Weekly Findings – May 20th, 2018
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
Graham Copley / Nick Lipinski
May 20th, 2018
- Chart of the Week – Lets Build an Ethylene Plant!
- But What If Everyone Else Does?
- Optimism Revisited – Nothing Changes Except the Players?
- Weekly Winners & Losers
Chart of the Week – Not Enough Margin
We have been dancing round the subject of possible significant overcapacity in basic chemicals and plastics in the next decade for some time – focusing on how refiners react to potential shifting demand for gasoline and diesel and what could happen to polymer demand in a more waste conscious world. These are not 2018-2021 issues (except perhaps polymer waste, which could gain emotional momentum more quickly), but the supply risks are real, and are now likely further at peril by what is happening with crude oil today. As crude oil prices rise, the top end of the cost curve in the chart above rises also. Were it not for high co-product pricing for propylene and butadiene, the critical end of the curve could be $100-300 per ton higher. Currently prices for ethylene and polyethylene in Asia are well above the levels suggested in the cost analysis, but any potential investor in the US is going to look at the curve and the data in the table below (which is the same as one imbedded in the chart), which drives the break-even theoretical margin that would accrue to a US ethylene producer exporting ethylene derivatives. The “required US export price” adds a cost of 5 cents per pound for freight – this cost could be higher for polyethylene but lower for liquids like ethylene glycol, styrene and EDC.
This 18-cent margin is not high enough to justify new investment in the US as a best case new facility will cost $1.20 per pound to build. After 10% depreciation you are looking at a 5% return on investment – only higher if the associate derivative can add to the overall returns of the combined project. However, even before this last leg up in crude pricing the project announcements have been coming quickly:
- Dow – expansion of 0.5 million tons at Freeport
- Exxon-SABIC – a new 1.5-million-ton ethylene based complex at Corpus Christi
- The much-hyped Shell facility in the Marcellus – another 1.5 million tons
- Formosa – St James LA – Phase 1 – 1.2 million tons of ethylene – Phase 2 could double this
- Total/Nova/Borealis – Port Arthur TX – 1.0 million tons
- What about Dow – another facility once the spin is complete??
This is 5.7 million tons, not including Formosa’s Phase 2 or the next Dow move
This adds to the yet to start-up, Indorama, Westlake/Lotte, Sasol, ShinTech and Formosa units currently under construction – see table below.
All of the new US “shale-based” ethylene listed above is before we get to large refinery-based projects and possible shale projects outside the US: Aramco (Motiva) in the US; Aramco in India; Vietnam; several more projects in China and now ADNOC in the UAE – see recent announcement and our work on “refinery chemicals”. A second SADARA complex? (The land is set aside for a second SADARA project)
The world could be awash with ethylene post 2023, especially if demand growth slows because of better levels of plastic recycling and reduced waste. As long as the cost curve has the shape in the “chart of the week”, US producers will have some margin cover, but if oil falls, the economics in the US begin to look challenging given the significant and rapidly growing export component of US production.
The chart below is intended to be “scary”; it shows a worst case. It is based on a chart that IHS presented at its March conference in Houston but we have added to assumptions post 2019 based on the announcements for the US since that time and listed in the earlier section – we have then taken some refinery and oil company liberties – assuming that Aramco goes through with its plans in India and in the US; that ADNOC also moves forward; and that other similar initiatives appear for China, India and other growing parts of Asia where integrated refining and chemical investments make sense – such as Vietnam. In the second demand line we have reduced consumption growth by 200 basis points a year to reflect plastics use reduction in single use application and better recycling – the reality is that the decline could easily be double what we are projecting – in a worst case you would be adding around 20 million tons more ethylene capacity than the world needed from 2022 to 2025, creating a 10-12% oversupply.
- The refiners/oil companies are not going to stop if they see this as captive demand for refined products or crude.
- India and China are not going to stop as they are very short polymers (China polyethylene and India all, but especially PVC). A less friendly trade environment will simply encourage more local investment.
- We are assuming a couple of refinery based investments in Europe in 2024 and 2025 – but there is likely no-one looking at this right now.
It is a natural evolution to move from the investment euphoria we see in ethylene and expect to see in chemicals more broadly as the demand for oil products starts to fall sometime in the next decade, to our broader work on optimism. Optimistic companies do not just simply miss earnings estimates. They have a mindset that projects a too rosy future for their business, because they are working off an assumption set that is too optimistic, either with respect to the broader markets in which they operate or with respect to their competitive position within those markets.
One sign of optimism is missed estimates, but that can either be a sign or a symptom, with the latter happening when optimism leads to misallocation of capital because of an overly bullish outlook. The misallocated capital drives lower returns leading to missed estimates and lower shareholder returns. We covered the subject in some detail in research earlier this week, but wanted to add one chart here showing how our optimist group and conservative group as identified in 2012 have performed since then. Note from the charts that the conservative group and the optimist straddle the performance of the market with the conservative group on top. This is despite 6 of the 20 in the optimist group getting taken out over the 5 years versus one constituent of the conservative group. Sometimes it is worth owning the bad actors because if they are so bad changes are forced on them, but as a group the conservatives are the best bet.
So how does this relate to ethylene? At a more granular level we believe that the US Gulf investments are based on assumptions that are too optimistic:
- Even at the current oil/natural gas differential the projects would not make an adequate return on investment unless international propylene and butadiene pricing were to fall relative to ethylene – and significantly.
- As is always the case in these investment bubbles, everyone is talking about protecting market share and only responding to expected customer needs. Customers are interested in a surplus and position their negotiations and commitments to help ensure that.
- The idea that oil may be lower in a few years is not factoring into any planning cases.
- The idea of competition from oil producers or refiners as other oil product demand peaks is also likely not in the risk assessment appropriately.
- Optimism can often be a function of available cash – “we have it, we want to spend it, what assumptions do we need to justify the investment?”
As our broader analysis shows, corporate optimism has a very negative impact on shareholder returns – but often optimism starts at the project level.
All of the ethylene analysis in this piece and in our prior work does not suggest a problem in the industry for several years. However, we would be looking for companies continuing to invest in stand-alone ethylene projects in the US as possible longer term short ideas – none of the current ideas are with publicly traded chemical companies – the two companies most exposed to likely poor returns are Shell and Nova in our view, but Sasol should also probably be included on this list (the stock price reflects this however)
We do think that the smarter companies will begin to look for consolidation moves over the next couple of years and we like a number of companies in part because of their potential to be targets: Braskem, WLK (as ethylene producers); HUN, TSE, 1COV, KRA, EMN and FUL, as downstream integration moves.
Interestingly, none of the ethylene exposed companies ranks in a chemicals “optimist” group except Sasol. The old Dow Chemical was perhaps the poster-child for optimism, but since the appearance of Third Point as an activist investor, and through the merger has been quite the opposite.
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