Chemicals Monthly – Summary – Focus On Ethylene

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SEE LAST PAGE OF THIS REPORT Graham Copley

FOR IMPORTANT DISCLOSURES 203.901.1629

gcopley@ssrllc.com

July 15th 2018

Chemicals Monthly – Summary – Focus On Ethylene

  • We are changing the publication timing a format of our Chemicals Monthly Research and will publish both a large cap and SMID piece at the same time mid-month.
    • We say goodbye to Nick Lipinski this month after 6 years (good luck Nick), but this is a change that we had been contemplating for a while – not a reflection on my excel skills!
    • This report contains a summary for the month, recommendation changes etc., and the accompanying two PowerPoints focus on the large cap and SMID data respectfully.
  • As we head into earnings we have a sector with mostly very strong earnings momentum, with prices rising and volumes strong – even as we look forward to possible volume risk.
    • Our expectation is for very good Q2 results but with the possibility of limited enthusiasm for guidance given the rollercoaster trade issues today.
    • More immune companies are those with a predominantly US footprint and less economically sensitive demand; recently added SMG to our focus list partly for these reasons
  • US ethylene is the exception (see below) costs are rising; prices are falling. Ethylene sellers are penalized (LYB) and buyers very advantaged – WLK and to a lesser degree OLN.
  • RPM races to the top of the performance chart – Exhibit 1 – because of some swift and definitive activist action that has been well received by shareholders, and this move pushes coatings to the position of the only subsector beating the market over the last month.
    • Otherwise, PX has responded well to deal related divestment news – our top pick.
    • FULL outperformed based on better numbers and remains on our preferred list
    • EMN remains positive for the year despite a very poor month for specialty and diversified companies – creating entry points again for DWDP, HUN, WLK, CF and LYB, all of whom should produce good Q2 numbers (guidance may trip up the ethylene sellers).
  • SMID ideas unchanged – Electronics, TSE, VNTR, IPHS, KRA, KWR, VHI
    • Pairs trade idea – no immediate catalyst – long IPHS, short BCPC

Exhibit 1.

Source: Capital IQ and SSR Analysis

Fundamentals – All Good Except US Ethylene

The world remains finely balanced for many materials, including chemicals, with pricing volatility in many commodities a function of well-balanced markets struggling with the stability of the outlook. The blame here lies firmly on the US Administration and its current approach to trade negotiations. As most companies think about guidance for 2H 2018 they are likely to be as much concerned about the impact of the drama on confidence and global economic growth as they are product specific trade issues. The Michigan Sentiment Index remains strong – Exhibit 2 – but disappointed versus expectations this week.

Exhibit 2

Source: University of Michigan

On the trade front, for example, while China may have singled out LDPE and LLDPE for tariffs among other polymers, the increasing surplus in the US can find markets outside China and China can find suppliers outside the US – the global balance does not really change (even if trade flows change) unless there is an overall pause in demand growth. This could come from either uncertainty (driving a drop in business or consumer confidence, or both) or wage growth, or, as happened in prior US trade moves, manufacturers in the US being forced to shut down because they cannot compete faced with the higher raw material prices caused by the tariffs.

Meanwhile, US ethane based ethylene producers are in some short-term trouble with local ethane prices spiking and ethylene prices collapsing – Exhibit 3 shows a short-term view of spot pricing and margins and Exhibit 4 shows the longer-term margin chart – we have been close to here before, but this time we got there suddenly and have gone lower. In Exhibit 3, the green line illustrates the MINIMUM MARGIN required to justify a new build in the US today.

The “cash cost” used in the calculation has roughly 2.5 cents per pound of fixed charges, such as labor, and as Exhibit 4 shows, historically we have bottomed at a spot margin of around negative 2.5 cents, economic break-even. The current theoretical margin is more like negative 7 cents per pound and likely represents limited volume being sold from inventory that was produced at a lower ethane cost. As shown in Exhibit 5, part of the issue is rapidly rising ethane prices on the Gulf Coast. The current spot margin is unsustainable and if it proves to be the average for July it will be the lowest monthly ethane based ethylene margins we have recorded in 38 years of data – production will be curtailed or spot pricing will recover. This spot market – as well as the Conway discount (Exhibit 5) are major competitive advantages for WLK. WLK is the largest spot buyer of ethylene in the US. Contract prices for ethylene are around 10 cents per pound higher than spot – but generate minimal margins for ethylene sellers.

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Some of Westlake’s purchases will be a blend of spot and contract prices which is the norm for the industry – we show contract and spot pricing and a blended margin in Exhibit 6 – sellers are losing money on a cash basis (although not on a variable basis) with a blended price agreement in July. Part of the problem is rising ethane, which, as can be seen in Exhibit 7 appears to be driven by shortage of ethane, otherwise fractionation margins would not be increasing. New ethylene capacity (increasing ethane demand) is part of the problem, as are restrictions on pipeline capacity from the Permian – not just limited to crude oil. Ethane is tight in the US Gulf for the first time since 2013 and this was always a risk in 2018 given timing of pipelines and ethylene capacity. There is enough ethane in the Permian to keep everyone happy – pipeline availability is the issue.

The happier ethylene producers are likely those with more flexibility on feedstocks as spot propylene pricing is above 40 cents per pound today.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

But all is not completely lost for the US industry – most companies are highly integrated downstream and polyethylene is trying to hold its own – pricing has been relatively stable this year – hard to see in the longer-term chart below (Exhibit 8), but integrated (ethane based) margins have fallen because of the rise in ethane pricing. Equally relevant, US polyethylene pricing is very “off trend” Exhibit 9, suggesting limited downside – ultimately US pricing is set by international pricing which is driven by a crude oil based cost. In a more balanced (normal) polyethylene market, current crude prices would suggest 10-15 cents per pound upside.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

Q2 conference calls are likely to focus on the US ethylene/polyethylene margin squeeze in July – most companies will likely suggest that this is a short-term problem – something with which we agree – but will likely not be overly bullish for Q3. Our position is unchanged – we still expect Q2 to be the low for the year and that the market will improve in the second half. It is certainly possible that July will drag Q3 below Q2, but we still expect an improving trend through the balance of the year and into 2019. We would buy WLK and DWDP today and on any weakness – LYB should also recover from any pullback with a good Braskem deal boosting the stock and a bad Braskem deal always a risk.

SMID Summary

Our recommendations are largely unchanged with the exception of adding SMG and RPM (see below) to our preferred list and a reiteration of our positive stance on FULL – Exhibit 10.

Exhibit 10

Monthly performance is summarized in Exhibit 11:

  • UAN reacting to positive Urea pricing news and the leverage of having only 35% of EV as equity at the start of the period
    • Should be positive read throughs for CF and MOS – both on our preferred list – neither stock is expensive.
  • RPM – very “left field”, quick and successful activist move – may be setting RPM up for sale in which case there is still plenty of upside.
    • Without any M&A there is still a significant cost opportunity and the activist is not in this for 15% – we are adding RPM to our preferred list.
  • The electronics group has pulled back over the last few months and we see this as an entry point – chip demand remains very strong and as long as production remains high suppliers will get paid, regardless of how much money the semiconductor producers make.
  • Lastly – Exhibit 12 – BCPC continues to defy gravity – we do not understand the logic of owning this name. The company needs a large acquisition to keep the momentum going and market values are high suggesting that there are no bargains out there.
    • There is a major pairs trade opportunity in our view – long IPHS and short BCPC

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12

Source: Capital IQ and SSR Analysis

Other Items Of Note

  • PX/LIN deal maintains its forward momentum – key chart repeated below – Exhibit 13

Exhibit 13

Source: Capital IQ and SSR Analysis

  • Cheapest stocks remain VNTR and 1COV (Covestro) both of which we like.
    • TiO2 may be an overcrowded space but VNTR would benefit from any change in sentiment and a sell down by HUN.
    • Covestro has the most poorly understood story in Europe based on the extraordinary range of analyst recommendations and target prices – target price low is €52, high is €152! We favor the higher number.
  • We continue to question both the strategy and leadership at PPG – we expect a change, which makes us more positive on the stock, but without a change, a larger dilutive acquisition is likely on the horizon and if it is somewhat “off-piste”, which we think is likely, the stock would react negatively

©2018, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. 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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