Rising Dollar and Falling Crude – Bad For Commodity Chems

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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

September 17th, 2014

Rising Dollar and Falling Crude – Bad For Commodity Chems

  • The rising dollar makes US imports cheaper, but if you are in the US Chemical Industry today you are hoping to increase US exports based on the competitive nature of US hydrocarbon feedstocks – the dollar move does not help this. Moreover, many of our Chemical names have significant offshore revenues and the translation effect on earnings can be significant.
  • Of all the Industrial and Material sectors, it is the Chemicals sector that most consistently and significantly underperforms in periods of dollar strength. If we look at the two bell-weathers Dow and DuPont, there is more consistency in this conclusion for Dow than for DuPont.
  • Separately, oil prices are falling; good for the overall global economy as spending power increases, but bad for a US chemical industry investing to exploit an oil and US natural gas price difference. The current drop in crude is a concern, but a further 15-20% drop would change the economics of many initiatives, most important, export of ethane from the US
  • Over the last couple of months, the global “break-even” price for ethylene – based on some fairly generic cost curve analysis has fallen by 15-20%. This will likely lower global pricing and export netbacks for the US. This is not relevant today, because production problems in the US have left markets very short. Oversupply in 2015 with lower global crude prices could drive significant negative revisions for the US ethylene based companies.
  • DOW and LYB have significant leverage to Europe and Asia and WLK has increased leverage to Europe with its Vinnolit acquisition. All have impressive earnings growth forecast for 2015 and all are expensive – we would be short all three if we felt that the dollar and crude trends would continue, with the caveat that there is an activist at DOW.
  • AXLL has valuation support and would benefit from any lower US ethylene pricing in 2015. AXLL has no exposure outside North America. While not commodity focused, DD has relative valuation support but big non-US exposure.
  • The Chemical sector will most likely underperform in any strengthening dollar scenario, but the ethylene companies will likely lead the decline. There is some relative safe haven in AXLL and the Industrial Gas companies, but only ARG does not have the dollar translation issue.
  • One caveat: DuPont could look right through the exchange rate issue, given the more active activist. The company’s earnings are very vulnerable to moves in the dollar, but the stock is relatively cheap and restructuring and cost cutting opportunities are high.

Exhibit1

Source: Capital IQ, SSR Analysis

Overview

While crude oil has been quite volatile in recent weeks it is also much lower than it has been with Brent breaking through what were thought to be support levels and sitting below $100 per barrel for the first time in a long while. At the same time, and probably somewhat connected, the dollar is strengthening. (Exhibits 2 and 3 summarize the analysis in the sections below. Note that we do not have much history or many data points for the Packaging sector)

It is possible to argue for continuations of both trends – oil supply/demand fundamentals driving more of the oil story than geopolitics, and the relative strength of the US economy. Of course it is likely that one is driving the other to a degree. Should the trends continue, there will be pluses and negatives. From a very macro perspective, high oil prices are a constraint on economic growth and a 15-20% reduction would have a positive impact on consumer spending outside fuel. A stronger dollar reduces the price of US imports. On the flip side; the stronger dollar reduces the non-US contribution to earnings for companies with global businesses. Lower oil prices reduce revenues for oil producers and negatively impacts anyone levered otherwise to a strong crude oil market – such as the US commodity chemical producers.

The commodity chemical group is negatively levered to the stronger dollar and to weaker crude, as many of the companies have significant offshore business, many of which have been improving in recent quarters and have been the drivers of earnings surprise. Lower oil prices reduce the margin umbrella that sits over US natural gas based chemical producers, and in globally oversupplied markets will negatively impact international pricing and consequently export netbacks from the US.

Today, the US is seeing record margins in the polyethylene chain, driven by low costs and higher pricing, with the higher pricing driven by real local shortages (as a result of chronic production problems in the US in 2014). If we continue to see the recent trend in crude oil we could be setting up for a very disappointing 2015, as record US production (post the production issues and driven by capacity additions), could meet head-on with lower international pricing (driving lower US export netbacks), and lower US demand as consumers shave inventory in expectation of lower forward pricing.

The global cost curve for ethylene has seen theoretical break-even pricing fall by as much as 15% over the last two months, and while this still leaves a comfortable umbrella both for US producers and those planning new capacity, it does call into question 2015 chemical price and profitability assumptions. A further 20% decline (natural gas at $4.00 per MMBTU and Brent at $80 per Barrel), would make some US projects marginal and probably kill the economics of moving US ethane to Europe and India.

Exhibit 2

Source: Capital IQ, SSR Analysis

Exhibit 3

Source: Capital IQ, SSR Analysis

The most exposed US names are DOW, LYB and WLK. All have earnings growth expectations for 2015 based on a high oil/natural gas spread and all (now) have exposure to Europe that will be a translation drag as the dollar gets stronger. DOW and WLK are the most stretched from a valuation perspective today. AXLL has no Europe exposure, and while a lower oil/gas spread might reduce chlorine margins, the company would benefit from any ethylene price reduction in the US caused by oversupply. The expected EPS growth in Ex 1 is more a function of AXLL running its plants better in 2015 rather than any heroic feedstock assumptions.

Overall, the chemical sector underperforms when the dollar strengthens, looking at periods which were not impacted either by the tech bubble or by the financial crisis. We would be cautious about underweighting both DOW and DD because of current activism.

A Stronger Dollar – No Real Fiend to Industrials and Materials, but an Enemy to Chemicals

A stronger US dollar has historically been bad news for the Chemical sector with the group the most consistent underperformer in periods of dollar strengthening. The two primary reasons for this are the significant exports of chemicals from the US, but more important, the significant non-North American exposure that the US chemicals industry has with assets all over the world – the Euro is the big concern here. In Exhibit 2 we show non-North American and European revenue exposure by broad Industrial and Materials sector, in Exhibits 3 and 4 we show the same for the individual companies in our Chemical universe (adjusting approximately for recent announced acquisitions for EMN, ALB and HUN) and the aggregate sub-sector figures.

Exhibit 4

Source: Capital IQ, SSR Estimates

Exhibit 5

Exhibit 6

When we look at periods of dollar strength we have excluded both the tech bubble of the late 1990s and the financial crisis as we believe that there were so many moving parts at those time that it is hard to attribute movements to a single factor. We looked at four periods of dollar strengthening – Exhibit 7:

  • September 1992 to March 1993
  • December 20014 to November 2005
  • December 2009 to June 2010
  • May 2011 to August 2012

Exhibit 7

Source: Capital IQ, SSR Analysis

There are lots of charts here – for each period we show the Industrials and Materials Sectors and the Chemicals sub-sectors. Note that given the way we derive discount from normal value and present the data, a rising bar represents underperformance – sectors getting cheaper.

The last chart in this section shows the data for the four periods for just Dow and DuPont. These are the two most important large cap names in the space and they are also the companies for which we have the most consistent and complete historic data. Dow Chemicals is a consistent underperformer in periods of dollar strength.

September 1992 to March 1993: Exhibits 8-9

Exhibit 8

Source: Capital IQ, SSR Analysis

Exhibit 9

Source: Capital IQ, SSR Analysis

December 2004 to November 2005: Exhibits 10-11

Exhibit 10

Source: Capital IQ, SSR Analysis

Exhibit 11

Source: Capital IQ, SSR Analysis

December 2009 to June 2010: Exhibits 12-13

Exhibit 12

Source: Capital IQ, SSR Analysis

Exhibit 13

Source: Capital IQ, SSR Analysis

May 2011 to August 2012: Exhibits 14-15

Exhibit 14

Source: Capital IQ, SSR Analysis

Exhibit 15

Source: Capital IQ, SSR Analysis

Exhibit 16

Source: Capital IQ, SSR Analysis

Crude Oil A Reversed Correlation

We have done the same sector/stock performance analysis with crude oil – looking for periods of crude oil weakness and plotting sector performances. The periods chosen are summarized in Exhibit 15. Interestingly, with the exception of the earliest period examined (2006/2007), the Chemicals sector has underperformed in in periods of crude weakness. Historically, (1980 through 2000) weaker energy signaled greater profits for chemicals and the sector would generally do well as crude prices fell – this was still the case in 2006. Since the emergence of cheap natural gas in the US and the reliance on the oil/natural gas spread to drive US profits the relationship has reversed and we see chemical underperformance as crude weakens. In the most recent three periods of crude weakness the commodity chemical group has underperformed more significantly than other subsectors.

Exhibit 17

Source: Capital IQ, SSR Analysis

July 2006 to January 2007: Exhibits 18-19

Exhibit 18

Source: Capital IQ, SSR Analysis

Exhibit 19

Source: Capital IQ, SSR Analysis

April 2011 to September 2011: Exhibits 20-21

Exhibit 20

Source: Capital IQ, SSR Analysis

Exhibit 21

Source: Capital IQ, SSR Analysis

March 2012 to June 2012: Exhibits 22-23

Exhibit 22

Source: Capital IQ, SSR Analysis

Exhibit 23

Source: Capital IQ, SSR Analysis

January 2013 to May 2013: Exhibits 24-25

Exhibit 24

Source: Capital IQ, SSR Analysis

Exhibit 25

Source: Capital IQ, SSR Analysis

Exhibit 26

Source: Capital IQ, SSR Analysis

The Effect on the Cost Curve

Falling crude oil prices represent a potential serious headache for the US Chemical industry, in particular those companies investing to exploit the low cost natural gas based feedstocks in the US. The opportunity behind these investments relies on a high premium for crude oil versus US natural gas on a fuel equivalent basis. Even with the current decline, the US opportunity still looks compelling, but there is a hierarchy of expected returns in the projects and agreements that have been made, and further falls in oil prices begin to make some of the more marginal projects look questionable.

Regardless of the investment economics, lower oil prices will create lower international chemical pricing in oversupplied markets and the effect of the recent oil decline has been to lower the theoretical break-even price of ethylene by around $200 per ton or around 15-20%.

Outside the US the only market tightness in the commodity space is the result of elective closures because of poor economics. In some sectors, such as PVC and polyester, global operating rates as low as at any point in history. As global costs fall, we expect global pricing to fall. Today the US ethylene market is very tight and lower pricing outside the US has little impact as US exports of ethylene derivatives are low and declining. However, we expect a much better ethylene supply situation in the US in 2015, with an increased need to export ethylene derivatives. If this occurs in a weaker global pricing environment it will reduce export netbacks to the US and inevitably impact US pricing.

If Brent remains in the $95-100 per barrel range and the US moves into an ethylene surplus in 2015, we would expect meaningful negative revisions for DOW, LYB and WLK. Lower ethylene pricing in the US would be positive for AXLL.

Exhibit 27

Source: IHS, Wood Mackenzie, SSR Analysis

Valuation

Exhibits 28 and 29 are updated versions of charts from our
Chemicals Monthly
, showing valuation and return divergence as measured on our models. We highlight companies that are at all time or 10 year valuation or earnings extremes. Exhibits 30-35 show valuation history for DOW, LYB, WLK, DD, AXLL, and OLN.

Exhibit 28

Source: Capital IQ, SSR Analysis

Exhibit 29

Source: Capital IQ, SSR Analysis

Exhibit 30

Source: Capital IQ, SSR Analysis

Exhibit 31

Source: Capital IQ, SSR Analysis

Exhibit 32

Source: Capital IQ, SSR Analysis

©2014, 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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