Ethylene – You Can’t Fight the Fundamentals

gcopley
Print Friendly, PDF & Email

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

July 5th, 2016

Ethylene – You Can’t Fight the Fundamentals

  • US ethylene producers look like they might be in for the prefect storm in Q3 2016.
    • Higher NGL prices as natural gas rises.
    • More capacity as facilities come back on line from shutdowns and the full weight of the Braskem/Idesa start-up is felt – this is a specific problem for polyethylene.
    • Seasonal and economic uncertainty driven demand weakness.
  • This is already impacting Q2 2016 with EMN already providing some “ethylene margin” based negative guidance for the quarter – EMN’s exposure is small compared with LYB, WLK and DOW.
    • Ethane based costs are up 2 cents per pound of ethylene vs Q1.
    • Propane based costs are up almost 6 cents per pound vs Q1.
    • Polyethylene pricing peaked in May and is already seeing declines. Our view was always that the startup of the Mexico facility would define the peak in polyethylene this year.
  • “Brexit”, in our view, will cause enough uncertainty to cause companies to be more conservative on spending – buying a few pounds of product less than they might need in July, August and September rather than a few pounds more as we saw in March, April and May.
    • Unless oil strengthens meaningfully, we think a current slow decline in polyethylene and many other product prices could become a rapid decline through Q3.
  • While the stocks are discounting trouble – particularly LYB and WLK – consensus estimates have not come down for LYB, WLK and DOW either for Q2 or Q3.
    • Estimates have come down for EMN following guidance.
    • Both LYB and WLK’s numbers could, in a low (but not worst) case be $2.00 per share too high for 2H 2016, with DOW $0.60 too high on the same basis.
    • This does not factor in general weaker demand in Europe or a weaker Euro.
  • None of the stocks looks particularly expensive on this basis (giving credit to DOW for the synergies of DOW/DD deal), but the likely negative revisions/guidance will probably produce better entry points for all.
    • We think (barring recession) ethylene is weak through 2017 and then improves – extreme valuation dips in WLK, LYB and any weakness in DOW should be a buying opportunity.

Exhibit 1

Source: Midstream Business, SSR Analysis

Details

Whether it is the second or third derivative of the rate of change of natural gas inventories in the US, something has the market spooked. Prices have risen steadily since February and are 50% higher than their early year low (Exhibit 1). This is despite inventories that remain at a 5 year high, but are closing in on the prior 5 year high each week – hence the sentiment – Exhibit 2.

Exhibit 2

Source: EIA, SSR Analysis

Rising natural gas has resulted in a steady increase in ethane and propane pricing and as shown in Exhibit 3 the feedstock costs on the basis of one pound of ethylene have increased – more for propane feed than for ethane, with propane not getting much of an offset from propylene as polypropylene has become oversupplied and remains very weak. This dynamic does not bode well for the economics of DOW’s new propane dehydro unit in Freeport.

Exhibit 3

Source: Midstream Business, SSR Analysis

The rise in costs comes at a time of increased supply/demand uncertainty. On the supply side we have the end of the spring ethylene turnaround season in the US, plus the addition of the new 1 million ton Braskem/Idesa ethylene/polyethylene complex in Mexico.

On the demand side we have the end of the seasonally strong demand (granted that seasonality is relatively weak these days for polyethylene) and now we have “Brexit”. We share the more negative views of the impact of “Brexit”. We think that a leaderless Europe and a leaderless UK will create a steep decline in consumer and business confidence in Europe – made worse if others (Russia and ISIS) exploit the lack of organization. We believe that the odds of a Pan-European recession are very high – with knock-on effects all over the world. On this basis we expect buyers of chemicals and plastics to cut back purchases – as they always do in times of uncertain demand. We would only change this view if we saw a rapid cost push from crude oil. We do not believe that a decline in US natural gas prices (which we think unlikely) would be enough to materially offset the polyethylene margins squeeze. Integrated polyethylene margins in the US are close to 25 cents per pound, despite a decline in June – Exhibit 4. Margins are higher in Europe and Asia.

Exhibit 4

Source: IHS, WoodMac, SSR Analysis

Ethylene demand growth is volatile and the chart in Exhibit 5 shows that 2015 looks to have been well above trend, suggesting inventory build somewhere in the chain. A correction in 2H 2016 and 1H 2017 is very possible.

Exhibit 5

Source: IHS, WoodMac, SSR Analysis

Consequently, we believe the odds are high that polyethylene prices fall far more quickly over the next couple of months than they have since May. We stand by our earlier projections that US polyethylene integrated margins will fall by as much as 15 cents per pound by the end of the year and we think we have seen 4+ cents in June and could see the rest by the end of Q3. Polyethylene pricing in the US has fallen by 8 cents per pound or more, in a three-month period, 12 times since 1990. Leverage by company is summarized in Exhibit 6

Exhibit 6

Source: Company Reports, WoodMac and SSR Analysis

Current consensus estimates for LYB, WLK and DOW are unchanged for Q2 and for Q3 and have seen minimal revisions since Q1 earnings reports. By contrast, EMN has given guidance, partly based on ethylene margin pressures and estimates are down there – it is unclear why this has not yet been extrapolated through to those who have much more ethylene exposure than EMN.

We would not be surprised to see some early Q2 guidance this week.

Valuation is discounting some, but perhaps not enough, trouble for all three stocks – LYB, WLK and DOW – especially if you give DOW the benefit of the doubt for the synergies which should accrue from the DD deal. Interestingly there is a reasonable correlation to the YTD performance and revisions, especially if you look at 2017 estimates – Exhibit 7. Valuations are summarized in Exhibit 8 and look interesting even if estimates for this year and next have a further 20-30% to fall. In our normalized framework we have shown Dow both without and with credit for its share of the expected synergies from the DuPont merger.

Exhibit 7

Source: Capital IQ

Generally, we want to buy cyclical stocks when they are at least 1 SD cheap. None of them is there yet but WLK is the closest. We think that revisions will likely create better buying opportunities than we have today – probably more so for WLK and LYB than for DOW, which will continue to see deal based support. We remain positive on DOW because of the merger, and would expect DOW to outperform LYB and WLK as polyethylene margins come down. We would wait for better entry points on LYB and WLK, but recognize that DOW will likely also come under pressure with any earnings miss or negative guidance.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10


Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12

Source: Capital IQ and SSR Analysis

©2016, 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.

Print Friendly, PDF & Email