Natural Gas – Rising As Inventories Build – Anticipates Supply Shock – Not Good for US Chemicals

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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

June 7, 2016

Natural Gas – Rising As Inventories Build – Anticipates Supply Shock – Not Good for US Chemicals

  • US natural gas prices are rising despite seasonally high and rising inventories
    • Suggests that investors/speculators anticipate a supply slowdown as a consequence of the record low rig counts
    • Inventories are at 5 year highs in part because of weak Q1 demand versus 2014 and 2015, not because production is surging
  • We had expected ethane prices to rise relative to natural gas as ethane exports rise and as expanded US ethylene capacity comes back on line after shutdowns
    • This strengthening has happened to a degree, but the recent rise in natural gas will push ethane higher in lockstep just as ethylene capacity is coming back on line
    • US ethylene margins are likely to get squeezed and polyethylene margins will likely suffer equally as again new capacity will make pricing difficult
    • Crude oil increases have helped the relative US position, but forward curves look worrying
  • The bigger problems are in methanol and urea, although international coal prices have bounced off the bottom which may impact Chinese export prices
    • Any pricing increase will likely not save Q2 and CF’s stock price reflects an expectation that Q2 estimates remain too high, despite a steady decline since March
    • LYB and WLK estimates have not moved meaningfully, but the stocks are weaker and discounting lower numbers
  • Natural gas is clearly pricing in a production surprise to the downside
    • Natural gas pricing likely does not have to spike meaningfully to encourage more production, but $3.00 per MMBTU is not an unreasonable expectation
  • We have learned from past mistakes that this is a train you should not stand in front of. No matter how articulate you might be on valuation or price and margin umbrellas – if natural gas keeps rising, particularly relative to crude oil, the stocks will go down
    • Exposed include: LYB, WLK, DOW, AXLL, OLN, CF, YARA
    • AXLL bid from Lotte may limit downside or create upside depending on structure
    • EMN may benefit if higher oil and gas means higher propane and a smaller hedging loss

Exhibit 1

Source: Capital IQ, SSR Analysis

Natural Gas Fundamentals In The US

Natural gas prices are rising quickly in the US and the forward curve is steeper than it has been in a while – Exhibit 2. This is not because of inventories, which remain well above a seasonal 5 year average – Exhibit 3 – but because of the expected impact of the precipitous fall in the rig count – Exhibit 4.

Exhibit 2

Source: Capital IQ

Exhibit 3

Source: EIA

Exhibit 4

Source: Baker Hughes

The rig count has been falling for a while and we have not seen a production response but this is mostly because the wells drilled last year and this year have been far more productive than expected on average. However, even with productivity gains we cannot have stability with the rig count as low as it is today. Note that the rig count chart is a little misleading as many of the oil wells drilled in the Bakken and the Permian and other areas have had plentiful associated gas – adding to the supply in the US. With the oil rig fall we lose the associated gas as well as the dedicated gas production.

Production stats have a lag to them and so far the data shows steady growth – Exhibit 5 – but pricing and especially the forward curve implies that this is going to end. The chart shows data through March 2016 – the rate of growth has slowed in the last couple of data points, but there is still growth. Part of the reason why inventories are as high as they are today is that Q1 was seasonally weak from a demand perspective – Exhibit 6.

Exhibit 5

Source: EIA

Exhibit 6

Source: EIA

Given the fall in the rig count there has to be some supply response and if we see the summer inventory build slow as a consequence, the price of natural gas could keep rising. However, if demand is subdued and inventories keep rising we may have seen all that we are going to get.

Sentiment is more positive for natural gas than crude oil or coal, even though all are on the increase – in Exhibit 7 we show an index for each and include the current forward curve, which is far more bullish for gas than crude or coal.

Exhibit 7

Source: Capital IQ

The Effect On Chemicals

The sentiment effect is generally more severe than the financial effect. We can already see significant weakness across the board – as indicated in Exhibit 1. While natural gas pricing has been rising since mid-February, it is clearly only in the last month that concerns that this might be something more permanent have started to reflect in stock prices.

The reality is that market fundamentals will dictate whether companies can pass through these cost increases – coming not just from natural gas, but also from crude and possibly also coal. In some markets producers may be able to pass on more than the cost increase and the sector has occasionally done well in periods of feedstock cost inflation. Given the global oversupply for many base chemicals, investing today on the basis that companies might succeed in recouping the cost increases does not seem prudent and much as we might like valuations and relative market positions for WLK, AXLL, CF and DOW, we would not step in front of possible cost inflation. Obviously the M&A interest in AXLL likely sets this company apart from the rest for the moment.

Ethylene – a Relative Story

In terms of the “relative” US story, rising crude oil has improved the US’ position in ethylene and the global cost curve is a lot steeper today than at the beginning of the year and even if we assume that natural gas rises to $3.00 per MMBTU we still have a significant margin umbrella – Exhibit 8. US ethylene pricing has not moved much from the 25-26 cent per pound range that we have seen for the last several months and that may well reflect that the incremental pound of ethylene in the US needs to be exported and therefore needs to be priced at a discount to find a market. Crude has risen relative to natural gas all year – Exhibit 9 – which should be good for the US ethylene producers. However, the forward curves would suggest that the trend is going to reverse (Exhibit 7 and Exhibit 9) and furthermore, timing may be a problem from a pricing perspective. In Exhibit 10 we show quarter on quarter pricing trends for US ethylene from 2000. The third quarter is not a great quarter for increasing ethylene pricing in the US.

We were already concerned that polyethylene and ethylene margins were likely to peak in Q2 2016 because of supply/demand fundamentals. The prospect of a feedstock and/or cost curve squeeze would make us even more cautious on the group near-term.

Exhibit 8

Source: IHS, SSR Analysis

Exhibit 9

Source: Capital IQ

Exhibit 10

Source: IHS, SSR Analysis

Urea – Likely an Absolute Story For a While

The picture is a little more certain and a little more bleak for urea and possibly also for methanol. The urea cost curve chart that we borrowed for our piece on CF – Exhibit 11 – was constructed in Q1 2016 and the increased natural gas price in the US will put immediate upward pressure on the costs reflected at the very left of the curve. While oil pricing may put some upward pressure on the cost bars shown in red, oil prices are not high enough to push those costs high enough to change the marginal producer – China high cost coal. International coal prices have bounced off the bottom and while that may raise the costs of the more efficient Chinese coastal coal based producers, it will likely not change the price setting mechanism unless inland coal prices rise also. The result will be a squeeze on all producers as the cost curve flattens and it is not surprising that Yara and CF are among the worst performers over the last 5 weeks. We like the valuation and leverage at CF, but it is hard to like anyone too much in a flattening cost curve environment.

Exhibit 11

Source: CF

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