Chemicals Monthly – A Whole New World

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

October 16th, 2014

Chemicals Monthly A Whole New World

  • The Commodity Chemical group underperformed the S&P by 13.2% over the last 4 weeks. As oil prices have collapsed and natural gas prices have risen from their summer lows, the theoretical competitive advantage that US producers enjoy could erode significantly. We noted this risk in September though we did not necessarily expect it to materialize with such urgency.
  • Over the past month we published on the issue noted above, in the broader context of expected weaker supply/demand fundamentals in 2015, a piece about the future structure of DuPont as well as a related blog on ethylene. Accompanying this report we have published a short update on the US ethylene space, following the recent oil moves.
  • After a period of underperformance, we have seen relative strength in the Agricultural Chemicals space with the group outperforming the S&P by 2% over the last month. Record yields are still expected for corn and soybeans. These harvests will be associated with lower prices for each commodity and correspondingly lower earnings from the American farmer – a drag on the Ag Chemicals group. The outperformance has more to do with relative value than fundamentals.
  • Chemical sector preferences are outlined below at the subsector and company levels. There may yet be more downside for many of these names but the diversified companies appear best suited to weather the current storm. DD remains our stock of choice.
  • AXLL may face some further negative revisions because of higher ethylene pricing in 2014, but valuation is compelling and a normal 2015, with lower ethylene pricing could generate significant upside. EMN has also, in our view been overly punished in the recent decline and looks interesting.

Exhibit 1

Source: SSR Analysis

Exhibit 2

Source: SSR Analysis –
See Appendix 1
for background and see
Appendix 2
for a larger version of this table.

Overview

It has been an interesting 4 weeks for the World and for the stock market, with our commodity chemical group down by more than 19% in absolute terms and more than 13% in relative terms. The commodity names have taken a beating because of the rapid decline in oil prices and the consequent implication for the ethylene margin umbrella in the US. While the ethylene market in the US remains very tight today, we expect a more oversupplied market in 2015 and as oil prices have fallen and economic news has deteriorated, there has been a loss of confidence in the US ethylene names and the under-performance has been dramatic, with both LYB and WLK down around 30% from recent highs. Over the last few days DOW has played catch-up, and is down almost 20%. The sector average is less negative because AXLL and OLN are not ethylene producers. See our accompanying piece today and recent work highlighted in the bullets for more on the ethylene space.

Otherwise the rest of the chemical space has fared poorly also, with the stand-out positive story Sigma-Aldrich, which accepted a cash acquisition deal about 10 minutes before the **** hit the fan – timing is everything and sometimes it is better to be lucky than good! The defensive subsectors have been defensive and our broad value screens worked well for once. Our undervalued groups, Diversified and Agriculture both outperformed the market as did Industrial Gases, always a defensive sector at times like these. In Exhibit 9 the Specialty Chemical group is very skewed by SIAL.

The decline in crude prices underlines a couple of broad concerns – first the oversupply of crude and condensates, mainly coming from the US, at a time when OPEC does not seem that willing to cut production. Second, more negative global economic news which has fueled the argument that we cannot grow ourselves out of this quickly. Near-term there is even more demand risk as buyers will likely minimize purchases in the hope that lower oil prices mean lower product prices going forward. This could result in a negative demand shock in Q4 2014. Demand has slowed for brief periods on many prior occasions as oil prices have weakened. The silver lining is that lower oil should have a net positive economic impact, but this is likely a 2H 2015 event if low oil prices are sustained.

Natural gas prices in the US Gulf remain quite high, more than likely a function of the proximity to winter and the fact that we are still very low on storage relative to history – Exhibit 3. That being said, a chart that we published in our recent Marcellus piece is very interesting, and is included again here as Exhibit 4. It shows how quickly Marcellus production of natural gas has grown relative to local demand and shows current daily production in Marcellus. The chart suggests that current production rates exceed peak demand in the North East, excluding New England. Perhaps we do not need as much storage anymore? The most recent well productivity data suggests that the trend we see in Exhibit 4 continues. However, the market clearly does not yet feel this way or natural gas prices would be closer to $3.00 per MMBTU rather than $4.00 per MMBTU.

Exhibit 3

Source: EIA

Exhibit 4

Valuation

Exhibit 5 summarizes our valuation work and the subsector classifications are summarized in Exhibit 6.

Exhibit 5

Exhibit 6

In Exhibit 7 we show company discount from normal value as measured on our valuation framework. With the recent selloff, many Chemical companies have retreated from record highs. In the coatings space, SHW is off its peak but remains within 2.5% of its all-time high while VAL shows a similar story but is generally less expensive and further off its peak (4.2%). Ag Chemical names appear heavily discounted but this reflects the poor outlook for fertilizers. MOS is near (1.6%) but not at a valuation low, as potash in particular remains more out of favor than everything else and we remain negative on
the outlook for potash
. Commodity chemicals have suffered the most at the hands of the factors discussed above. Moves in oil and gas have not favored domestic ethylene producers while the strong USD compounds problems further. AXLL may benefit from these moves should prices for NGLs like ethane remain low and ethylene pricing in the US move closer to the levels required to support broad derivative exports.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibits 9 and 10 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our September Chemicals Monthly. The Commodity group reversed its strong performance of previous months and was the worst performer as the specter of international competition looms. Coatings, previously noted for being expensive, also underperformed on both a relative and absolute basis in another trend reversal. Past laggards such as Ag and diversified, though still performing poorly YTD, have outperformed their peers in the recent selloff. Specialty’s outperformance is actually somewhat misleading. The announced acquisition of SIAL by Merck drove this performance but when SIAL is removed from the group, specialty chemicals drops to a roughly -5% performance relative to the S&P.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 11 through 13 show profitability at the sector, subsector, and stock level.

In Exhibit 11 we highlight RPM, SMG IFF, VAL and CYT in green – all are at (or within 2% in CYT’s case) 10 year or all time peaks in return on capital. RPM and CYT therefore have some earnings support for the valuations noted above, and HUN looks very cheap on current and expected earnings and hence makes our Exhibit 1 screen.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibits 12 and 13 show the net income margin for the Chemicals sector as a whole and for the individual subsectors, respectively. Earnings in no way reflect the weakness in the sector in recent weeks, suggesting that the market anticipates much more meaningful negative revisions to come.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13

Source: Capital IQ and SSR Analysis

Portfolio Performance

The October portfolio selections are shown in Exhibit 14. Our portfolios have begun to produce robust returns as the expensive slanting commodity names that have hampered our short performance for most of the year have capitulated with the market sell-off. On the long side, DD was the main driver of outperformance for the balance of September – note the company has fallen out of the attractive valuation screen for October, leaving no companies in the long overlap group.

Exhibit 14

Source: Capital IQ and SSR Analysis

Exhibit 15

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • After an unexpected decline in July, consumer spending increased 0.53% MoM in August. Figures from April through June were revised negligibly. Consumer spending saw a smooth rise higher in 2013 but volatility has emerged in 2014. Absent wage growth, it would appear that spending will spike seasonally and remain subdued otherwise – Gallup data tracking weekly consumer spending indicated July spending was up over June levels, when spending declined from a higher (Memorial Day influenced?) May figure.
  • The longer term post-recession recover in consumer spending has been impressively uniform. With gains in August, expenditures in 2014 have risen at a monthly rate of 0.18% compared to the 0.22% monthly gain seen in 2013 and 0.16% from 2009 through 2013. Wage growth could offer a boost to an American consumer that has largely seen stagnant income. It has been suggested that such a wage boost could be delayed as higher earning baby boomers retire and are replaced in the workforce by younger, lower earning workers.

Exhibit 16 Exhibit 17

Source: BEA

Construction

  • Negative revisions have struck the seemingly good numbers of June and July, bring them down 0.7% and 1.3% respectively. It was widely assumed that with certain construction markets still down 40% from their pre-recession peaks, 2014 would see an acceleration in activity but housing markets remain weaker than expected. Generally positive data has flattened as the year matures.
  • Now 3/4s through 2014, it is highly improbable that we will match the 8% annual growth seen in 2012-2013. September’s figure shows an improvement of 0.56% year to date.

Exhibit 18

Exhibit 19

Source: US Census Bureau

Agriculture

  • Weakness in grain pricing continues. With the (unlikely to be severe) frost the last remaining obstacle for this year’s corn and soybean crops, record yields continue to be expected and will continue to weigh on pricing. We appear to have hit a pricing floor for most products but we do not expect any meaningful price recovery without a supply related event.
  • These weak farm economics explain some of the poor performance of the Agricultural Chemicals sector. Refer to our blogs on potash – we remain quite negative in terms of the longer-term pricing outlook.

Exhibit 20

Source: Capital IQ, SSR Analysis

ISM

  • ISM manufacturing data was largely positive through August after coming off the weather influenced lows of the first quarter. After PMI hit 59 for the first time since March 2011, we saw a sharp retreat to 56.6 in September. The last time we saw a reading like that was also in 2011, shortly before funk enveloped markets in the second half of the year. Inventories shrunk modestly (from 52 to 51.5), while production hovered at 64.6, barely up from 64.5 in August. New orders came in at 60 (anything over 50 indicates expansion), a steep drop from 66.7 in August and a departure from this year’s march upwards.
  • For some time there have been similar indications that the US economy was truly about to gain steam, only to taper off and lose momentum. Domestic manufacturing should be advantaged moving forward given the abundance of natural gas, but to get the economy running on all cylinders we will need to see a pickup in housing and construction activity, as well as wage growth to support the spending trends that have defied stagnant incomes.

Exhibit 21

Source: ISM

Exhibit 22

Source: ISM

Trade

  • The dotted line in Exhibit 23 is a twelve month rolling average. Cutting through the month to month volatility, we see Chemical trade volumes have been flat for the past several years. The recent slowdown can in part be explained by a lack of basic chemical supply in 2014 in the US because of the well documented production issues for ethylene, but it is also interesting to note that China’s imports of polyethylene have stopped growing in 2014, which may be a broad negative signal for export volumes generally.
  • Year over year, the British pound have been resilient versus the dollar, up 1.7%. BRIC currency depreciation has been significant with the Russian ruble still off 21.8% versus the dollar YoY while the Brazilian real lost 8.3%. We have seen the dollar 5.8% stronger versus Euro YoY – Exhibits below.

Exhibit 23

Source: US Census Bureau

Exhibit 24

Source: IMF

Exhibit 25

Source: IMF

Commodity Fundamentals

Supply/Demand

Please see our
December piece on US ethylene demand
for our recent more detailed perspective. We remain concerned that high absolute pricing for chemicals are constraining growth. Given the significant production outages in the US this year we would have been in all sorts of supply and pricing troubles had there been robust real demand growth.

Note that we have made a change to our external data source in 2014 and that we are now using chemical market data from Wood Mackenzie. The supply/demand data for 2013 is very similar to that of IHS and we have not changed our historical data.

As is shown in Exhibit 26 and 27, 2014 will likely show some very poor overall ethylene production and operating rates given the additions to capacity and the expectations that existed at the beginning of the years. Production problems have been the root cause, and they continue. Problems have been well above average this year, limiting the available capacity. Operating ethylene facilities are running at maximum rates and we expect the industry to run on that basis through the end of this year to replenish what are now very low inventories. Some companies have delayed late year maintenance shutdowns because of the lack of product. The US is likely to see minimal growth in ethylene production in 2014 because of these operating problems, despite a nominal increase in capacity. What was expected to be a weaker second half market for ethylene because of new capacity is now likely pushed to 2015 or the very end of 2014. The market has been balanced through the elimination of marginal exports of ethylene derivatives, and in our view by limited real domestic demand growth – because of high prices.

More available capacity and higher operating rates in 2015 could flood the US market, causing the export push to re-emerge and having a broad negative effect on pricing.

Production is summarized in Exhibit 26 and operating rates are summarized in Exhibit 27.

Exhibit 26

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 27

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

Energy – Exhibit 28

Oil prices have fallen meaningfully since our last report and have decoupled from the stronger dollar. The market is focused on real supply/demand for oil and the building surplus of oil and condensate in the US. See our recent
energy launch
and accompanying
ethylene research
for more details.

Natural gas is discussed in more detail in the overview.

Exhibit 28

Source: Capital IQ and SSR Analysis

Ethane remains very weak because of limited demand as a consequence of the significant US ethylene plant closures which continue through October, though LyondellBasell has now started it new furnaces in Texas and should be consuming more ethane than a month ago. Ethane extraction margins have revisited the lows of late 2013, as shown in Exhibit 29, and
as discussed in recent research
. Ethane is weakening in step in both the Mid-West and in the US Gulf – Exhibit 30 – but the Conway gap has increased over the last few days, perhaps because of increased demand in TX.

Exhibit 29

Source: IHS, Mackenzie Wood and SSR Analysis

Exhibit 30

Source: Midstream Business and SSR Analysis

Propane and Butane prices are not yet moving down with crude, but they should and they likely will. Propane exports from the US continue to grow and are now so significant that recent sales into Europe have been below local fuel values as there is too much available. Butane should start seeing support from the expected start of the winter gasoline blending season, but with gasoline pricing falling in the US, Butane should also come down. While both may become more attractive relative feedstocks in the US, it is unlikely that they will fall far enough to compete with ethane. Butane may see less support than in prior years because of the volume of light condensate finding its way into the US gasoline pool. The swing in Propane is a function of real oversupply a year ago that has been quickly corrected through exports and current pricing reflects export netbacks – mainly from Europe – Exhibit 31.

Exhibit 31

Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing has jumped quickly in the spot market in the US in response to the ethylene shortage, and the higher spot price resulted in higher contract prices in September, which will lead to higher real prices in October, because of contract lags – given where crude has moved, we would expect demand for polyethylene to shrink in October and pricing should start to reverse its recent trend quickly. Integrated polyethylene margins hit an all-time high in September – but we guess that it will be very short lived. Note that the contract prices shown in Exhibit 32 are “list” against which there are significant discounts depending on customer scale. Today the spot market for HDPE is in the $0.85-0.90 cent per pound range and is at a sizeable premium to “net” contract pricing. Also note that major consumers of polyethylene had 30 day price protection and some even have longer periods. Consequently, September increases will have more of an impact on numbers for LYB, WLK and DOW in Q4 than in Q3.

PVC prices have not risen with ethylene and this will be a negative for AXLL and Oxy and Shin-Etsu in Q4, though we think all three will likely benefit from lower ethylene pricing in 2015.

Exhibit 32

Source: IHS and SSR Analysis

Valuation Charts

The exhibits below show our mid-cycle “normal” valuation framework for the chemical sub sectors and the first exhibit (33) summarizes the results and is a repeat of Exhibit 5.
Exhibit 33

Valuation Charts – Exhibits 3436

Exhibit 34

Source: Capital IQ and SSR Analysis

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36

Source: Capital IQ and SSR Analysis

Skepticism Analysis

We apply the framework from our skepticism analysis on the broader Industrials and Basic Materials sectors to the Chemical space – see
our past research for more detail
. The primary conclusions are:

  • Diversified Chemicals has the highest skepticism index value of the subsectors – this is driven by DuPont, which has the highest skepticism value of all the companies in our Chemical universe. Ag Chem remains undervalued as earnings are slightly below trend, and expected to worsen. Conversely, Specialty is being granted a premium valuation that is discounting a rise in returns from current levels that are largely in line with trend. In Exhibit 39 there are no companies currently at skepticism extremes. Note that SIAL is in the process of being acquired by Merck and we will be removing it from our coverage.

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis


Recent Chemicals Research

October 2, 2014 – DuPont Can Be a Bad Stock: If Trian is Right, But Gives Up

September 23, 2014 – Why 2015 Could Be a Short Sharp Storm for US Ethylene

September 17, 2014 – Rising Dollar and Falling Crude: Bad For Commodity Chems

September 11, 2014 – Oil: The Big Uncertainty for US Chemicals
(blog)

September 9, 2014 – Marcellus Opportunity: Why We Should See More Chemical Investment

September 2, 2014 – Strong Manufacturing – Buy Industrial Gases
(blog)

August 14, 2014 – US Ethylene: It’s a Record Breaker – But No One Really Wins Quickly Anymore

August 12, 2014 – To Russia, But Not With Love – Right Now

July 28, 2014 – Industrial Gases: APD Must Focus on Costs, But PX the Better Investment

July 23, 2014 – DuPont: Ag-rivating, But Unlikely to Change Without Action

June 16, 2014 – European Basic Chemicals: There Is Life In The Old Dog Yet!

June 2, 2014 – DuPont: A Cost Initiative Could Be Substantial

May 15, 2014 – Chemicals Revisions: Not Positive Enough and Not Supportive of Values for Many

May 13, 2014 – DuPont: The Case for $85 – But Why We May Need to be Patient

April 29, 2014 – Dow vs. Lyondell: Bet on the Company with More Levers to Pull – DOW

April 28, 2014 – US Natural Gas: Not Out of the Woods Yet!

April 25, 2014 – Air Products and Praxair: A Tale of Two Strategies

March 31, 2014 – Petrochemical-Fest: A Summary of the Texas Gathering

March 24, 2014 – Seeding a Better Investment

March 23, 2014 – Why the Basic Chemical Investments in the US Will Likely Disappoint

March 19, 2014 – Peak Valuation in Some Commodity Chemicals – Something to Watch

March 5, 2014 – APD: Time to Move to the Sidelines – PX More Interesting

February 24th, 2014 – Dow: A More Optimal Path, But a Hard Destination to Reach

February 17, 2014 – Dow: Loeb versus Liveris – Watch From A Distance

February 9, 2014 – Rising Natural Gas Prices and Rising Commodity Chemical Company Estimates: How Can This Be?

January 9, 2014 – Chemicals Companies in 2014

December 30, 2013 – DD: Still An Interesting Investment

December 16, 2013 – US Ethylene: The Case for a Better 2014

December 10, 2013 – Exporting Shale: A More Logical Perspective

November 18, 2013 – The Recommendation Signal: Another Reason to Look at DuPont

November 7, 2013 – Lyondell: Growth or Income, Both Have Risk

November 7, 2013 – DuPont: An Unusual Stake in the Ground (blog)

October 29, 2013 – PPG: What Do You Have to Believe

October 21, 2013 – Common Sense Restructuring: Some Money to Be Made

September 23, 2013 – The State of the US Chemical Industry

September 15, 2013 – Optimism and Forecasting in the Chemical Industry

August 5, 2013 – Understanding Transformational Change: The Eastman Example

August 5, 2013 – Potash: Breaking Up Apparently Isn’t That Hard to Do
(Blog)

July 25, 2013 – DuPont: Getting Appropriate Value for the Growth Engine

June 19, 2013 – Complexity, Volatility, and a Market Where Neither Extremes Work Well

June 14, 2013 – Ethylene: Unlikely to Be a Quick Fix for Williams

May 13, 2013 – DuPont: Betting the Farm – But Perhaps a Need to Crop the Portfolio?

Appendix 1 – Exhibit 1 Analysis

In Exhibit 1 the following apply:

  • Green is good – Red is bad. The more intense the shade of green or red the more interesting or negative the factor looks for the sector.
  • Length of bar – wider signifies more important
  • Arrow direction – “Up” means the situation is becoming more positive from a stock selection perspective. So a green valuation bar with an upward arrow means that the stocks look cheap from a valuation perspective and they are getting cheaper. A red ISM bar with a downward arrow means that the ISM numbers suggest downside and they are getting worse.
  • Arrow size – how significant the move is.

Input Analysis

In the input analysis bar we attempt to show how important the natural gas/oil advantage is for each sector (length of bar); how positive it is (color of bar); and which direction it is moving (direction of arrow).

Demand Analysis

For each of our industry sub-sectors we have taken company by company data and generated an average segment exposure. For some companies this information is provided explicitly and for others we have taken estimates from presentations, annual reports and other sources. The segment break-downs are summarized in the charts below: Exhibits 40 to 44.

Exhibit 40


Source: Company Reports and SSR Analysis

Exhibit 41

Source: Company Reports and SSR Analysis

Exhibit 42

Source: Company Reports and SSR Analysis

Exhibit 43

Source: Company Reports and SSR Analysis

Exhibit 44

Source: Company Reports and SSR Analysis

We have then grouped the categories into buckets for which we can measure growth drivers. Those groupings are summarized in Exhibit 45 below.

The first table summarizes the data in the pie charts above and then shows which market driver we use to model each end market. The second table then breaks each sub sector into these market driver buckets and then adjusts for how much business is in the US and how much is external. We add a factor which we call “trade” which brings into play the US trade balance and the strength/weakness of the dollar.

This analysis then drives the “Demand” section of the schematic in Exhibit 2.

Exhibit 45A

Source: Company Reports and SSR Analysis

  • Note that for the “trade” component, we have arbitrarily assumed that 25% of offshore sales are influenced by the US balance of trade and by exchange rates, while 75% of offshore sales are influenced by the same factors as listed above. It is more than likely that this is a different split for different sub-sectors and this will be a subject for further analysis.
  • Note also that we have done some initial correlation work to look at the impact of the factors below on revenue growth and it does show that sub-sectors with a greater exposure (in our analysis) to the ISM data (for example) have a greater correlation between the ISM numbers and demand growth. This will also be the subject of future research.

Exhibit 45B

Source: Company Reports and SSR Analysis

Valuation Analysis

The valuation analysis draws from our mid-cycle “normal value” work detailed above and our revisions work also detailed above. We have – for the moment assumed that valuation is 60% of the story and revisions is 40% for each sector. We will test this more empirically in the coming months.

Appendix 2

©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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