Chemicals Monthly – Race to the Bottom

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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

December 17th, 2014

Chemicals Monthly Race to the Bottom

  • Things have moved faster than we expected for commodities – spot prices have fallen quickly for ethylene in the US but costs have fallen faster for all feedstocks but ethane. US producers using propane and butane as feedstocks today are getting ethylene for free! Stock prices have not fallen fast enough to reflect the December competitive landscape, but that landscape is unlikely to persist.
  • With WTI now under $55/barrel, the economics of numerous chemical investments will be called into question. This spills into new ethylene capacity, new derivative capacity and particularly, ethane and ethylene exports. With a highly uncertain price outlook for oil, forward guidance will be hard to trust beyond the immediate future.
  • The Commodity group has fallen off dramatically due to oil and spot ethylene price declines but the negative revisions for 2015 have a lot further to go in our view. Some stocks, like LYB are trading below normal value but we are not yet ready to close our eyes and buy – the environment is uncertain and the stocks not cheap enough to offset the risk.
  • Coatings stocks have been strong of late and the subsector is near a thirty year valuation peak, warranted to an extent by record earnings and consolidation. This is the only group with positive revisions but they may see an inflection point starting with SHW’s recent downward guidance.
  • Chemicals research since our last monthly has included: the acknowledgment of further downside in Commodity names even as valuations normalize, a company specific piece on PX (a growth at a reasonable price opportunity) and a short term piece on LYB and DOW Also see our blog on these ethylene names.
  • Chemical sector preferences are outlined below at the subsector and company levels. DD remains our company of choice, but we believe EMN increasingly warrants attention – see recent research. PX also has upside as it stands above its gas peers. AXLL remains the most positively exposed to lower ethylene prices

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

Opportunities probably still abound in the Chemicals space (note our revised bullets below) but it is an act of real bravery today to step in front of the macro signals, with oil prices collapsing and economic growth estimates being revised downwards steadily outside the US, suggesting poor non-US growth and a stronger dollar. Our favorite topic of discussion continues to be the commodity chemicals names but now for new reasons: valuations have normalized (and very very quickly) yet we believe that downside remains to the extent that 2015 may be a particularly bumpy road should ethylene prices spot persist in their current range and European ethylene costs remain close to current levels..

Last month we discussed the myriad opportunities available to market participants and these mostly exist as they did at the time of our last writing . However, the discourse about energy has dominated the other themes in the space and we therefore see it fitting to discuss the Commodity names and other related ideas. With revisions down only 6% over the last six months for these names, there is a lot further to go as values discount something much worse for 2015.

  • Lower ethylene prices follow lower oil prices. Both WTI and Brent are now down over 45% from their mid-Summer peaks and ethylene prices have been routed as well, with US spot prices falling from over 70 cents per pound at the peak in September to below 40 cents today – still not low enough to effectively compete with current European costs.
  • As oil prices fall, European ethylene makers benefit in that their feedstocks are primarily naphtha based (more closely resembles oil) while the US has recently favored ethane (more closely resembles natural gas). Naphtha prices have tumbled to $575/ton, down 40% from their June highs. Ethane is down 20%.
  • Naphtha produces higher volumes of co-products given that it contains molecules with more carbons which can be split into numerous smaller hydrocarbons (butadiene, propylene, etc.) Ethane based production in the US only produces hydrogen as a co-product which is not nearly as valuable as the credits European producers are earning. US ethylene producers using propane and butane as feed have ethylene costs at or below zero today – unsustainable but frightening.
  • Therefore, the cost advantage that US ethylene producers had from low cost ethane is being eroded and their relative results could be much impressive on the international stage in 2015.

It is because of these dynamics that we have unfavorable views of LYB, WLK and DOW. LYB and DOW may benefit from unusually high margins in their European operations from 4Q but market participants with a longer term horizon may look past this to their downward revisions for 2015. LYB is below normal value today and DOW also, though by a smaller margin. Buying the stocks today may look OK in 9-12 months, but may look quite bad in 2-3 months or even 2-3 weeks, depending on oil.

Praxair is a value opportunity in the gas space that we are surprised to see given its strong business model, history of generating returns for shareholders and generally industry leading growth. Currently, the company is cheap when compared to its own history, APD, the chemicals sector and the industrials and materials sector. It appears that PX has been left behind given the turmoil in the chemicals space, creating an opportunity especially if low oil can spur growth in Europe and China. APD and ARG do not trade at the same discount that PX does despite their similar outlooks.

While we have not written about paint for some time, the sector has continued to rise and now carries the highest multiples in our chemicals coverage with both SHW and RPM at or near all-time highs. In 2013 we discussed the assumptions necessary to justify these valuations- there continues to be a disconnect between valuations and returns, which would have to rise considerably from what are already record levels to support the premiums seen.

Our other recommendations have remained intact from previous months:

  • We remain underweight commodities – we would be sellers of Dow on the ethylene story were it not for the activism – the activism would probably make us a buyer at the margin. LYB meanwhile may have value in the short term but such calls are notoriously difficult and its outlook for 2015 is largely negative on what could be dramatically lower ethylene prices. This is also true for WLK and it does not have the short term benefit of Europe as a saving grace.
  • Diversified remains the more interesting undervalued group – TiO2 is part of the issue, but it is at the bottom of the cycle. We like both DD and HUN.
  • EMN is the most interesting specialty name – see recent research. It is very inexpensive, but is also complex. Overall the sub sector is expensive.
  • Industrial gases is all about APD in the eyes of investors and the sell side but we prefer the valuation of PX and its consistent track record of growth.
  • PPG has more operating leverage opportunity in the coatings space than others and it is the only stock we would consider in an otherwise very expensive space. The space is worth watching as it potentially comes off of valuation highs.

Natural gas prices are high, in our view, given the higher inventories (Exhibit 3 and, perhaps more importantly, the very high level of production (Exhibit 4). Some downside has been realized since our last writing but we still do not believe in $4/MMBTU prices.

Exhibit 3

Source: EIA

Exhibit 4

Source: EIA
Valuation

Exhibit 5 summarizes our valuation work and the subsector classifications are summarized in Exhibit 6. The commodity group has continued its long fall out of bed with its market cap down from over $141 billion in September to roughly $114 today. Downward revisions are most notable in this sector. Coatings are still the only group with positive revisions over the last six months, partially as a result of falling pigment and petroleum input costs. In the specialty space, we have written favorably about EMN’s valuation and continue to hold this view with the recent share price moves. While the sector has traded down with the market, particularly in the last week, most valuations are not yet compelling. Indeed, certain subsectors are mined with value traps, especially in the commodity names.

 

Exhibit 5

Exhibit 6

In Exhibits 7, we show sector discount from normal value as measured on our valuation framework, and in Exhibit 8 we show discount by company. Ag Chemical names screen as the most discounted but this reflects the poor outlook for fertilizers. MOS is near (1.6x) but not at a valuation low, as potash in particular remains more out of favor than everything else. Increasing premiums in the Coatings subsector are being driven by increasing returns as a result of stable North American markets and lower input costs.
Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibits 9 and 10 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our November Chemicals Monthly. Strength was seen again in coatings, though without the uniformly double digit returns of last month. Both coatings and gases beat the S&P in November after particularly weak performance in the gases last month. The commodity names suffered the most as the North American feedstock advantage has been eroded by crude prices falling globally.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

Source: Capital IQ and SSR Analysis
Profitability

Exhibits 11 through 13 show profitability at the sector, subsector, and stock level.

In Exhibit 11 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.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibits 12 and 13 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 explains most of the downside we have seen recently.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13

Source: Capital IQ and SSR Analysis

 

Portfolio Performance

The December portfolio selections are shown in Exhibit 14. It has not been a year for valuation plays, but the overlap of value and our Skepticism Index continues to produce alpha – Exhibit 15.

Exhibit 14

Source: Capital IQ and SSR Analysis

Exhibit 15

Source: Capital IQ and SSR Analysis
Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • With lower gas prices providing an implicit tax cut, we would expect consumer spending to trend higher into the end of the year. Early retail spending reports would suggest that this is the case as well. See SSR Consumer Analyst Rob Campagnino’s Holiday Spending Forecast.
  • Gains in consumer spending rolled on in October but 2014 has been notably volatile. After September’s decline of 0.23%, October’s expenditures rose 0.2% leaving 2014 with monthly average growth of 0.15%, the same monthly gain seen from 2009 through 2013. While this is lower than 2013’s average monthly rate of 0.22%, strong December retail sales and lower oil prices might suggest looser wallets through the holiday shopping season.

Exhibit 16

Exhibit 17

Source: BEA

Construction

  • Positive revisions have largely replaced the negative revisions previously seen for the summer months. August and September have both been revised up roughly 1% with October’s figure showing a month over month gain of just over 1%.
  • Construction spending is up 1% for the year, a departure from the 8% annual growth seen in 2012-2013. This marks an improvement from previous numbers that have now been revised up but is disconcertingly slow nonetheless.

Exhibit 18

Exhibit 19

Source: US Census Bureau

Agriculture

  • Agricultural commodities have turned around after their slide earlier in 2014. Though soybeans were flat in the last month, corn was up over 2% while wheat gained almost 8%. Expectations for the Chinese harvest, colder weather in the US and slow moving trains have spurred prices higher over the last couple of months.
  • Our colleague Rob Campagnino sees fewer corn acres planted in the 2014/2015 growing season – see recent research.

 

Exhibit 20

Source: Capital IQ, SSR Analysis

ISM

  • November saw the PMI back at its highs and firmly in expansion territory. Inventories have fallen to 51.5 from 52.5 in a move back towards September’s levels. Production hovered near its recent levels, coming in at 64.4. New orders came in at 66, a reading more in line with the growth trend seen this year after October’s large jump.
  • The US is currently acknowledged as the best of a bad lot of global economies. The domestic energy story is far from over and has helped insulate the economy from troubles abroad. It should be noted that while low oil prices are good for individuals, the nascent US energy sector will struggle with profitability going into 2015. As we mentioned in our last note, challenges moving into 2015 include renewed weakness from the Eurozone, recession in Japan and continued struggles in emerging economies.

Exhibit 21

Source: ISM

Exhibit 22

Source: ISM

Trade

  • The dotted line in Exhibit 23 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%. Midway through Q4, we have seen the dollar 5.3% stronger versus the Euro quarter over quarter – Exhibits below.

Exhibit 23

Source: US Census Bureau

Exhibit 24

Source: IMF

Exhibit 25

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 this year 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 26 and 27, 2014 will likely show 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 this year. In turn, this has resulted in quite high pricing. Operating ethylene facilities are running at maximum rates and we expect the industry to run on that basis through the end of this year to replenish what are now very low inventories. Some companies have delayed late year maintenance shutdowns because of the lack of product. The US is likely to see minimal growth in ethylene production in 2014 because of these operating problems, despite a nominal increase in capacity. What was expected to be a weaker second half market for ethylene because of new capacity is now likely pushed to 2015 or the very end of 2014. Prices are falling with the decline in oil price, but the market remains quite constrained in November and prices would have fallen much more quickly had there been more supply. If Williams brings its 2 billion annual pounds of capacity online by year end, we could see prices fall from their high 30 cents/lb range that was unthinkable only a couple of months ago.

More available capacity and higher operating rates in 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 26 and operating rates are summarized in Exhibit 27. 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 26

Source: IHS, Wood Mackenzie and SSR Analysis
Exhibit 27

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

Energy – Exhibit 28

Even as we wrote about oil’s decline last month, crude continued its relentless march lower with both Brent and WTI now below $60/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. 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 is discussed in more detail in the overview.

Exhibit 28

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 through November. While Lyondell has started its new furnaces in Texas, Williams remains shutdown in Louisiana and there have been a couple of further outages from Exxon, Shell and Ineos. Ethane extraction margins have remained at the lows of late 2013, as shown in Exhibit 29 and as discussed in recent research . Ethane has modestly reversed its decline – Exhibit 30 – and the Conway gap has increased slightly over September levels, probably because of increased demand in TX but prices are still far from their highs early in 2014.

Exhibit 29

Source: IHS, Mackenzie Wood and SSR Analysis
Exhibit 30

Source: Midstream Business and SSR Analysis

Propane and Butane prices have moved down with crude – propane most dramatically. Propane exports from the US continue to grow and are now so significant that recent sales into Europe have been below local fuel values as there is too much available. Butane should start seeing support from the expected start of the winter gasoline blending season, but with gasoline pricing falling in the US, butane should also come down. Counter to our previous assertions, propane and butane currently appear to be the lowest cash cost feedstocks though this depends on co-product values. The swing in Propane is a function of real oversupply a year ago that has been quickly corrected through exports and current pricing reflects export netbacks – mainly from Europe – Exhibit 31. 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. The question is at what price do these inputs finally bottom out, a question which we should have more color on as we continue into 2015.

Exhibit 31

Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing will likely follow ethylene – which has fallen very sharply from its highs of 72 cents/lb in September. As mentioned previously, spot prices for ethylene today are in the high 30 cents/lb range. Potentially counteracting a steeper fall are North American production problems and comparatively stable demand. Note that the contract prices shown in Exhibit 32 are “list” against which there are significant discounts depending on customer scale. Today, the spot market for HDPE is in the $0.74-0.75 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.

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 5.
Exhibit 33


Valuation Charts – Exhibits 34-36

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:

  • Exhibit 37 shows each subsector’s Skepticism Index value. Ag Chem has surpassed Diversified Chemicals for the highest skepticism index value of the subsectors – we would have more faith in the Ag result given our recent analysis of the Skepticism Index and its efficacy. Exhibit 38 shows R2 by subsector, measuring the extent to which valuation is explained by return on capital. In Exhibit 40 there are no companies currently at skepticism extremes. Note that SIAL is in the process of being acquired by Merck and we will be removing it from our coverage.

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40

Source: Capital IQ and SSR Analysis

Recent Chemicals Research

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

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

September 2, 2014 – Strong Manufacturing – Buy Industrial Gases (blog)

August 14, 2014 – US Ethylene: It’s a Record Breaker – But No One Really Wins Quickly Anymore

August 12, 2014 – To Russia, But Not With Love – Right Now

July 28, 2014 – Industrial Gases: APD Must Focus on Costs, But PX the Better Investment

July 23, 2014 – DuPont: Ag-rivating, But Unlikely to Change Without Action

June 16, 2014 – European Basic Chemicals: There Is Life In The Old Dog Yet!

June 2, 2014 – DuPont: A Cost Initiative Could Be Substantial

May 15, 2014 – Chemicals Revisions: Not Positive Enough and Not Supportive of Values for Many

May 13, 2014 – DuPont: The Case for $85 – But Why We May Need to be Patient

April 29, 2014 – Dow vs. Lyondell: Bet on the Company with More Levers to Pull – DOW

April 28, 2014 – US Natural Gas: Not Out of the Woods Yet!

April 25, 2014 – Air Products and Praxair: A Tale of Two Strategies

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

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 41 to 45.

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

 

 

Exhibit 45

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 46 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 46A

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 46B

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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