Trading Ethylene? – Tread Carefully

gcopley
Print Friendly
Share on LinkedIn0Tweet about this on Twitter0Share on Facebook0

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

September 23rd, 2016

Trading Ethylene? – Tread Carefully

  • Ethylene margins in the US in Q2 and Q3 have recovered significantly since the early part of the year, largely because of supply shortages in the US (stemming from prolonged shutdowns) but helped by:
    • Very robust demand for ethylene derivatives – especially polyethylene
    • Some desire to build inventory ahead of planned polyethylene start-ups that preceded ethylene startups – this has been hard to do in an undersupplied market
  • Q3 is likely to provide some upside surprises for the ethylene sellers (polyethylene prices are a little higher but have not seen the spike that ethylene has) – LYB will gain as a net seller
    • Ethylene buyers will be squeezed and WLK may be hurt by legacy Axiall September purchases
    • Estimates for LYB, DOW and possibly WLK may not reflect the likely improvement
  • The stocks remain very undervalued in relation to their near term earnings potential – but in our view this is justified and this is why we would tread carefully trading into the quarter
    • The US will add more than 5 million tons of ethylene capacity in 2017 – mostly towards the end of the year, but the chart looks ugly
    • The current tightness is a consequence of unexpected plant outages and possibly above trend demand for polyethylene (so maybe an inventory build)
    • Natural gas is rising relative to crude oil, lowering the theoretical US margin umbrella should oversupply lead to pricing that is more reflective of the cost curve – Exhibit 1
  • However, we believe (see prior research) that ethylene could have quite a bright future once the 2017 wave of US capacity is behind us, as on a global basis the US additions are much less significant. We would likely be buyers of the space once 2017/2018 estimates reflect what will likely be a margin squeeze that could last as long as 18 months
    • DOW is our preferred way to play the sector today but we anticipate very good entry points for LYB and WLK, possibly by year-end

Exhibit 1

Source: IHS, Wood Mac, SSR Analysis

Overview

US and global ethylene and polyethylene markets (ethylene now more than polyethylene) continue to defy gravity as we come to the end of Q3. US ethylene pricing is up 30% since May and the market appears to be very tight, based on current ethylene inventory levels. Currently ethylene pricing is trying to find a level that destroys incremental export demand for the marginal derivative in order to remain balanced. But appearances can be deceiving and can possibly lead to the wrong conclusions.

On the positive side:

  • Polyethylene demand remains very strong and growth in apparent demand this year could exceed 5% globally. This is now the largest part of the ethylene market by such a wide margin that it is pushing ethylene demand above trend growth rates.
  • US operating and maintenance problems have curtailed production versus expectations, keeping inventories low and spot market availability limited. This would have been a bad quarter (especially August/September) for Axiall – given its exposure to the spot ethylene market, had it remained a stand-alone entity.
  • There is likely a desire to build inventories in the US, specifically by Sasol, ahead of the start-up of its polyethylene JV in the US with Ineos. Sasol would likely rather lend (than sell) ethylene today to others in the US, or build its own inventory, given its ethylene unit start-up is now likely to be more than a year behind this polyethylene unit. Sasol’s exit as a seller has helped tighten the market.

On the negative side:

  • Polyethylene demand growth “feels” too high – it should be strong but not this strong. It is possible that there is an inventory build going on for one of several reasons:
    • Concern about shipping times for product moving around the world – the Hanjin problems will not have helped here.
    • Concern that oil has bottomed and will go up from here – buyers may be fearful that rising oil prices would lead to higher polyethylene prices.
  • New capacity now – Saudi Arabia, Mexico, expansions in the US associated with the recent shutdowns.
  • New capacity later – four start-ups in the US in 2017 – Oxy, Exxon, Dow and CPChem – adding over 5 million tons of new ethylene on an annualized basis – Exhibit 2.
  • Almost all new capacity in the US will need to be exported from the US as some sort of ethylene derivative and spot prices in the US will need to fall to facilitate that.

Exhibit 2

Source: Wood Mac, SSR Analysis

It all comes down to timing – whether the restart of the shutdown units in the US will provide enough ethylene to satisfy Sasol’s need to build inventory and create a surplus beyond that, and when that will occur, or whether we see ethylene remaining tight until the 2017 start-ups begin to hurt – late 2017.

The inventory build expected by WoodMac over the next 12 months is significant and could boost apparent US demand growth for ethylene by as much as 2-3% in 2017 – Exhibit 3

Exhibit 3

Source: Wood Mac, SSR Analysis

The stocks are pricing in weakness, despite what we believe could be upside surprises for LYB and DOW in Q3 2016. For WLK it is less clear as ethylene margin will be good, but it is possible that the company inherited some of Axiall’s spot ethylene purchase commitments for September, which could hurt given current pricing.

It is also possible that LYB and DOW put up good Q3 numbers and the stocks go nowhere or possibly decline because of the 2017 concerns. Estimates for LYB do not reflect any real weakness in ethylene/polyethylene in 2017/2018 and both we and the share price believe that this is unlikely.

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

Why the Stocks Are Not 50% Higher Today

Investors are not excited about the sector because of the wave of capacity on the horizon and Exhibit 6 puts more history to the chart shown in Exhibit 2. The picture is more dramatic when you look at the whole thing on an annual percentage increase basis – Exhibit 7. It has taken far less of an increase in capacity in the US in the past to ruin the market for several years and clearly this overhang is preventing anyone from judging the stocks on current earnings. In Exhibit 7 we also show US ethylene margins and the most interesting point of reference in our view is what happened to margins post the capacity increase in the 1987-1990 period. Margins quickly collapsed to near historic lows in 1992/3 and precipitated a significant round of industry consolidation. The more recent period is deceiving as part of the much higher margin picture we see for ethylene has been the result of complete integration with polyethylene in the US and the margin moving to ethylene from polyethylene, and part has been the margin umbrella created by the higher crude oil prices relative to natural gas – which still remains quite robust, despite being well off its highs – Exhibit 8.

Exhibit 6

Source: IHS, Wood Mac, SSR Analysis

Exhibit 7

Source: IHS, Wood Mac, SSR Analysis

Exhibit 8

Source: Capital IQ, SSR Analysis

But This is a Global Market…

While the US picture looks scary in the near term, the global picture looks much more interesting and much less terrifying! Outside the US, ethylene investment has slowed dramatically, and has done so for a couple of very sustainable reasons:

  • The cost of construction has escalated, with stronger regulations, more environmental focus, skill shortages etc. There have been some recent horrible cost over-runs – Braskem/Idesa and Sasol – as a result of which the projects are likely never to achieve an acceptable return on invested capital.
  • Feedstock advantage has been a critical success factor, as the US has seen, with no-one willing to bet that the high margins seen around the world today can be sustained and that, as for most of the last 30 years, marginal pricing will be set by the cost curve. Consequently, if you do not have what you believe will be a sustainable cost advantage you are not building..
    • US shale should remain competitive
    • Argentina has enough for perhaps one world scale unit
    • European shale is a decade away and may not yield chemical feedstock
    • Coal to chemicals only works if crude is very high and coal is very low – note that Asia coal prices are recovering – Exhibit 9

Exhibit 9

Source: Capital IQ, SSR Analysis

It is not clear to us who will build after this wave in the 2017/2018 period, and where. There is a chance that any weakness in global margins in 2017/2018 causes a major round of consolidation in the industry and distracts companies from building for a while. Consequently, our models and expectations suggest improving global ethylene operating rates from 2019 – Exhibits 10 and 11.

Exhibit 10

Source: IHS, Wood Mac, SSR Analysis

Exhibit 11

Source: IHS, Wood Mac, SSR Analysis

…Can Investors Look That Far Ahead – As the Risks Are Not Insignificant

If you had a five year buy and hold strategy, LYB, DOW and WLK would look very interesting today. The stocks are clearly already discounting trouble – DOW looks more interesting if you give the company the benefit of the doubt on the merger synergies – Exhibit 12. They are probably not discounting enough trouble, because there is an expectation of negative revisions and they generally do not perform well during a period of negative revisions – but that downside could be quite limited – very limited in our view in DOW’s case because of the merger and the expectation of value creation above and beyond the ethylene cycle.

Exhibit 12

Source: Capital IQ, SSR Analysis

Risks

We have been trying to understand and predict ethylene and other commodity cycles for over 30 years and our track record is not bad, but it is not good either. On the supply side you have reasonable certainty – you know what is being built and what is on the ground – what you do not know is whether things will be built on time – Braskem/Idesa and Sasol are good examples of how it can go wrong – Dow Chemical and Exxon appear to have the blueprint for how to do it right. You also cannot predict “unplanned plant closures” and if the market is finely balanced these can matter – as they have in 2016.

The demand side has always been the greatest source of uncertainty – less so on a general underlying trend basis but more so on inventory volatility around that trend.

  • The biggest downside risk to our short-term dip, long-term buy thesis is that demand in 2015 and 2016 has been inflated by a “low crude” inventory build, and as indicated earlier our view is that apparent polyethylene demand is just a little too good to be true. The 50-year trend for ethylene is very compelling – Exhibit 13.
    • The expected jump in capacity combined with a drop in real demand growth could pressure prices and margins for several years and this would make LYB, WLK and DOW look quite expensive today – downside greater than 25%.
  • The disaster scenario would be the above demand picture playing out in a low crude/high natural gas world – taking away the margin umbrella in the US.
    • This is highly unlikely given that the route to lower crude pricing (absent a severe global slowdown) is probably more US Permian production, which should coincidently flood the US natural gas market.
  • A global economic slow-down or recession is always a risk to this group – demand falls (made worse by destocking), pricing collapses and possibly crude oil falls at the same time.
    • Both this scenario and the one above would likely create very interesting entry points for all names, but at prices well below current levels – these environments would inevitably drive further industry consolidation – LYB would probably (eventually) be the most levered way to play any subsequent opportunity.
  • The upside risk – i.e. the risk of not jumping in today and missing a long-term low in the names would come from some combination of sustained very strong demand growth, further unexpected plant closures and/or delays to the start-ups expected in 2017.
    • Demand growth would be reliant on the idea that global demographic and purchasing trends are driving above trend increased use of plastics packaging – especially in food and we have reached a point where film down gauging is reaching a limit. We have no strong opinion either way, except to note the risk that the last two years might have been impacted by re-stocking.
    • Prolonged production shutdowns may be here to stay – for a while. Plant complexity, much more stringent inspection processes and a lack of qualified contractor labor have been the causes over the last few years and we do not think any of those factors change for at least 3-5 years until we have an oversupply of skilled labor in the US Gulf.
    • Start-up delays are possible, but Oxy is almost at mechanical completion, and Dow Chemical and Exxon are best in class (and have had plenty of relatively recent experience with new construction). CPChem has perhaps some chance of delay, but we would not invest on that basis.
      • That said – these are complex facilities and even the best have experienced problems during plant completion, testing and start-up.

If there is no margin collapse in 2017 and if somehow the industry can manage its way through the capacity adds without any real degradation in margins – this is a big “if” – then LYB is by far the more levered way to play the upside. The company has purchased close to $14 billion of stock since 2013 and should continue to do so. The dividend yield is 4.4%.

Exhibit 13

Source: IHS, Wood Mac, SSR Analysis

©2016, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. 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.

Print Friendly