US Ethylene It’s a Record Breaker – But No One Really Wins Quickly Anymore

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

August 12th, 2014

US Ethylene It’s a Record Breaker – But No One Really Wins Quickly Anymore

  • August US ethylene margins have (in theory) reached an all-time record at around 45 cents per pound for ethane based production. The drivers are a real shortage of ethylene caused by production problems, focused mostly at LyondellBasell and Williams.
  • The production shortfalls come on the back of an extreme year for planned ethylene maintenance closures. Spot price for ethylene and some derivatives have risen quickly and ethane feedstock prices have fallen, because of lack of demand, and supply increases.
  • Further planned closures in September and October and the delay of the Williams restart until October should keep the market precariously balanced in our view. It will likely be early 2015 before we see ample supply of ethylene in the US.
  • But the ethylene market is largely irrelevant to the publicly traded companies with the exception of Axiall and Celanese, who are major buyers. Axiall already warned that Q3 will be impacted by higher ethylene costs, but it will probably be more of a hit than expected.
  • What matters to WLK, LYB, DOW and AXLL is whether this shortage of ethylene allows for much movement in derivative chemical and polymer prices. If polyethylene and PVC contract prices go up then the companies see a bigger jump in earnings.
  • The ethylene producers will see a better Q3 because costs are down and more quickly than anticipated – LYB may make up more than was lost through its delayed plant restart. DOW should do well as should WLK.
  • The real boom could come in Q4 with derivative pricing higher and feedstocks still low. In our view this is a blip not a trend – we think 2015 will be oversupplied relative to 2014 which we will cover in a separate piece.
  • AXLL has taken a sizeable hit already and may see further Q3 and Q4 negative revisions – the stock is inexpensive and could see a much improved 2015 so we would see any further weakness as an opportunity.

Exhibit 1

Overview

Operating difficulties have conspired to create the widest cash margin for ethylene ever seen in the US in August. Production problems – most significantly at Williams and LyondellBasell, have reduced US ethylene inventory to near record lows sparking a bidding round for what is available and lifting spot pricing as high as 70 cents per pound, and likely pushing August contract prices higher also. At the same time, record natural gas production in Eagle Ford in particular, but also in Marcellus, has boosted ethane supply at a time when two major consumers cannot consume. Ethane values have revisited their historic lows relative to a weaker natural gas price.

Most ethylene in the US is sold on a combination of spot and contract prices and the margin shown in the exhibit is generated by averaging spot and contract prices – as such it may understate August margins given that: a). we are only half way through the month and b). August contract prices are not yet set.

Exhibit 2

Source: IHS, Wood Mackenzie and SSR Analysis

The chart looks compelling, but there is not much to do with it, given the very limited nature of the ethylene spot market in the US and also the contract market. More important, such a high proportion of US ethylene producers today are integrated at least one step downstream, that it is not ethylene that matters but the pricing of its derivatives and sometimes their derivatives also.

  • The lower natural gas price and ethane price is good for all producers of ethylene.
    • LYB will get benefit on its operating plants – which may more than offset the cost of the lost production at La Porte
    • Williams loses out completely as its shutdown will now run through October
    • Good for DOW and WLK
  • There appears to be reluctance to push polymer contract prices as high as spot ethylene might suggest possible.
    • Spot ethylene suggests that polyethylene prices should move by 10-15 cents per pound and while the spot polyethylene market is up sharply, there has been a muted response on the contract side so far – a possible 3 cents per pound increase in September
    • Ethylene spot buyers are in a couple of categories today:
      • Traders who are short.
      • Sellers of derivatives in the spot market who can afford to pay – historically these tend to be Styrene or Ethylene Oxide or EDC producers, where ethylene is the smaller part of the molecule.

As we think about Q3 2014, margins are going to be better for ethylene producers more because of lower costs than higher prices – though higher prices will help also. Margins are likely to be higher than companies suggested in Q3 guidance.

Ethylene buyers are in trouble, and while AXLL indicated this would be a headwind in Q3, the company probably underestimated the headwind given more recent data. AXLL needs to raise PVC prices to offset the ethylene cost increase, which while possible would most likely have a lag, leading to better Q4 margins rather than help in Q3. AXLL estimates for Q3, while down sharply, may still be too high if ethylene remains as strong as it is today through September. Q4 estimates will be too high unless PVC prices increase. AXLL is cheap – well below what we would consider mid-cycle value – driven by the current higher cost problem and persistent operating issues in 2014. The stock could double to reach “normal value”, though this is unlikely before 2015, and we would see any further revision driven weakness as an opportunity.

Operating Difficulties Have Lasted Too Long

The US basic chemical industry has been impacted by a number of operating difficulties in 2014, materially impacting the results at companies like Axiall and Williams Partners, but now also impacting LyondellBasell. Williams is expected to be out of action until October and LYB’s La Porte facility, while operating now, was delayed long enough to warrant lower Q3 earning guidance. We have made some forward estimates in what is otherwise a Wood Mackenzie estimate below – Exhibit 3

Exhibit 3 – US Ethylene Capacity Outages

Just looking at the unplanned piece we show in Exhibit 4 that we are at very high levels of unexpected losses today. US ethylene capacity is around 28 million tons today, and as the chart shows we have lost around 5% of that capacity on a rolling annual basis over the last few months to unexpected shutdowns. Planned shutdowns generally take out 3-4% of capacity annually, but they are grouped in the spring and the fall and this year could take as much as 7% of capacity off line in September and October.

Exhibit 4

Source: Wood Mackenzie and SSR Analysis

Not surprisingly the ethylene inventory level in the US, which had reached historic highs (appropriately – it would seem) in the early part of the year is now hitting extreme lows and the data in Exhibit 5 is a few weeks old so we would guess that current inventories are a little worse than suggested. At the chart shows, the US does not keep much inventory in terms of the number of days of demand. What tends to happen in these situations is that ethylene consumption is curtailed and production of products like polyethylene and PVC fall. Generally it is the lower value export sale that is lost.

Exhibit 5 – US Ethylene Inventories

With LYB restarting and with increased capacity, we should see some improvements in availability, but probably not enough to ease pricing until the planned shutdowns are over in October.

Prices Higher – Feedstocks Lower – Margins at a Record

The charts below summarize:

  • the moves in ethylene prices (Exhibit 6)
  • the new decline in ethane extraction margins, highlighting how oversupplied the market is (Exhibit 7)
  • the recent decline in natural gas prices in part driven by the mild summer (Exhibit 8)
  • which has allowed natural gas inventories to close some, though not much, of the very wide gap created by the very cold winter (Exhibits 9 and 10) – natural gas is still very vulnerable to another cold winter based on this data.
  • ethane pricing in the Gulf and the Mid-West (Exhibit 11)
  • a 33 year history of US ethylene margins based on ethane feed and using an average spot and contract ethylene price (Exhibit 12)

Exhibit 6

Source: IHS, Wood Mackenzie and SSR Analysi

Exhibit 7

Source: IHS, Wood Mackenzie, Mid-Stream and SSR Analysis

Exhibit 8

Source: Mid-Stream

Exhibit 9

Source: EIA

Exhibit 10

Source: EIA

Exhibit 11

Source: Mid-Stream and SSR Analysis

Exhibit 12

Source: IHS, Wood Mackenzie and SSR Analysis

But Ethylene Does Not Drive The Bus – Much

There are not that many companies exposed to the ethylene market in a meaningful way anymore. Most ethylene producers are integrated downstream for all or most of their product and the merchant market has shrunk over time. Today the only meaningful sellers of ethylene in the US are Chevron Phillips, DuPont (small), LyondellBasell (small), Flint Hills (Koch Industries), Shell, and Williams. Of the two levered publicly traded names both LYB and Williams are unlikely to be beneficiaries of this current peak – Williams is still out of the game and LYB probably owes ethylene to counterparties it has borrowed from during its extended shutdown and will not have much to sell near-term.

Most ethylene sales today are at some combination of the monthly negotiated “contract” price and the spot price, so ethylene pricing will rise and Axiall made a note of this as it gave cautious Q3 guidance. Big buyers of ethylene are Axiall, Celanese, Huntsman, Oxy, Shintech (Shi Etsu), and Old World Industries. All of these companies are making ethylene derivatives where ethylene is a smaller component of the derivative, such as PVC and ethylene oxide.

More important for all of the majors is how much this higher price environment for ethylene impacts the prices of derivatives. If it results in polyethylene price increases or PVC price increases there is broad margin and profit expansion for the companies that are integrated and offsets for those facing higher ethylene pricing.

The PVC producers are likely to push the hardest as so many of the producers are facing the higher ethylene prices directly. The polyethylene producers are making such a significant integrated margin that contract prices will likely only rise if there is real product shortages and spot prices spike – which they have – and remain high. There is talk of a 3 cent per pound increase in polyethylene prices in September but it is not clear how broad the producer support is.

Polymer prices tend to lag, in that buyers have some level of price protection – 30 days and in some cases 60 days. Consequently, if gas and ethane prices remain low, we may see a bigger margin and profit benefit in Q4 2014 than in Q3 2014.

Investment Conclusion

If we look at the correlation between valuation and returns on capital as defined in
our work on Skepticism
, the three big ethylene guys, LYB, WLK and DOW all have current valuations that are not only high, but anticipate higher returns than are already discounted in forward estimates – in other words they need positive revisions or earnings surprises. The SI charts for each are summarized in Exhibits 13 through 15. These higher ethylene margins, if sustained through 2014, should help justify the premiums – but we see risk if estimates rise too high for 2015 as we do not expect to see a repeat of 2014 in 2015 from a supply availability perspective.

Conversely, but not surprisingly, the ethylene buyers are the other way around – cheap and discounting negative revisions (Exhibits 16-18). Please note that we have limited history for CE and that is why we have not included the company in this sort of analysis previously. We see the opportunity in AXLL much better than CE today. We also still think HUN is interesting particularly given the disconnect between earnings and valuation.

Despite the expensive nature of WLK, LYB and DOW, we would certainly not recommend exiting positions today, though we do think that these are getting very stretched and absent some interesting restructuring (only really now possible at DOW), we are running out of upside.

We would be much more interested in the depressed values at AXLL and to a lesser extent CE and HUN.

Exhibit 13

Source: Capital IQ and SSR Analysis

Exhibit 14

Source: Capital IQ and SSR Analysis

Exhibit 15

Source: Capital IQ and SSR Analysis

Exhibit 16

Source: Capital IQ and SSR Analysis

Exhibit 17

Source: Capital IQ and SSR Analysis

Exhibit 18

Source: Capital IQ and SSR Analysis

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