Chemicals Monthly – Spoiled for Choice

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Graham Copley / Nick Lipinski



November 18th, 2014

Chemicals Monthly Spoiled for Choice

  • There is too much going on the chemical space and it is getting harder to select which theme or themes to play and then how to play them. Activism is one theme, in our view best played today through DD. Deals are another, also best played through DD. From a Commodity perspective, we like buyers like AXLL and TSE rather than sellers.
  • Oil prices have continued their downward trend and are approaching a level ($70 a barrel) that brings the economics of the more marginal planned chemical investments into question – such as the export of ethane. The uncertainty that oil brings to the commodity space is significant, as it calls into questions all forward estimates.
  • The Commodity group largely rebounded with the market in the second half of October after widespread significant underperformance as oil began to fall, but negative revisions have continued. The group still trailed the S&P since our last monthly report, as did every Chemical subsector outside of Coatings.
  • Coatings stocks have been strong of late and the subsector is approaching a thirty year valuation peak, warranted to an extent by record earnings and consolidation. The Diversified group continues to have valuation support and earnings remain above trend.
  • Chemicals research since our last monthly has included: the possibility of further downside in the Commodity names, a company specific piece on EMN (which we see as overlooked and undervalued), as well as a piece on capital (mis)allocation as an explanation for activism. Also see our blog on APD, with a read through to DD.
  • 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. AXLL may face some further negative revisions because of higher ethylene pricing in 2014, but valuation is compelling and a normal 2015, with lower ethylene pricing could generate significant upside.

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 – Sensory Overload!

Covering the chemicals sector in the US in the run up to the bursting of the tech bubble was possible one of the most mind-numbingly dull and at the same time frustrating periods of my career. No-one cared – for months at a time! It did not matter how different or insightful the research was, the stocks were of almost zero interest to all but a handful of deep value managers who did not want to talk anyway because they were underperforming so horribly. Fast forward to today, where arguably the sector has never been as interesting as and full of opportunities and potential pitfalls.

  • We have activists – Dow, DuPont, Air Products and others, some more “active” today than only a few weeks ago.
  • We have deals – Dow has several, DuPont Performance Chemicals, Eastman/Taminco, Albermarle/Rockwood and Huntsman TiO2……
  • We have changes in the coatings industry with consolidation everywhere
  • We have energy – do you buy into the ethylene story or do you sell it today – regardless, the investments continue and the announcements are not over, with Indorama throwing its hat in the ring recently, and Total filing for permits for a new unit, while ASCENT has awarded design contracts for its plant in VW.
  • We have overcapacity of many products in China

Investors have more things to think about in this space today than at any time in recent memory – far too many given the size of the sector and the limited interest in an average portfolio. Some companies are getting left out because they aren’t interesting enough or because their recent moves add a level of complexity that investors do not need to take the time to understand because there are other “easier” choices. In our view, Eastman and Albermarle fit in the complex bucket, while Praxair, Airgas, Scotts, and possibly Olin, Fuller, Axiall and Cabot sit in the boring bucket, though all have had company specific issues this year.

What to focus on now becomes quite a hard question to address. The activists are not going away at either Dow or DuPont and the wars of words have begun – we think the upside is greater at DuPont than at Dow, but we would own both. On ethylene, we would direct readers back to what we wrote on potash when the cartel broke down – we believed that it was not a simple issue and was unlikely to be fixed quickly, resulting in longer term pressure on potash prices. The ethylene story is similar – the oil status quo has been broken, and while a major geopolitical event could turn things around, without that we have probably not yet established a floor. We have certainly not established a floor for international basic chemical prices, despite many steep falls over the last few weeks – so we remain negative on ethylene, despite a balanced market in the US. Like Potash, forward curves and price forecasts are more negative/conservative than they were before the step change, but in our view they still have downside.

We have not changed any of our recommendations despite the moves of the last 2 months

  • We remain underweight commodities – we would be sellers of Dow on the ethylene story were it not for the activism.
  • 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 complex. Overall the sub sector is expensive
  • Industrial gases is all about APD in the eyes of investors and the sell side. We like PX as the recent laggard – but growth has been elusive.
  • We don’t really like Agriculture at all, but MON looks interesting on valuation and we also think the seed/pesticide sector could get some M&A boost in the medium term.
  • 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.

Natural gas prices are high, in our view, given the higher inventories (Exhibit 3), but more important, the very high level of production (Exhibit 4). We think there is downside to natural gas pricing if the weather is mild through November and early December.
Exhibit 3

Source: EIA

Exhibit 4

Source: EIA

Exhibit 5 summarizes our valuation work and the subsector classifications are summarized in Exhibit 6. The Coatings group has seen the only positive revisions in the Chemicals space over the past several months and valuation has followed returns higher. Specialty’s premium is influenced by the inclusion of SIAL, which will be removed pending the completion of its acquisition by Merck. Several other Specialty names are on the expensive side (IFF, ECL) but we again note EMN’s attractive valuation. Outside these two groups, the sector as a whole looks significantly cheaper than it has recently, with a notable turnaround in the Commodity group.

Exhibit 5

Exhibit 6

In Exhibit 7, we show company discount from normal value as measured on our valuation framework. Ag Chemical names screen as the most discounted but this reflects the poor outlook for fertilizers. MOS is near (1.6%) 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.
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 October Chemicals Monthly. Strength has been consistent throughout the Coatings space, with PPG, RPM, SHW and VAL all up over 13%. This was the only group to beat the S&P over this time. The other groups mainly trailed the market by about 1%, with Gases the notable outlier on the downside (driven by relative weakness in PX).

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

Source: Capital IQ and SSR Analysis


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

In Exhibit 11 we highlight VAL, SMG, SHW, CYT, IFF and RPM 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 in no way reflect the weakness in the sector in recent weeks, suggesting that the market anticipates much more meaningful negative revisions to come.
Exhibit 12

Source: Capital IQ and SSR Analysis


Exhibit 13

Source: Capital IQ and SSR Analysis

Portfolio Performance

The November portfolio selections are shown in Exhibit 14. Our portfolios held most of the October gains that were driven by weakness in the expensive screening commodity names.

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

  • Personal consumption expenditures saw the biggest month over month decline since Janaury in the latest data (through September). With lower gas prices providing an implicit tax cut, we would expect consumer spending to trend higher into the end of the year. See SSR Consumer Analyst Rob Campagnino’s Holiday Spending Forecast.
  • The longer term post-recession recovery in consumer spending has been notably uniform. After September’s decline of 0.23%, expenditures in 2014 have risen at a monthly rate of 0.14%, consistent with the 0.15% monthly gain seen from 2009 through 2013. However, this is lower than 2013’s average monthly rate of 0.22%, and we have seen more volatility in spending in 2014 as well.

Exhibit 16 Exhibit 17

Source: BEA


  • Negative revisions continued the trends established in over the summer with August and July’s figures being revised down again. The anticipated turnaround in construction has been a bit disappointing given that certain construction markets are still down 40% from their pre-recession peaks.
  • With less than two months remaining in 2014, it is unlikely construction spending will match the 8% annual growth seen in 2012-2013. Through September, spending is down a somewhat surprising 1% for the year.

Exhibit 18

Source: US Census Bureau


  • After several months of falling grain prices, we have finally seen a turnaround with prices for corn, wheat and soybeans all up ~10%+ from mid-October through mid-November. Corn is the leader of the pack. With record domestic yields still expected, prices have risen largely due to a brief coldsnap and the expectation that China will not see the harvests that were expected.
  • 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


  • October saw the PMI back at its highs and firmly in expansion territory. After shrinking in September, the inventory component rose in October from 51.5 to 52.5, while production edged higher to 64.8. New orders came in at 65.8, a sharp gain over September’s 60 level and more in line with the strong numbers seen year to date.
  • 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. 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


  • 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 off 30% versus the dollar YoY and the Brazilian real down 10%. Midway through Q4, we have seen the dollar 7% 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


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. Start-ups in late November could precipitate further price weakness before year end.

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


Energy – Exhibit 28

Oil prices have fallen meaningfully since our last report and have decoupled from the stronger dollar. The market is focused on real supply/demand for oil and the building surplus of oil and condensate in the US. 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 is weakening in step in both the Mid-West and in the US Gulf – Exhibit 30 – but the Conway gap has increased slightly over September levels, probably because of increased demand in TX.

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. While both may become more attractive relative feedstocks in the US, it is unlikely that they will fall far enough to compete with ethane. Butane may see less support than in prior years because of the volume of light condensate finding its way into the US gasoline pool. 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.

Wood Makenzie has a theory that propane prices could fall more quickly in a mild winter as we run out of logistic alternative to move the product and it would have to drop to a level that made it an attractive ethylene feed. That occurrence would likely coincide with very low natural gas prices (mild winter) and ethane and propane could spiral down as each looks to find a buyer.

Exhibit 31

Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing will likely follow ethylene – which fell significantly in October and will likely fall again in November, but for the moment is enjoying record margins for domestic sales. 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:

  • Diversified Chemicals has the highest skepticism index value of the subsectors – this is driven by DuPont, which has the highest skepticism value of all the companies in our Chemical universe. Ag Chem remains undervalued as earnings are slightly below trend, and expected to worsen. Conversely, Specialty is being granted a premium valuation that is discounting a rise in returns from current levels that are largely in line with trend. In Exhibit 39 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


Recent Chemicals Research
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

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 44.

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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