2014 – Peak Valuation in Some Commodity Chemicals – Something to Watch

March 5, 2014 – APD: Time to Move to the Sidelines – PX More Interesting

February 24th, 2014 – Dow: A More Optimal Path, But a Hard Destination to Reach

February 17, 2014 – Dow: Loeb versus Liveris – Watch From A Distance

February 9, 2014 – Rising Natural Gas Prices and Rising Commodity Chemical Company Estimates: How Can This Be?

January 9, 2014 – Chemicals Companies in 2014

December 30, 2013 – DD: Still An Interesting Investment

December 16, 2013 – US Ethylene: The Case for a Better 2014

December 10, 2013 – Exporting Shale: A More Logical Perspective

November 18, 2013 – The Recommendation Signal: Another Reason to Look at DuPont

November 7, 2013 – Lyondell: Growth or Income, Both Have Risk

November 7, 2013 – DuPont: An Unusual Stake in the Ground (blog)

October 29, 2013 – PPG: What Do You Have to Believe

October 21, 2013 – Common Sense Restructuring: Some Money to Be Made

September 23, 2013 – The State of the US Chemical Industry

September 15, 2013 – Optimism and Forecasting in the Chemical Industry

August 5, 2013 – Understanding Transformational Change: The Eastman Example

August 5, 2013 – Potash: Breaking Up Apparently Isn’t That Hard to Do
(Blog)

July 25, 2013 – DuPont: Getting Appropriate Value for the Growth Engine

June 19, 2013 – Complexity, Volatility, and a Market Where Neither Extremes Work Well

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

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

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 40 to 41.

Exhibit 40


Source: Company Reports and SSR Analysis

Exhibit 41

Source: Company Reports and SSR Analysis

Exhibit 42

Source: Company Reports and SSR Analysis

Exhibit 43

Source: Company Reports and SSR Analysis

Exhibit 44

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 45 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 2.

Exhibit 45A

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 45B

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

©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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