Friday Findings – April 20th, 2018
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
Graham Copley / Nick Lipinski
April 20, 2018
- Chart of the Week
- Q1 Preview – The SSR Approach
- IMF – Losing the Momentum
- CE/EMN – Is EMN One Step Behind?
- Weekly Winners & Losers
In research published earlier this week, we touched on a subject that we believe will become key to the development of the chemical industry in the next decade – what oil majors and refiners will do in the face of peaking and then declining demand for both gasoline and diesel. The peak and the decline will be driven by the rapid adoption of EVs in the 2020s, based on both affordability and availability. We do not know which year gasoline demand will peak, but we are fairly certain that it will. We also do not know the rate of decline, and the possible set of credible input assumptions to any model can drive wide ranges of answers to both questions, especially the latter.
Over the last couple of weeks, both Aramco and Shell have made comments, Aramco more granular than Shell, suggesting that the issue is already in focus with at least some oil producers and refiners. While conventional refined products demand will likely decline during the next decade, chemical demand is still expected to grow, and refiners will look at chemicals as a place to put unwanted surplus hydrocarbons. Major oil producers will likely focus on any project that ensures consumption of oil, and chemicals will become increasingly important as transport fuels decline.
For perspective – and we take an extreme view here for illustration – if every US refiner with an FCC (Fluidized Catalytic Cracker) were to switch operations to maximize the production of propylene at the expense of gasoline components (making all propylene available to the chemical markets), they would add 65% to current propylene availability in the US. If the price of oil base feed fell to encourage flexible ethylene facilities to switch from NGL’s to refinery naphtha, we could add another 20% to propylene supply. These are large and troubling numbers and should be qualified as follows:
- Only about 70% of US FCC capacity is in markets where there is already local propylene demand.
- There is not enough splitter capacity to purify all of this additional refinery supply, so investments would be needed.
- The 65% conclusion includes a move away from alkylate to chemicals.
- For the ethylene plants in the US to switch to heavier feeds, crude would have to fall materially relative to US natural gas and/or naphtha would have to fall relative to crude (implying that gasoline pricing falls relative to crude).
- In this case the global ethylene cost curve would flatten materially – very bad for an export oriented US ethylene and derivative businesses.
Note that in the chart below US chemical feedstocks from refineries are a minimal share. This is because most of the US feed is NGL (Natural Gas Liquids) based, including condensate. Outside the US, the chemical feedstock bar would be much bigger – including in the Middle East as refineries there produce significant quantities of naphtha for export.
The work published this week scratches the surface of a subject that requires more analysis and follow-up, and will be a topic of interest for years. If independent ethylene producers stop building (as they should with this risk on the near to medium investment horizon), then ethylene and propylene could become quite short in the early part of the next decade, only to be swamped with new production in the second half of the decade. Whether these issues/risk will have any implications on valuation in the near-term is unclear. The market is forward looking, but generally not that forward looking and earnings should be strong and stronger through 2018 and 2019, in our view. We already like the consumers of ethylene, propylene and aromatics because their end markets are strong and for the most part their sectors/products have seen underinvestment – TSE, HUN, 1COV, WLK, FUL, EMN and probably BASF. Buying a basket of these names might be a better longer-term play than owning DWDP, LYB and Braskem (which we also like today), but everyone could be an acquisition target as the fundamental dynamics change post 2020.
At SSR we do not maintain complex earnings models on the 200 or so companies that we follow in Industrials and Materials, and we have no comment on whether a specific company might beat or miss by a penny in any specific quarter. However, that does not mean that we cannot use some of our macro models to highlight some anomalies for the quarter and here we focus on deviations from mean at both the sector level and company level and look at how optimistic our serial optimists are this quarter.
As you look at the first chart some points to note:
- Q1 2018 should benefit from the new tax laws, so we would expect averages to be higher than the median.
- We are in a strong global economy with volumes high and prices rising – so again we would expect averages for Q1 to be above the median.
- On that basis:
- Paper and packaging estimates look high.
- Transport and Electrical Equipment look too low, as do Capital Goods.
- Chemicals has strong growth and pricing but much higher materials than a year ago. So less clear.
- We have excluded Q1 2009 and 2010 from the analysis as they represent the lows and peaks of the recession and distort the data.
In the second chart we look at which companies are the highs and lows in each of the groups just for this quarter and in the third we plot the quantum of expected Q2 EBITDA growth against how much each company has either overestimated or underestimated earnings over the last 5 years. Everyone in the bottom right quadrant has earnings growth expectations and has historically been too optimistic. The chart is too busy to label every company – let us know if you would like to see the positioning of a specific company or set of companies not shown.
Completing the set, in the third chart we show which companies are furthest away from their own historic Q1 averages. Combining all of the data together:
- IP looks the most interesting risk based on this analysis.
- It would have been FMC, but the company has guided up earnings twice in the last few weeks so it is likely that the step change expected will happen.
- MOS also looks like a risk given the company’s perennial optimism.
- GNRC estimates are likely driven by the severe storms in the Northeast in Q1 – unlikely that the estimate is correct, but the company could just as easily beat as miss given the lumpiness of storm related income for GNRC in the past. GNRC is not an earnings optimist however and the stock is still inexpensive in our view.
- LYB, WLK, and CAT also look interesting on the long side. We would add DWDP to this list – excluded from the analysis because of lack of consistent history
In the last section we talk about the momentum in the first quarter – expected strong growth and higher raw materials driving pricing that will either impact in Q1 or Q2 or both. At the same time, the more bullish economic expectations that have driven the market and earnings over the last 12-18 months are starting to slow, with the IMF not moving their 2018 and 2019 – still strong – economic forecasts in their most recent publication. As is clear in the exhibit, economic forecasts seldom stay flat for long and can lead to a change in direction. IMF concerns focus on a couple of developments: country debt, in a rising rate environment, and trade, though the debt commentary is more recent.
In the face of the debt issue, it is in the best interest of many companies – not least of which the US – to maintain the growth momentum and encourage further growth, even if that leads to slightly higher inflation. All this suggests that the trade issues should go away as cooler heads prevail and all sides can say they have achieved something.
Celanese and Eastman have spent the last 6 months announcing price increase after price increase for a whole variety of products, driven by the rising price of crude and higher input costs, but successful because of the stronger economy and rising demand which generally gives customers limited options in a price negotiation. As the chart below shows, as goes CE, so goes EMN, and it is a relatively safe bet to assume that EMN beats expectations next week. Unfortunately, as shown in the second chart, you don’t get paid on the day. EMN remains on our preferred list despite strong outperformance last year – CE will likely perform as well as EMN, but has much higher expected EPS growth in 2018 at this time so EMN could benefit from better relative revisions. We still believe that EMN is held back by poor articulation and execution of strategy today.
- Weekly Winners & Losers
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