Chemicals Monthly – Free Falling

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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

January 20th, 2015

Chemicals Monthly Free Falling

  • Brent Crude prices have dropped another 16.5% over the last four weeks, but despite that our commodity group outperformed the S&P 500 by 4.2%. These moves aptly describe the current situation – confused. Instantaneous profitability remains extremely high, but only because free falling chemical prices have for now been matched or outpaced by free falling costs.
  • We are playing special situations within the group, and would generally be quite nervous about the sector with some high valuations in the Coatings area and significant general cost and demand concerns for all sectors in 2015. We like EMN, as we think that valuation more than discounts the possible hedging losses; PX because of valuation and the underlying strong business model, and DD (despite valuation) because we think the activist “cost” argument has significant legs.
  • The Commodity group has bounced off weakness over the last few weeks and the ethylene guys – DOW, WLK and LYB are hovering around fair value. However, oil below $50 makes the rest of the world competitive with the US in export markets, and in a weak demand environment, US margins could fall below normal – suggesting more possible downside in the stocks. Even the ethylene buyers could struggle in a weak demand and low global cost environment.
  • Coatings marched even higher over the last four weeks helped by PPG’s strong earnings report. PPG remains the only member of the group in our view with significant internal levers to pull on the cost/efficiency front and we see less altitude sickness with this name than with others.
  • Chemicals research since our last monthly has included a comprehensive piece on what could happen to the global ethylene cost curve as energy prices weaken and the impact on US profitability. We also published a detailed piece on why we think that EMN’s stock is fully pricing in the risk of hedging losses and is a top pick for 2015.

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:

We feel somewhat different about the space today than we did a month ago, and overall see more risk than opportunity. We are focused on three names that we think are almost special situations on the long side, DD, PX and EMN, and while we still believe that valuations are extremely high in the coatings space, we would not short it today as it is probably seen as a relative safe haven given what is going on elsewhere.

The commodity sector is in turmoil, with oil prices showing more weakness than most expected even a few weeks ago and very little consensus over where prices will be two weeks from now let alone in a year. Current oil, natural gas and co-product prices generate a cost curve that approximates Exhibit 3. Ethylene and propylene prices are falling all around the world as costs come down, but are for the most part lagging. It is estimated that the polyethylene integrated margin in the US today is at least as high as it was in the best months of 2014, because costs have fallen more quickly than prices – Exhibit 4 shows the pace of decline in US polyethylene pricing. It is likely given, supply/demand balances globally that, regardless of oil, chemical/plastic prices would have fallen anyway and that margins would have compressed. If energy prices hold at current levels we would expect to see rapid margin compression throughout the chain over the next few months.

The most interesting factor in the chart below, is that for more than four weeks now we have had propylene prices lagging the decline in energy all over the world. This has boosted margins from naphtha units and for anyone that can get their hands on cheap propane. In the US, ethane is no longer the feedstock of choice, and in Exhibit 5 we borrow a chart from Woodmac’s latest piece showing a convergence of costs from different feedstocks in January. Propane was the clear favorite. Their forecast assumes that co-product will continue to fall relative to energy in the US and that some of this current phenomenon will go away.

Exhibit 3

Source: Wood Mackenzie and SSR Analysis

Exhibit 4

Source: Midstream Business

Exhibit 5

US Ethylene Prices and Costs from Various FeedstocksWoodmac January 17 2015

http://fileserver-prod.woodmac.com/data/files/80/44/1121/DM294/y2015/26579648/excel_files/Graphics_ETH_ST_Template_VO/4/CostandMargins/ethylenecashcostproductioncashcostsunitedstates.png

The more interesting question at this time is who will blink first. Current economics barely support the export of ethylene derivatives from the US let alone capacity additions in the US that would target additional exports.

Today we have the following new ethylene plants in the US past the FID (Final Investment Decision) phase, with all but Sasol having spent hundreds of millions already: Exxon, DOW, CP Chem, Formosa, Oxy/Mexichem, and Sasol. There is a further list of announced plans/projects which have yet to reach FID and these include: Aither, Appalachian Resins, Axiall, Badlands NGL, Hanwha, Indorama, Lotte, Nova, Odebrecht-Braskem, Sabic, Shell, Shintech, Total and Williams. Clearly not all of the planned projects will go ahead, but we would also expect to see some delays or cancellations among those already past the first post if energy prices remain where they are for the medium term.

Our favorite ideas in the space are: DuPont, not because of fundamentals or because of valuation, but because we think the cost opportunity is huge and because the activist is getting traction; EMN, because we think valuation is staggeringly attractive and that once the company clears the air around its hedging liabilities, the upside is significant; and PX, simply based on valuation and the ongoing capital and cost discipline.
Valuation

Exhibit 6 summarizes our valuation work and the subsector classifications are summarized in Exhibit 7. The commodity group outperformed over the last week, bouncing off mid-December lows, but likely has further downside as revisions (post conference calls) reflect a more reasonable assessment of how 2015 will look. Coatings remains a very strong sector from a performance perspective, but as SHW has already shown, estimates are getting quite challenging to meet where there are no cost levers to pull.
Exhibit 6

Exhibit 7


In Exhibit 8, we show sector discount from normal value as measured by our valuation framework, and in Exhibit 9 we show discount by company. Ag Chemical companies continue their reign as the cheapest in our chemicals coverage, mostly due to the continued poor outlook for potash. Coatings remain expensive because of earnings optimism and lower input costs. The spring painting season should give us more color as to whether or not these valuations are justified.
Exhibit 8


Source: Capital IQ and SSR Analysis

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 December Chemicals Monthly. Coatings continues is streak with strong performance also observed in diversified and commodity names. In a reversal from last month, both gases and specialty lagged the S&P. Despite falling crude prices globally, the commodity names were strong with LYB being notable with its announcement of a new CEO.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis
Profitability

Exhibits 12 through 14 show profitability at the sector, subsector, and stock level.

In Exhibit 12 we highlight several companies in green – all are at 10 year or all time peaks in return on capital. RPM and CYT therefore have some earnings support for the valuations noted above, and HUN looks very cheap on current and expected earnings and hence makes our Exhibit 1 screen. SHW is notable in that its valuation above appears largely unsupported by its earnings here.

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. Earnings continue to exhibit strength but the negative revisions highlighted above and the drop in crude prices likely suggest more downside.
Exhibit 13

Source: Capital IQ and SSR Analysis

Exhibit 14

Source: Capital IQ and SSR Analysis

Portfolio Performance

The January portfolio selections are shown in Exhibit 15. With such a short time period to measure performance over, our results look less than stellar. However, historically the names with favorable readings in terms of valuation and our Skepticism Index have produced alpha and this was true in 2014 as well – Exhibit 16.

Exhibit 15

Source: Capital IQ and SSR Analysis

Exhibit 16

Source: Capital IQ and SSR Analysis

 

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • The latest reading from the BEA would suggest that lower oil prices are fueling consumer spending. Spending was up over 0.6% in November though some concerns have emerged about retail spending in the last week or so. Whether or not recent blips can derail a positive trend will be seen as the new year rolls on.
  • The most current data is for the month of November where consumer spending was up again, this time more markedly than the roughly 0.2% gain seen in October. The annualized monthly gain for 2014 stands at 0.26% and could rise should December’s numbers come in strong. These figures would also place 2014 above 2013 which saw average monthly gains of 0.15%.

Exhibit 17 Exhibit 18

Source: BEA

Construction

  • In the Census Bureau’s latest release, positive revisions continue with October and September both seeing upward revisions approaching 1%. With these revisions painting a more positive picture, November’s figure is something of a disappointment, showing a contraction of 0.25% month over month.
  • Construction is up 2.13% for 2014, a departure from the 8% annual growth seen in 2012-2013. With positive revisions all the rage, 2014 may show a rate of growth above 2% but this is still somewhat sluggish.

Exhibit 19

Exhibit 20

Source: US Census Bureau

Agriculture

  • After a couple months of strength in grains, the last month was a marked downturn. Soybeans were down over 5.2% while corn saw declines around 7% and wheat was hit hardest of all, losing some 14% month over month. Weather and the USDA report published at the beginning of the year contributed to the weakness.
  • Our colleague Rob Campagnino sees fewer corn acres planted in the 2014/2015 growing season – see recent research.

Exhibit 21

Source: Capital IQ, SSR Analysis

ISM

  • December continued the volatility seen through 2014 with the PMI falling from 58.7 in December to 55.5 in January, a number we saw earlier in 2014. New orders also declined sharply, from 66 to 57.3 and production saw similar weakness declining from 64.4 to 58.8. These are by far the worst declines in the last 12 months but with only 1 month of negative data after months of positive readings, we are hesitant to put too much stock in them.
  • Negative global growth revisions have continued to pour in over the past few weeks with Europe and emerging markets looking particularly weak. The US remains an asylum for growth amidst this negative backdrop but whether or not this is sustainable is unclear. It is important to remain wary of global concerns such as Japanese recession, Eurozone weakness and the impact of low oil prices on one of the key engines of domestic growth.

Exhibit 22


Source: ISM

Exhibit 23

Source: ISM

Trade

  • The dotted line in Exhibit 24 is a twelve month rolling average. Cutting through the month to month volatility, we see Chemical trade volumes have been flat for the past several years. The recent slowdown can in part be explained by a lack of basic chemical supply in 2014 in the US because of the well documented production issues for ethylene, but it is also interesting to note that China’s imports of polyethylene have stopped growing in 2014, which may be a broad negative signal for export volumes generally.
  • BRIC currency depreciation has been significant recently with the Russian ruble now at all-time lows versus the dollar and the Brazilian real down 10%. Now with 4Q14 in the books, the dollar continues to show its strength – it was 8.2% stronger versus the Euro quarter over quarter – Exhibits below.

Exhibit 24

Source: US Census Bureau

Exhibit 25

Source: IMF

Exhibit 26

Source: IMF

Commodity Fundamentals

Supply/Demand

Please see our December 2013 piece for the way in which we think about ethylene supply/demand and our more recent September update . We remain concerned that high absolute pricing for chemicals are constraining growth. Given the significant production outages in the US in 2014 we would have been in all sorts of supply and pricing troubles had there been robust real demand 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.

As is shown in Exhibits 27 and 28, 2014 had some uninteresting overall ethylene production and operating rates (of nameplate capacity) given the additions to capacity and the expectations that existed at the beginning of the years. Production problems have been the root cause of lower production and they continue. Problems have been well above average this year, limiting the available capacity. This has restricted availability of ethylene which has been seen through lower exports of ethylene derivatives from the US in 2014. Operating ethylene facilities are running at maximum rates and we expect the industry to run on that basis through the end of the first quarter of 2015 to replenish what remain very low inventories. Some companies delayed late 2014 maintenance shutdowns because of the lack of product and 2015 has started with a couple of additional production difficulties, hence our expectation that plants will run full out until the end of Q1 and possibly into Q2. Prices are falling with the decline in oil price, but the market remains quite constrained in early 2015.

More available capacity and higher operating rates starting in Q2 2015 could flood the US market, causing the export push to re-emerge and having a broad negative effect on pricing.

Production is summarized in Exhibit 27 and operating rates are summarized in Exhibit 28. Note that at no point in the forecast period do we see operating rates that would suggest a tight market as in 2000 and briefly in 2005/2006.

 

Exhibit 27

Source: IHS, Wood Mackenzie and SSR Analysis
Exhibit 28

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

Energy – Exhibit 29

Even as we wrote about oil’s decline last month, crude continued its relentless march lower with both Brent and WTI now below $50/barrel. Fundamentals continue to drive price declines as supply remains intact from OPEC countries holding market share and US producers that have yet to react meaningfully, though recent well completion numbers suggest declining US production in the quarters to come. Downward revisions to global growth continue to put a damper on expected demand. See our recent energy launch and accompanying ethylene research for more details.

Natural gas prices in the US are volatile, as one would expect in winter, but volatile around a lower base than we saw a couple of months ago. We remain of the opinion that it will need to be a very cold winter to stop prices weakening even from recent lows.

Exhibit 29

Source: Capital IQ and SSR Analysis

Ethane remains very weak because of limited demand as a consequence of the significant US ethylene plant closures which continue, and because of the slow restart to the Williams unit. Ethane prices are very low, but this has less to do with the availability to crack ethane today and more to do with the greater appeal of propane as a feedstock and the elected reduction in ethane consumption. Propane and propylene pricing in the US create an environment today where ethylene can be produced almost for free. Propane is displacing ethane and ethane extraction margins remain very depressed as a result. Conway and Mont Belview prices are currently close to parity but there have been some wild swings in recent weeks.

Exhibit 30


Source: IHS, Mackenzie Wood and SSR Analysis

Exhibit 31

Source: Midstream Business and SSR Analysis

Propane and Butane prices have moved down with crude and remain the most attractive feedstocks for ethylene today – Exhibit 32. To this end, feedstock cash costs seem to converge on 10 cents/lb in 1H2015 based on data from Wood Mackenzie. This scenario sees flexible crackers producing the highest volume of product as feedstocks continue in their race to the bottom.

Exhibit 32


Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing have followed ethylene, though not as rapidly and integrated polyethylene margins (which applies essentially to every producer) in January may end up higher than the highs of 2014. Note that the contract prices shown in Exhibit 33 are “list” against which there are significant discounts depending on customer scale. Today, the spot market for HDPE is in the $0.62-0.65 cent per pound range and is no longer at a premium to “net” contract pricing. Also note that major consumers of polyethylene had 30 day price protection and some even have longer periods. Consequently, November/December decreases will have more of an impact on numbers for LYB, WLK and DOW in Q1 rather than the earnings soon to be announced for Q4 2014.

Exhibit 33

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 (34) summarizes the results and is a repeat of Exhibit 6.
Exhibit 34

 

Valuation Charts – Exhibits 35-37

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36


Source: Capital IQ and SSR Analysis

Exhibit 37

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:

  • Exhibit 38 shows each subsector’s Skepticism Index value. We found a data reference error in our model and have been understating the SI for the commodity group for some time. The sub sector SI is at an all-time high given that the companies are still earning well above normal levels of profit and expectations are that this will for the most part continue. The stock sell off however is a clear indication that investors think estimates are set to fall. Exhibit 39 shows R2 by subsector, measuring the extent to which valuation is explained by return on capital. Exhibit 40 shows that only commodities as a sub sector has a major disconnect between stock values and earnings. In Exhibit 41, EMN is the standout, with valuations discounting a collapse in earnings and far more of a collapse than can be explained by the limits of possible feedstock hedging losses.

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41

Source: Capital IQ and SSR Analysis

Recent Chemicals Research

December 9, 2014 – Weaker Global GDP Suggests Some Heroic Expectations/Assumptions

January 13, 2015 – Own Goal Investing – EMN Presents Another Opportunity

January 12, 2015 – Favorites for 2015 & Industrials & Materials Methodology Review

January 5, 2015 – The Ethylene Conundrum: EMN the Value Play

December 8, 2014 – LYB and DOW – A Holiday Present From Europe With Interesting Implications

December 4, 2014 – LyondellBasell and Westlake – Not Yet!

November 24, 2014 – Praxair – An Unusual GARPY Opportunity
November 11, 2014 – Eastman: A Good Story, But At Risk Of A Complexity “Own Goal”

November 6, 2014 – Capital Allocation – Why The Activists Are Where They Are

October 31, 2014 – The Power of Positive Thinking – APD and the DD read-through

October 16, 2014 – Commodity Chemicals – Overdone? Maybe Not

October 2, 2014 – DuPont Can Be a Bad Stock: If Trian is Right, But Gives Up

September 23, 2014 – Why 2015 Could Be a Short Sharp Storm for US Ethylene

September 17, 2014 – Rising Dollar and Falling Crude: Bad For Commodity Chems

September 11, 2014 – Oil: The Big Uncertainty for US Chemicals (blog)

September 9, 2014 – Marcellus Opportunity: Why We Should See More Chemical Investment

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 42 to 46.

Exhibit 42

Source: Company Reports and SSR Analysis

Exhibit 43

Source: Company Reports and SSR Analysis
Exhibit 44

Source: Company Reports and SSR Analysis

Exhibit 45

Source: Company Reports and SSR Analysis

Exhibit 46

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 47 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 47A

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 47B

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

©2015, 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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