Chemicals Monthly – Volatility: Crude, and Activists

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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

February 18th, 2015

Chemicals Monthly Volatility: Crude, and Activists

  • Dialogue in the chemicals space continues to be dominated by swings in crude and activism. Brent has risen almost 23% in the last month, powering ethylene producers higher but offering little clarity from a planning perspective. On a related note, we expect that margins will weaken in Q1 based on ethylene price movements and capacity expansions – Williams is finally running! This is discussed in greater detail below.
  • As expected, lower energy prices have caused a short term drop in demand (in favor of an inventory draw) for any product with a high energy content – in the expectation that pricing will follow energy. Export HDPE prices have fallen from a peak of 75 cents per pound in September to 48 cents per pound today. These low prices make capital investment aimed at exporting polyethylene from the US look questionable.
  • We continue to like the inexpensive and quasi-special situation names. DD and Trian have escalated their war of words in recent days as DuPont deftly changed its board composition to address some of Trian’s complaints. While our other favorites, EMN and PX, have not had the same degree of headline exposure, they offer compelling valuation.
  • Commodity names have continued their rebound – DOW, LYB and WLK were all up double digits in absolute terms over the last month. As oil has come off its lows, concerns over destocking and more meaningful demand declines have been somewhat mollified. Hopes for higher prices and that buyers, sensing a bottom in oil, will spur demand have moved stocks higher despite significant negative revisions.
  • We continue to point to high valuations in Coatings names and February marks the first time that the group has seen downward guidance in many months. In relative terms, the subsector was mixed. While SHW beat on earnings and outperformed with RPM, VAL and PPG underperformed the S&P.
  • Chemicals research since our last monthly has included a piece on the pricing gains we see coming for gases in 2015. We also published a piece on the impact that current energy environment will have on ethylene producers should it persist.

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 have developed a more cautious outlook on the sector in general as energy markets have made their recent moves and favor companies that are particularly inexpensive, have cost levers that can be pulled and/or have an activist involved to engage on/encourage either of the two prior points. This leaves us with DuPont and Eastman, both companies that we written about several times in the past, and the industrial gases names .

The proxy fight at DD is heating up. The board additions the company are good choices and the timing of the announcement put pressure on Trian to up its game ahead of an April proxy deadline. Trian has provided a great deal of data about DuPont’s performance and its very poor guidance and lack of R&D productivity – subjects we have written about with the regard to the industry and DuPont specifically extensively. We are in broad agreement with Trian on these points and we have also written that we think the cost cutting opportunities at DD are much higher than the current internal targets. Jim Gallogly will likely try to bring some board focus here, as it is what he is best at; how quickly is a different question. In the meantime, both Trian and DD have what may look something like a presidential campaign over the next 6 weeks as they try to get the “vote”. A negotiated settlement with Trian getting board representation is still possible in our view. We would stick with the stock at this time.
APD has more ground to cover in its race against PX and we favor the latter. Consensus has APD growing faster – Exhibit 3 – but we believe that the growth is not enough to justify the current price and cannot be achieved simply through cost cuts. APD has to chase pricing where it can and its expected price leadership will help others as much as it helps APD. On that basis we prefer PX as the valuation is much more compelling. In Exhibit 4, we show the different consensus view and while we agree that APD should grow EBITDA faster than PX (because of cost cutting) we do not see why PX will lag on a revenue growth basis.

Exhibit 3

Source: Capital IQ, SSR Analysis
Exhibit 4


Source: Capital IQ, SSR Analysis

Volatility has continued in energy markets with our Commodity group benefitting the most as oil tacked sharply upward over the last month. Still, management teams have been hesitant to spell out guidance given the unpredictably associated with violent price moves lately. We view this as the smart thing to do even if it makes our job modestly more difficult; building major pricing gains into planning assumptions over the next year and deploying capital correspondingly is likely just as destructive as assuming indefinite price depression. Related to planning is the lack of announcements related to current plans for ethylene plants. Last month, we noted that several projects are beyond the final investment decision for the Gulf despite the questionable economics associated with energy markets at that time. It appears that the export oriented Gulf expansions are still on track for the most part and the export discussion may heat up should the restart of Williams and an inventory rebuild have the US swimming in ethylene in another quarter or two.

Another notable departure from January is that cash costs ticked up materially for all feedstocks but ethane – Exhibit 5. This also factors into our reasoning for stating that margins are likely to decline. Not only are prices still far from their 2014 highs (so are costs), but we are now seeing prices falling at a slower rate while costs tick up for almost all feedstocks – except ethane.

Exhibit 5


Source: Wood Mackenzie

Our preferred names and associated rationales have not changed materially over the last month: DuPont because we believe that the cost opportunity is huge even should the activist fail, though fundamentals and valuation are less inspiring than in our other favorites; EMN , now that we have greater clarity on the cost of the propylene hedge and because of its very favorable valuation; and PX, based on valuation, pricing improvements across the gases landscape and ongoing capital and cost discipline.

Valuation

Exhibit 6 summarizes our valuation work and the subsector classifications are summarized in Exhibit 7. With most company’s having given preliminary numbers for 4Q14, we see some declines in return on capital and continued negative revisions. Nonetheless, performance has been strong across chemicals with commodity names doing particularly well as oil has moved upwards. The coatings strength that we noted over the past several months continued but, for the first time in several months, we saw negative revisions in some of these names countered by positive revisions in Ag names.
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. In terms of subsector valuation rankings, not much has changed since we published in January. Ag names remain the least expensive though they are not at the valuation lows they were last month. Coatings remain expensive with SHW, VAL and PPG marked in red due to their 10 year valuation highs in exhibit 9.

 

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 January Chemicals Monthly. Coatings and diversified bucked the trend and were the worst performers of the bunch over the past month, lagging the S&P. Commodity names were particularly strong as oil rebounded. Ag names moved up with modest upward guidance. Specialty chemicals names also performed well.

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 in Exhibit 9, 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 pose a threat, perhaps offset by the more positive outlook for oil prices.
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

  • After upward revisions for November and October, December’s consumer spending figure came in a bit soft, showing a sequential decline of 0.10%. While this does not point to an imminent slowdown, it does throw some doubt on the supposition that lower oil will spur expenditures.
  • The most current data is for the month of December. With the full year’s numbers in the books, the annualized monthly gain for 2014 stands at 0.26%. Despite modest volatility in 2014, the year’s average monthly gain was 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 November both being revised upward. While November still shows a decline from October, construction in December increased to an annual rate of $982bn, a rate not seen since 2008.
  • Construction was up 2.18% in 2014, a departure from the 8% annual growth seen in 2012-2013. Even with recent positive revisions, this is relatively slow growth. March will bring the first numbers for 2015.

Exhibit 19

Exhibit 20

Source: US Census Bureau

Agriculture

  • Though crops were not the victim of selling in February that they were in January, downward moves continued over the last month. Soybeans are down 0.50% since we last wrote with corn down 1.03% and wheat down 2.44%. The USDA again predicted oversupply in wheat hence its larger decline.
  • 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

  • January marked another volatile month with the PMI falling from 55.1 to 53.5 in January. New orders also declined, from 57.8 to 52.9 and production saw similar weakness declining from 57.7 to 56.5. While these numbers uniformally point towards slower growth, we are seeing manufacturing growth nonetheless with the PMI and new orders in positive territory for 20 consecutive months now. Both are up YoY.
  • Quantitative easing has retaken the stage as growth estimates remain poor across the globe. Germany remains the strongpoint for Europe with Greece and Cyprus still showing the poorest fundamentals. The US has a more positive outlook but the strong USD threatens this. We remain wary of global concerns including East Asian slowing, Eurozone weakness and the strong USD.

 

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 underperformance has continued recently with the Russian ruble hitting fresh all-time lows versus the dollar and the Brazilian real down 17% YoY. YTD, the dollar continues to strengthen – it was 15.7% stronger versus the Euro thus far in 1Q15 than 1Q14 – 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 were the root cause of lower production in 2014 and they continue now as most operating capacity has been doing so at a very high rate. Problems have been well above average in 2014 and unplanned outages are expected to continue in 2015 though their extent is difficult to predict. This has restricted availability of ethylene which, in combination with a global price collapse, has contributed to lower exports. Operating ethylene facilities are running at rates in excess of 90% though the recent restart of Williams’s Geismar plant may lower that number temporarily. The restart could, however, be offset by outages, planned and unplanned, at units across the Gulf operated by Dow, Shell, Chevron-Phillips JV and ExxonMobil. We expect the currently operating units to run on at their high rates as inventories continue to be restored. Some companies delayed late 2014 maintenance shutdowns because of the lack of product and now appear to be paying for that. In short, 2015 has started with some production difficulties, hence our expectation that plants will run full out until the end of Q1 and possibly into Q2. Curiously, even as oil rebounded over the last month, US ethylene spot prices declined from $0.37/lb to $0.35/lb. We suspect that this is related to the Williams restart and the prospect of supply growth from capacity additions.

We cautioned about supply last month but we again warn that 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

Our discussions of crude’s march lower have gone out the window with Brent now back above $60 only a month later. Price gains come on the back of capex cuts by US E&P companies and reports of lower rig counts across the US. The expectation is that oil production in the US will decline over the next several months and quarters. With the demand outlook is still fuzzy, supply questions are driving the market. We also note that political instability could drive prices higher as civil war ravages Libya and the Islamic State remains in Syria and Iraq not far from major fields. 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 generally lower than they were during a year ago. While temperatures have dropped over the past week, it will take a longer period to move the needle on Nat Gas prices.

Exhibit 29

Source: Capital IQ and SSR Analysis

Ethane remains very weak because of favorable economics associated with cracking propane as a result of somewhat resilient coproduct values. Ethane declined over the last month while propane increased, again due to the appeal of coproducts. Propane is displacing ethane and ethane extraction margins remain very depressed as a result. Should ethane remain out of favor, its prices will remain depressed though propane may quickly fall out of favor if price appreciation continues. We see ethane eventually seeing support given its incredibly low cost basis. The Conway – Mont Belview spread remains very tight but some divergence may be observed if extreme weather and temperatures continue across the Midwest and Northeast.

Exhibit 30


Source: IHS, Mackenzie Wood and SSR Analysis

Exhibit 31

Source: Midstream Business and SSR Analysis

Propane and Butane remain the most attractive feedstocks for the time being. However, as discussed above, we believe that it is likely that propane prices will rise and thus their cash costs will rise. According to Wood Mackenzie, we are already seeing this with cash costs for propane up from $0.10/lb to over $0.20/lb. This scenario sees flexible crackers producing the highest volume possible from propane until co-product credits can no longer offset rising cash costs. Still, oil’s rise has kept the ratio of propane and butane to crude low, hence their relative attractiveness– Exhibit 32.
Exhibit 32


Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing has strengthened over the last month with buyers now stepping in, perhaps nervous about paying higher prices as inputs rise. Note that the contract prices shown in Exhibit 33 are “list” against which there are significant discounts depending on customer scale. Today, the spot export market for HDPE is below 50 cents per pound – down steeply from the $0.62-0.65 cent per pound range in December. This steep drop is in part because of costs, but is also as a result of the expected demand slow down as consumers reduce inventories expecting lower pricing going forward. Exhibit 34 is another chart borrowed from Wood Mackenzie

Exhibit 33

Source: IHS and SSR Analysis

Exhibit 34 – Spot Export Polyethylene Prices


Source: Wood Mackenzie

Valuation Charts

The exhibits below show our mid-cycle “normal” valuation framework for the chemical sub sectors and the first exhibit (35) summarizes the results and is a repeat of Exhibit 6.

Exhibit 35

Valuation Charts – Exhibits 36-38

Exhibit 36

Source: Capital IQ and SSR Analysis

Exhibit 37


Source: Capital IQ and SSR Analysis

Exhibit 38

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 39 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. This discourse apparently still exists given the recent rebound in the names. Exhibit 40 shows R2 by subsector, measuring the extent to which valuation is explained by return on capital. Exhibit 41 shows that the Commodity and Specialty subsectors have some disconnects between valuation and earnings. In Exhibit 42, 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 39

Source: Capital IQ and SSR Analysis

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

February 9, 2015 – Industrial Gases – Pricing Coming and Good for All

January 27, 2015 – US Ethylene – Who Will Blink First

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 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

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 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

Exhibit 47

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 48 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 48A

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 48B

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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