Chemicals Monthly – Energy Volatility Distracts

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Graham Copley / Nick Lipinski



November 15th, 2013

Chemicals Monthly – Energy Volatility Distracts

  • It has been a mainly positive earnings season for the Chemicals space, with surprises predominantly to the upside and revenues up 6% year over year. Q4 guidance has been mixed however, and several companies (notably the major industrial gas players) have cited stagnant US industrial production.
  • Earnings beats led to outperformance in all subsectors save Commodity (weighed down by weakness from DOW despite revenue growth for the group overall) and Industrial Gases (guided Q4 lower). Coatings, the most richly valued subsector, enjoyed strong gains yet again, led by a 10% move higher for PPG, which remains our favored way to play an otherwise expensive sector.
  • We have seen more volatility in oil prices recently as the market weighs fundamentals (demand versus cost of supply) against possible changes in political risk. With WLK, AXLL and LYB fully reflecting the feedstock advantage in the US, in our view, we would expect greater stock volatility in response to relative moves in natural gas and crude going forward.
  • Recent Chemicals research has highlighted Lyondell, PPG, and restructuring possibilities at Dow and DuPont.
  • Chemical sector preferences are outlined below at the subsector and stock level.

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.


The Chemicals sector as a whole reported positive earnings surprises, beating estimates by 5% on average. Revenues for the group were up 6% year over year, but at the subsector level there was considerable divergence. Specialty Chemical companies saw the strongest revenue growth, Agricultural the weakest – Exhibit 3. Major Industrial Gas players ARG and PX guided down for Q4 2013, with stagnating US industrial production the culprit .

In Exhibit 3 we also show growth expectations for Q4 2013. Before we get too excited about the Diversified projection we should note that Q4 last year marked the real step down in TiO2 pricing and volumes and so this year it is a relatively easy comp for all. The negativity around Ag remains significant but in part this is a potash problem and should not extend to the core businesses at DD and DOW.

Exhibit 3

Source: Capital IQ and SSR Analysis


Exhibit 4 summarizes our valuation work.

Exhibit 4

The group composition is summarized below. As noted in our piece on transformational change from August , we have adjusted the group constituents, changing EMN from a Diversified to a Specialty company.

Exhibit 5

Exhibit 6 shows subsector discount from normal value in standard deviations.

Exhibit 6

Source: Capital IQ and SSR Analysis

In Exhibit 7, reproduced and updated from our recent comprehensive Chemicals report , we show company discount from normal value as measured on our framework. WLK, RPM and LYB are outliers on the expensive side, each at a 10 year or all time valuation peak (PPG and ARG are within 5% of 10 year highs and are highlighted as well). On the flip side, no companies are at all time valuation lows – OLN was last month, but made a move to the upside following earnings.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibits 8 and 9 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our October Chemicals Monthly.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

Monthly Topics: Valuation Dispersion

Earlier this month we published a comprehensive piece on the Industrial and Materials laggards for the year and how they were beginning to play catch up. The broad topic is summarized below and we then look specifically at Chemicals.

Regardless of what the broader market does for the balance of the year, within Industrials and Materials we would expect the laggards to play catch-up with the leaders. Moreover, we have seen some anecdotal evidence of nerves at the top (MWV, LYB, IP) and relief or more confidence at the bottom (FCX, AA, CAT) as we have gone through the earnings season.

Today, the divergence of valuation across the Industrials and Materials group is at a 13 year high as shown in Exhibit 10. Note that in this analysis we are looking at 131 companies and consequently one or two that could be argued to have changed their business models permanently are not going to influence the conclusion. The spread is greater than it was in late 2007 and the following correction was significant. In this analysis we are looking at the “deviation from normal value” for each company, and plotting effectively the dispersion as measured by the standard deviation of the results – see the full research note for a complete definition .

Exhibit 10

The undervalued larger cap names in our coverage are summarized in Exhibit 11, and in Exhibit 12 below we show how the 30 most undervalued on January 1st 2013 (regardless of market cap) have performed on an absolute and relative basis each quarter.

Exhibit 11

Source: Capital IQ and SSR Analysis

After lagging a very strong market in the first half of 2013, the cheapest Industrial and Basics stocks outperformed in Q3 and this has continued thus far into Q4. The initial underperformance and the subsequent turnaround have been driven by the Metals sector – early laggards (notably X and CLF) have led the way higher in the second half of the year. AA has been one of the big winners a month into Q4, up 17% versus the S&P and approaching $10 a share after spending much of the year as the most undervalued stock in our universe.

Exhibit 12

Source: Capital IQ and SSR Analysis

The Picture Is a Little Different for Chemicals

Firstly, the divergence is not as broad as it is for the larger group; in fact it does not look overly concerning – Exhibit 13.

Exhibit 13

Source: Capital IQ and SSR Analysis

The undervalued stocks at the beginning of the year have generally done well and kept pace with the broader market – Exhibit 14 – despite significant negative revisions – Exhibit 15. However, this group does include both DuPont and Air Products.

Exhibit 14

Source: Capital IQ and SSR Analysis

Exhibit 15

Source: Capital IQ and SSR Analysis

Unlike the broader group and ignoring the first quarter, the value stocks at the beginning of 2013 have seen worsening revisions relative to the valuation leaders as the year has progressed. Again the data is being influenced by APD and DD.

Exhibit 16

Source: Capital IQ and SSR Analysis


Exhibits 17 through 19, also repeated and updated from our state of the industry report , are new to the Chemicals Monthly and show profitability at the sector, subsector, and stock level.

In Exhibit 14 we have highlighted those companies at or near earnings highs – no companies screen at earnings lows on these time frames. WLK and ARG were also highlighted in the corresponding valuation exhibit (Exhibit 7) – record valuations are at least partly justified by record earnings.

Exhibit 17

Source: Capital IQ and SSR Analysis

Exhibits 18 and 19 show the net income margin for the Chemicals sector as a whole and for the individual subsectors, respectively.

Exhibit 18

Source: Capital IQ and SSR Analysis

Exhibit 19

Source: Capital IQ and SSR Analysis

Portfolio Performance

The October selections are shown in Exhibit 20. DD remains attractive despite its recent performance, but this is partly because it is hard to find a cheap stock anywhere in the sector today.

Exhibit 20

Source: Capital IQ and SSR Analysis

We have back tested the methodology and show the results for the current year in Exhibit 21. Results have been mixed in recent months. In a pattern similar to that exhibited by our portfolio selections for the broader Industrial and Basic Materials group, year to date returns have been most robust for the overlap screen (9.0% in excess of the market, exclusive of transaction costs). The Skepticism Index screen has performed decently as well (5.1%), while the valuation screen has trailed the market (-4.2%).

Exhibit 21

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Personal consumption expenditures continue to rise steadily in the latest data through September. July figures were revised down by a fraction of a percent and the August number was revised up similarly.
  • In the four years since the September 2009 low, expenditures have grown at a compound annual rate of 2.3%, slightly below the rate of the four year period preceding the 2007 spending peak (2.8%)

Exhibit 22

Exhibit 23

Source: BEA


  • The September update to the Census Bureau’s construction spending report has been delayed due to the recent government shutdown, and will be released in early December along with the October results.
  • Data through September show a continuation of the recent uptrend. The monthly increase through 2013 year to date has been 0.4%, down from a 0.6% monthly gain in 2012. Nonetheless, construction spending in August reached an annual rate not seen since April 2009.

Exhibit 24

Exhibit 25

Source: US Census Bureau


Exhibit 26

Source: Capital IQ, SSR Analysis


  • The latest PMI reading for October showed continued strength, ticking up slightly to 56.4, firmly in expansionary territory. We have some reservations about industrial activity for the duration of the fourth quarter, as several chemical companies with typically strong gauges on production have been cautious.
  • Since the largest gap in recent history opened up between production and inventories in July, production has dropped off and inventories have risen.

Exhibit 27

Source: ISM

Exhibit 28

Source: ISM


  • Chemical trade volumes continued their pattern of spiking up and down in consecutive months, and were up sharply on the month, though below the peak from earlier in the year. The dotted 12 month rolling average is beginning to trend up slightly but is far from strong.
  • The Japanese Yen and the Indian Rupee have suffered the most over the past year, down 24% and 13%, respectively, versus the dollar. Thus far, Q4 has seen the dollar weaker versus the Euro by nearly 5%– Exhibit 31.

Exhibit 29

Source: US Census Bureau

Exhibit 30

Source: IMF

Exhibit 31

Source: IMF

Commodity Fundamentals (unchanged from last month)


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

In both of the charts that follow we include IHS’ revised forecaster for the balance of 2013. IHS has made a significant positive revision to its estimate of Q3 production in the US, lifting operating rates to a healthy 92% of nameplate capacity. Interestingly they have not made a similar change to expected demand in Q3 and are instead showing an ethylene inventory build, which is repeated in their Q4 forecast. Producers suggest that operating rates are high, but neither domestic demand growth nor trade data is very supportive of the idea of a better market today. Note that while production is improving, operating rates are not.

Capacity is expected to grow by close to 2 billion pounds in 2014 versus 2013, which means that demand needs to grow by more than 3.0% in 2014 just to maintain current operating rates. According to IHS, US ethylene demand grew by 2.6% in 2012 and will be essentially flat in 2013.

Production is summarized in Exhibit 32 and operating rates are summarized in Exhibit 33.

Exhibit 32

Source: IHS and SSR Analysis

Exhibit 33

Source: IHS and SSR Analysis


Energy – Exhibit 34

The Middle East continues to dominate the crude oil story but Brent is off its highs and is bouncing round $110 per bbl. Natural gas has seen a recent spike based on cold weather and a surprising inventory number but remains relatively cheap.

Exhibit 34

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 this year, margins have now been negative for 13 months in a row – Exhibit 35.

Exhibit 35

Source: IHS and SSR Analysis

Butane continues on its more positive trend associated with the usual winter gasoline blending season and while propane is no longer declining relative to crude it is fairly stable and at an all time low (the line continues to decline in the chart as it is a 12 month average). This propane value in the US continues to create great incentive to export US propane to Europe as an ethylene feed, where logistics and feedstock flexibility exist. Ethane is now by far the most attractive feedstock for ethylene production. Ethane has not weakened further relative to natural gas. The longer-term trend relative to crude remains negative – Exhibit 36.

Exhibit 36

Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing is higher in the US, with producers achieving increases in September and holding on to them so far. Markets are not significantly oversupplied, but there is no shortage of product and 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 37 to start moving down from the recent rise.

Exhibit 37

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 (38) summarizes the results and is a repeat of Exhibit 4.
Exhibit 38

Valuation Charts – Exhibits 3941

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41

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. Agricultural Chemical stocks are right in line with historical earnings but investors are discounting a fall in returns. See Exhibits 42 and 43.
  • PPG and LYB are highlighted in red in Exhibit 44, with skepticism index values within 5% of all time lows for each company.

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44

Source: Capital IQ and SSR Analysis


Recent Chemicals Research

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 45 to 49.

Exhibit 45

Source: Company Reports and SSR Analysis

Exhibit 46

Source: Company Reports and SSR Analysis

Exhibit 47

Source: Company Reports and SSR Analysis

Exhibit 48

Source: Company Reports and SSR Analysis

Exhibit 49

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 50 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 50A

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 50B

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

Source: IHS and SSR Analysis

©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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