Rising Natural Gas Prices AND Rising Commodity Chemical Company Estimates.

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

February 9th, 2014

Rising Natural Gas Prices AND Rising Commodity Chemical Company Estimates.

How can that be?

  • US natural gas prices have risen quickly in response to stronger than normal seasonal demand driven by the colder weather. We see further upside to gas prices if the weather forces inventories to drop as quickly in the next week as they have done in recent weeks.
  • This higher priced natural gas is putting cost pressure on commodity chemicals – most notably ethylene (from upward pressure on feedstock costs) and chlorine (from rising electricity costs where consumers do not have fixed price contracts), and should result in meaningfully lower margins in Q1 2014 versus Q1 2013. Even if product prices react there is generally a lag, with the costs hitting in real time. Profitability should fall significantly from Q4 2013 levels also.
  • Q1 2014 consensus estimates for the exposed companies have in some cases been rising over the last few weeks – in part drive by strong Q4 2013 results. For all of the ethylene companies Q1 2014 estimates now sit higher than Q1 2013 earnings, most significantly for WLK and LYB, who are the most levered to ethylene margins and therefore changes in natural gas prices.
  • Valuation is most extreme for the ethylene companies, with DOW, LYB and WLK all close to 52 week highs. AXLL and OLN are more reasonably valued in our view with OLN the most attractive. Current valuations do not reflect the risk of meaningful revisions to short term earnings.
  • So far, the activist interest in DOW has put a bit of a floor under the stock, with the stock outperforming meaningfully on down days. This support may limit the impact of negative revisions or guidance and LYB and WLK may show more downside as a result.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

US natural gas prices have spiked above $5.00 per MMBTU, since the middle of January and continue to do so thus far in February. With the cold winter natural gas demand has been well above normal – last week the inventory draw-down for natural gas in the US was more than 10x the 5 year average for the week. This has led to a 20% decline in inventories over the past two weeks and inventories are now at the lower end of their long term trend. The gas bears will say that production can be ramped up very quickly to offset the increased demand, but if we have couple more weeks of very cold weather we could see gas prices for the quarter well above both the first quarter of last year and the recent fourth quarter.

There is no real strength in either the ethylene market or the chlorine market in the US – the two products that benefit most meaningfully from low cost US natural gas, and seasonally this is one of the weakest demand periods of the year. We may see some movement in product pricing, but not enough to offset the raw material cost rise and furthermore, there is always a lag. If natural gas prices averaged $5.00 per MMBTU for the first quarter, costs for many ethylene and chlorine facilities in the US could be as much as 33% higher in than in Q1 2014 – equivalent to 8-10 cents per pound for ethylene.

Interestingly, we have seen broadly positive revisions for ethylene companies for the first quarter – generally following good fourth quarter reports. And for DOW, LYB and WLK we have estimates that sit well above Q1 2013 actual earnings.

THIS MAKES NO SENSE – It is likely that companies are going to be forced to issue negative guidance – probably by the end of February – possibly starting with Westlake (on February 20th), who will likely post a very good quarter for Q4 2013, but be forced to comment on Q1 and should by then have plenty of negative data points. We may get a hint when AXLL reports on February 12th.

Some companies look more overvalued than others – some justified by earnings expectations that now look stretched – others look expensive even with inflated earnings expectations. We would be most concerned about the US focused companies, such as AXLL, OLN and WLK, with WLK looking the most stretched from a valuation perspective, but expected to have an offset from a very good Q4 2013.

DOW and LYB are also very exposed, but they could both see a slight offset from Europe if Brent remains weaker than it was in Q1 2013. The European improvement however, will not likely offset the US headwind. Estimates for Q1 2014 look most reasonable for OLN and stretched for everyone else, particularly WLK, though we do not think that either DOW or LYB will make the expected numbers unless natural gas falls quite quickly from current levels.

Natural Gas Is Expensive and Poised To Get Worse

At the end of January 2014 natural gas inventories in the US were at a 5 year seasonally adjusted low – Exhibit 2. The drop in inventories has been in direct response to the cold weather related demand in the US – something that we have written about recently. Looking at the data another way and calculating a weekly standard deviation around a norm, the current level of low inventories is statistically significant and in our view should support today’s higher natural gas prices – Exhibit 3.

Exhibit 2

Source: EIA

Exhibit 3

Source: EIA and SSR Analysis

Exhibit 4

Source: EIA and SSR Analysis

Natural gas pricing is off its recent peak of last week, but remains much higher than it was at this time last year and year to date averages are summarized below in Exhibit 5 (Henry Hub). If this were to flow directly through to power prices we would be looking at a 36% increase. If we assume that ethane tracks natural gas (but maintains its recent average negative extraction margin) we are looking at around a 7.5 cent per pound reduction in ethylene margins. These numbers will get larger if gas remains at its current level or rises, because prices in February and March of last year averaged around $3.45 MMBTU.

As a reminder;

  • DOW has approximately 10 pounds of ethylene per share levered to North American natural gas. For Dow a 10 cent per pound lower margin is a 25 cent per share hit per quarter.
  • LYB has around 13.5 pounds per share on the same basis – 34 cents per quarter
  • WLK is close to 50 pounds per share – $1.25 per quarter.

For the chlorine producers a 33% increase in power costs is a 5-10% increase in cost of goods sold, given the mix of businesses that AXLL and OLN have. Electricity costs are roughly half the full cost of production for chlorine. The chlorine chain is roughly 65% of OLN’s business and 30% of AXLL’s business.

Exhibit 5

Source: Capital IQ

Earnings Estimates and Revisions Seem To Be Missing This – So Far

So far, earnings revisions have been more influenced by Q4 earnings than they have by current fundamentals. As shown in Exhibit 6 estimates for LYB and WLK are up versus where they were at the beginning of the year; estimates have risen for some for Q2 2014 also – Exhibit 7. The chlorine guys – and we would include Dow in that group – appear to be thinking about chlorine more appropriately.

Exhibit 6

Source: Capital IQ

Exhibit 7

Source: Capital IQ

Looking at Q1 2014 estimates versus Q1 2013 – all the ethylene guys are calling for growth. While LYB and DOW have other businesses which might cause an offset we think these projections are ambitious given the analysis above. Note that WLK also has a significant chlorine business and will get hit in both verticals if gas remains high.

Exhibit 8

Source: Capital IQ

Valuation – Not Paid To Take the Risk

Our commodity index is looking quite expensive both on our normalized framework and on a simple price to sales analysis Exhibit 9. AXLL is not included in the valuation indices because it does not have a return on capital history that fits the analysis. Its recent underperformance has made it less of a valuation outlier in our view and we could make a case that it is no more than fairly valued today if we give a step up in normal

earnings from the PPG acquisition. OLN still looks inexpensive and the most interesting story in the group. Consequently the high aggregate numbers are all there because of the ethylene producers, WLK, LYB and DOW.

Exhibit 9

Exhibit 10

Source: Capital IQ and 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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