European Basic Chemicals – There Is Life In The Old Dog Yet!
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
Graham Copley / Nick Lipinski
June 16th, 2014
European Basic Chemicals – There Is Life In The Old Dog Yet!
- Transactions in Europe signal two coincident events in our view: first capitulation on the part of local producers around the idea that “waiting and hoping” is not a strategy – the Industry has significant structural impediments to future prosperity/viability, and these need to be addressed.
- The second is a clear belief that the worst may be behind us from a demand perspective, even if the cost structure looks troubling and overcapacity is unlikely to get fixed through growth. Consolidation allows for capacity rationalization and better operating rates for the facilities that remain.
- There is also increasing interest in looking at opportunities to export US production economics to Europe. More companies are looking at exporting ethane from the US to Europe and there is clearly some interest other elements of the PVC chain with the WLK acquisition of Vinnolit.
- In the vinyls space, it would make most sense for both the Ineos/Solvay divested assets and the Dow assets to end up in companies that are already present in these businesses in Europe – to assist with the needed consolidation – or perhaps they should end up together!
- Profitability has improved in Europe despite some fairly terrible cost positions versus both the US and the Middle East – Exhibit 1. The negative here is that prices in Europe are well above US and Middle East costs, which will encourage exports from these regions to Europe as surpluses build in the US and Middle East. We do not expect a straight line recovery in profits and there may still be some disappointing quarters ahead.
- Better structure in European vinyls helps the value of the Dow chlorine spin; lower benzene costs help newcomer Trinseo (though initial valuation is not a bargain and Q2 for benzene does not look as good as Q1). Moving US ethylene (or equivalent) to Europe hurts the sellers – SABIC, Shell, Total and Ruhr Oel. Ineos remains in the overall driving seat in our view.
Source: Capital IQ, Company Reports
The level of interest in European basic chemicals has increased significantly in recent weeks. The reality is that there could not really have been less interest in the space than there was this time last year, so the improvement is from a very low level.
- In the PVC chain we have had three moves and there are two more to come
- Kem One has emerged from bankruptcy with new PE owners – maybe this time the timing is right
- Westlake has agreed to acquire Vinnolit – A German based producers of PVC, EDC, VCM and Chlor-alkali
- The European commission has approved the JV between Ineos and Solvay, creating the largest player in Europe with around 40% of the PVC capacity.
- The first deal(s) to come is the result of Ineos/Solvay’s need to divest in order to meet the conditions of the EU. These assets alone accounts for almost 15% of European PVC capacity – and include EDC, VCM and chorine.
- The second is the proposed DOW exit of its chlorine business. Dow is currently the largest producer of chlorine and caustic soda in Europe, and has been for years – the company has around 2 million short tons of chlorine capacity – all in Germany. It will likely lose its leadership position to the new Ineos/Solvay joint venture.
- Dow is not a PVC producer – it makes EDC (which it sells) and Epoxies – and these businesses will be part of the sale. However, most of the chlorine is used in the polyurethane business which will stay with Dow.
- Last week saw the IPO of Trinseo – formerly Styron. While this was an NYSE listing, the bulk of Trinseo’s assets are in Europe. This the former Dow Chemical styrenics and polycarbonates business.
The timing is interesting for all of these moves as, while generally things got worse in Europe in 2013 versus 2012, there has been steady improvement since the middle of 2013. We believe that the activity is a sign that producers are now realistic about how generally bleak the European future might be and are consequently willing to start looking at more radical solutions. PVC margins deteriorated through 2013 in Europe, but have seen some improvement this year. Trinseo lost a small amount of money in 2013, versus a small positive in 2012 (based on its filing), however its last 6 months so have seen an improving trend.
However, Investment Opportunities are Limited
Trinseo (TSE) is currently not making much money and the IPO price, which values the company at around $2.1 billion, of which $1.2 billion is debt, implies further improvements, which need to come from better fundamentals in Europe or something clever on the raw material side.
- On the negative side, the company is very tied to Dow because of history and plant locations. Raw material and service agreements may give the company fewer degrees of freedom
- On the positive side Chris Pappas is a great operator and has done well to get the company where it is today in the recent business environment.
WLK, DOW and LYB
and the other US companies we have covered in detail and see our recent work for more specifics on our views.
Otherwise in Europe there are very few direct routes to possible improvements in European basic chemicals
- ERCROS (PVC) in Spain is almost a penny stock at this point having lost money for the last 5 years – recent numbers are improving however.
- BASF will get a lift, but any improvement may be too small to notice given the size of the company.
- Lanxess is under new leadership and the stock has performed poorly into that leadership change based on some poor numbers and an asset write down last year. That said the stock is certainly not a bargain today.
- SABIC’s European operations are too small to move the needle and while more feedstock flexibility in the UK might help, the company has a larger naphtha based complex in The Netherlands, which will likely continue to drag on earnings. SABIC is a big seller of ethylene in Europe and is vulnerable to imports of ethylene and derivatives from the US.
The near-term opportunity for all of these businesses is to explore whatever routes are possible to export US economics to Europe –
something we have written about previously
. Options are summarized in Exhibit 2, together with names of companies either already pursuing those options or have the greatest opportunity.
The precursors to PVC and styrene are the most efficient ways to do this from a shipping perspective but the overall economic advantage is likely greatest in the PVC chain.
- We see Ineos already active – investing to move ethane to the UK and Scandinavia, and recently commissioning a large ethylene terminal in Antwerp, attached to the ethylene pipeline grid in Europe.
- Both Versalis (to France) and SABIC (to the UK) have indicated interest in moving ethane, but both would need significant investment.
- There are other ethylene terminals in Europe but the only other one connected to the grid is owned and operated by Exxon.
- Westlake has the ability to move EDC from the US to Europe – it already has the terminal in the US and has – or could have surplus – ethylene and chlorine. There will be significant logistic challenges getting the benefit of this in some of Vinnolit’s facilities, but not in others.
- Westlake’s logistical degrees of freedom would increase if they were the buyer of the Ineos/Solvay assets mentioned above.
- Westlake may be a logical buyer of these assets but we do not think it would be the only bidder, with likely interest from both Asian and Middle East based companies.
- Ineos does not have EDC capacity in the US, but does have ethylene.
- Trinseo is likely tied into long term supply contracts from Dow and may have limited flexibility here. There may be some incremental opportunity to move US sourced ethyl-benzene to Europe and this may become more important if other European styrenics producers look to do the same – Ineos again for example. Moving ethyl-benzene or styrene to Europe will also depend on the relative price of benzene – if benzene is cheaper in Europe than the US – as it was for the whole of the first quarter, the export is less obvious. Recent US benzene prices have been lower than European prices, a switch from Q1. (Benzene is around 70% of a styrene molecule). Over the last 14 years, benzene prices in the US have averaged higher than Europe, but not by much.
- US exports of Styrene to Europe have increased meaningfully in Q2 versus Q1 – this may be a benefit or risk to TSE depending on who is exporting to who.
Fundamentals in Europe are still fairly grim
Near-term, there is no fundamental reason to cheer in Europe. While the economy may have turned a corner this year, it has had many years of misery and this leaves the region with significant overcapacity in basic chemicals despite some rationalization.
Among the European producers, Ineos has really been the only company on the offensive. The rest have for the most part been hunkered down trying to ride out the storm and hope for the best – albeit with some plant closures here and there – Dow has been quite active, but again more defensively, shutting down older and smaller facilities. LYB has also made some closures.
Operating rates are generally very poor
- Ethylene operating rates in Europe remain very poor (at times sub 80%) – some companies (Dow for example) have been campaigning units – running occasionally – where they have multiple facilities. This allows for maximum operating rates on the plants that run. This is a practice not seen in European ethylene for decades.
- West European PVC operating rates are at or slightly above 80% – similar to ethylene and this is despite European producers increasing exports over the last several years – mainly to Eastern Europe and Russia.
- Polyethylene and styrene operating rates are not much better, though there have been some signs of life in the styrene markets – which has helped pricing and has been directionally supportive of Trinseo’s IPO.
- Some of the styrene benefit in Europe has comes from lower benzene pricing in Q4 2013 and Q1 2014 versus the US, but this advantage looks to have gone away in Q2.
Economics are better but still very poor
- Low operating rates hurt plant efficiencies and cash costs increase. On an average European ethylene plant, if operating rates drop from 90% to 70% cash costs of production can increase by as much as 10% per metric ton of production – non cash overheads would also be spread over a lower production volume.
- Generally European pricing has stayed ahead of European costs despite production costs generally being much higher than they are in the US and Middle East.
- This is allowing companies to make some money in many areas
- Both LYB and DOW had much better first quarters in Europe – we are not convinced that the second quarter will be as good for either company.
- Trinseo showed progressive quarterly improvements from a low in Q2 2013.
- PVC margins have improved in Europe this year versus last and are still improving.
- The turn in pricing is likely a function of customers wanting marginally more product this year as the economy has turned, versus years of wanting marginally less product.
- This is allowing companies to make some money in many areas
- But – higher prices present a different problem. European net prices are well above US net prices today and far above US and Middle East costs – for many products. This increases the incentive to ship to Europe.
- With the Williams and LyondellBasell ethylene expansions in the US either on line or imminent, we see a potential surplus of ethylene in the US for the balance of the year – given slow US demand growth – see our research on why we expect US and global demand growth to remain slow.
- This could encourage some “special” ethylene pricing deals to encourage derivative exports.
- The Middle East has one plant start-up near-term, but the next big expansion is SADARA – the Dow/Aramco JV in Saudi Arabia. The risk to Europe from the Middle East would be a slow-down in demand and demand growth in Asia, leaving Middle East producers looking for another market.
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