The Great Ethylene Debate
Basic chemical stocks have had a very good 2013; LYB has risen 37%, WLK 45%, and DOW (which is a more diverse portfolio) has managed 36%. Earnings are very strong in North America for many based on the advantage derived from cheap natural gas in the US and Canada.
Estimates are generally anticipating further earnings growth in 2014, and where portfolios are North America centric, this can only come from one of two places – either more product to sell or improved operating margins (which really comes down to improved pricing relative to raw material cost). We have some production increases for select companies in 2014, but estimates broadly suggest incrementally better margins in 2014. We are skeptical, and would suggest that there is almost zero chance that estimates are correct. However at the same time we are intrigued by the possibility (albeit small) that they could be too low.
Operating rates in the US for the key basic building block, ethylene, are quite high – above 90% of capacity, and in periods of strong demand growth we have seen this level of plant utilization support pricing well above the marginal cost of supply, as buyers anticipate growth and possible shortage and bid up the last pound available. This is not happening today because demand growth over the last three years has been a fraction of the historic average, and the US is adding enough capacity for ethylene in 2014 to meet demand growth if it simply repeats growth over the last three years (roughly 2% per annum – versus an historic average of 4.5%). Our operating rate projection is not very exciting and is summarized in the chart.
Near term, we could actually see a wave of oversupply as new capacity should come on stream for ethylene in Q2 2014 while inventories are at an historic high. This could take pricing down for the balance of the year and result in disappointments for companies such as LYB, WLK, DOW and even AXLL and OLN, given that we also expect some chlorine surpluses around the same time. This forms our base case for 2014, and helps form one side of our negative stance on the group generally – the other side being valuation, which is stretched and anticipating only good times ahead for all but OLN and to a lesser extent DOW.
But…we could be quite wrong, as 90+% operating rates cannot be trusted! One or two significant unplanned plant outages and the story changes completely. A surge in exports of easy to move materials such as EDC and styrene to Europe (see recent research) could also help to tighten the market. Lastly there is the issue of confidence: the stock market has it, chemical and polymer consumers in the US do not. If the US budget agreement drives confidence at the small and medium sized business level and if interest rates remain under control, there is a chance that we could see a step up in demand in the new year as business buy ahead of what they think will be higher growth. Shortages, or perceived shortages of polymers and chemicals can drive marginal pricing up quickly, dragging contract pricing along behind. If this happens estimates are too low, possibly much too low. We think that has a 25% chance of occurring, with our more negative case at 75%.
The stocks are generally discounting the latter scenario in our view not the former. The greatest upside anticipation in our view is in LYB, and only OLN looks attractive on a valuation basis, with DOW fairly valued and WLK and AXLL expensive, but not much when looked at in the context of their current earnings.