Chemicals Monthly June 2014

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SEE LAST PAGE OF THIS REPORT Graham Copley / Nick Lipinski

FOR IMPORTANT DISCLOSURES 203.901.1629/203.883.1927

gcopley@/nlipinski@ssrllc.com

July 20th, 2014

Chemicals Monthly

  • Chemical stocks have treaded water over the past month after a largely positive earnings season, as our group has been roughly flat to the steadily climbing market. Revisions have been negative for all subsectors midway through 2014, save the barely positive Specialty subsector, but were stable this past month in the wake of earnings reports.
  • The Commodity group continues to show relative strength, leading the Chemicals subsectors and outpacing the market by nearly 3% since our last monthly report – valuations here are getting elevated in some instances (LYB, DOW) but we are less concerned about WLK and AXLL. Agricultural Chemicals remain weak.
  • Natural gas pricing has drifted into the $4.60-4.70/mmBTU range on increased demand as summer sets in – potential crude oil supply disruptions amidst growing turmoil in Iraq could support higher prices in the near term. Inventories, though still below historic seasonal norms, are trending higher.
  • In June we have continued our coverage of DuPont, highlighting the potential benefits of a cost initiative, and also highlighted improving dynamics in the European basic chemicals industry.
  • Chemical sector preferences are outlined below at the subsector and stock level. Note that we have moved the Commodity group to underweight, but move AXLL to our preferred list within the subsector. WLK has been removed from our Commodity concerns following the Vinnolit acquisition and MLP announcement. Our agriculture related work has also made us more positive on MON.

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 a relatively stable month for the Chemicals sector. Revisions, where they have come in, have been marginal and the group overall was virtually flat to the market which is relentlessly trending higher. Continued momentum in the Commodity space was countered by weakness in Industrial Gases and the other subsectors were all within range of the S&P’s 3.8% gain since our last report.

One of the takeaways from Q1 earnings reports was a recovering Europe. Industry fundamentals on the continent are also showing some positive signs for the first time –
see recent research
. Domestically, plans to exploit the natural gas derived cost advantage are moving forward – a JV between Oxy and Mexichem received final permitting from the EPA on a 1.2 billion pound ethylene cracker. Natural gas pricing itself has been up on the month and in recent days in response to increased cooling demand and the potential crude supply strains from political and social turmoil brewing in Iraq. The fundamentals offer further support for the view of upside pricing risk, as inventories remain statistically well below their five year historic bound, even as they rise from depleted winter levels – Exhibits 3 and 4 on the following page.

Iraq could be the wild card here – Iraq’s oil production is roughly equal to OPEC’s current spare capacity and a loss of Iraqi oil could make the market outside the US quite tight quite quickly. With the US growing surplus unable to reach the global market we could see a jump in Brent and Brent related crude prices and the gap extend with WTI, which would inevitably be pulled up as well, though perhaps not enough.

  • From a chemical perspective – higher Brent drives higher international plastics pricing and US ethane based producers in theory make more money
  • However – a big jump in oil will have a negative effect on the market because of economic growth fears and this may overwhelm any perceived margin gain – this is not a “safe haven” sector.

Exhibit 3

Source: EIA

Exhibit 4

Source: EIA and SSR Analysis

Valuation

Exhibit 5 summarizes our valuation work. Revisions have been modest over the past month with Q1 earnings reports behind us. The trend thus far in 2014 has been toward negative revisions, with only the Specialty group narrowly averting EPS cuts. The next best subsector, somewhat surprisingly, has been Coatings – these stocks have mostly maintained their estimates midway through the year despite forward looking numbers that must remain increasingly strong to support lofty valuations.

Exhibit 5

The subsector classifications are summarized in Exhibit 6.

Exhibit 6

Exhibit 7 shows subsector discount from normal value in standard deviations.

Coatings and Ag Chem remain the expensive and cheap outliers, respectively, and Diversified remains inexpensive by virtue of DuPont’s relative attractiveness. Of the Agricultural stocks, MON and MOS are each roughly 1 SD below normal, SMG is the polar opposite at 1 SD above norm, and CF is trending cheaper after being roughly at fair value in recent months.

Exhibit 7

Source: Capital IQ and SSR Analysis

In Exhibit 8, reproduced and updated from
our past comprehensive Chemicals report
, we show company discount from normal value as measured on our framework. The left side of the chart is once again stacked with red (companies at all time valuation highs). PPG is within 3% of its all time valuation high and we have noted it as well. LYB has a short history but has performed very well of late and the stock continues to make new highs.

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 March Chemicals Monthly.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 11 through 13, also repeated and updated from
our state of the industry report
, show profitability at the sector, subsector, and stock level.

In Exhibit 11 we highlight PPG and VAL as companies at or near earnings highs; IFF is within 2% of peak earnings and we have highlighted it as well. No companies screen at earnings lows at this time.

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.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13

Source: Capital IQ and SSR Analysis

Portfolio Performance

The June selections are shown in Exhibit 14. DD remains just outside the top five in the long side valuation screen. DOW entered the short side skepticism screen last month – valuation has advanced ahead of returns that are strong, and expected to increase. In other words, Dow will need to keep delivering upside surprises to support higher values. Fellow Commodity Chemicals player LYB similarly joined the SI screen this month.

Exhibit 14

Source: Capital IQ and SSR Analysis

Our portfolios continue to disappoint in 2014, after solid performance in 2013. May performance was solid, notably the overlap portfolio, but June returns have been negative across the board, driven by continued momentum in some names that our models highlight as increasingly extended. Our portfolios work as value gains relative to momentum.

Exhibit 15

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Consumer spending somewhat unexpectedly declined in the April BEA data. After March’s figure showed the strongest month over month increase since 2005, April’s number was the sharpest month over month decline since 2009. Personal consumption expenditures had continued to rise during the notoriously distruptive winter months, and the strong March figure suggested there was still pent up demand that would continue to accrue in the spring. It is possible March’s increase stole some purchases typically made in April and it would not be surprising to see consumer spending bounce back in May given the recent multi year trend.
  • Stagnant wage growth and a declining unemployment rate that largely reflects a lower labor force more than increasing employment remain causes for caution. Gallup noted daily consumer spending (self-reported) was up in May, $10 sequentially from April and $8 year over year.

Exhibit 16 Exhibit 17

Source: BEA

Construction

  • As of last month, construction spending had seen a plateau form in the first few months of 2014 – since then, preliminary February and March figures saw considerable positive revisions (+0.56 and +0.96% respectively) and April showed a slight gain as well. The intermediate term chart at left is still choppy but has a pronounced uptrend once again. This should continue into the spring as projects delayed by the snow begin or resume.
  • After bottoming out following a long period of decline in the aftermath of the mid 2000s overexpansion, construction spending rebounded at a 6.4% annual clip over 2011 and 2012. Most of this growth came in 2012 when construction spending rose 8.1%. That pace slowed by 100 basis points in 2013 but there is considerable room for continued expansion. For reference, at a 7% annual growth rate, we would not reach the 2006 construction spending peak until the fall of 2017.

Exhibit 18

Exhibit 19

Source: US Census Bureau

Agriculture

  • Ag pricing moderated slightly after jumping last month on prospective planting data. Corn intended acres planted came in lower than estimated, at the lowest level since 2010 – this will still be the fifth largest corn crop since 1944. Pricing has encouraged farmers to shift acreage away from corn and towards soybeans, and indeed soybean acres came in at a record level, though also below consensus. Soybeans, corn and wheat were all down 1-2%.
  • See our colleague Rob Campagnino’s work on the implications of the EPA’s renewable fuels mandate with respect to ethanol.
  • Also see our blogs on potash, where we remain quite negative in terms of the longer-term pricing outlook.

Exhibit 20

Source: Capital IQ, SSR Analysis

ISM

  • Amidst a bit of confusion (and two revisions on the day of the release) the ISM’s PMI reading rose slightly, to 55.4, falling just a tenth of a point short of expectations. New orders were up nearly two points after a flat reading last month.
  • Production held stable after bouncing strongly off of recent lows that had dipped the sub-index into contractionary territory. Inventories ticked up. We would expect indicators to remain strong in Q2 given the pent up demand that the notably harsh winter likely fostered.

Exhibit 21

Source: ISM

Exhibit 22

Source: ISM

Trade

  • Note we have updated our trade chart to exclude Medicinal & Pharmaceutical products from the broader Chemicals categorization – this more accurately reflects the companies in our coverage. The resulting chart still shows significant volatility, but also a high level of surplus – including Medical & Pharma, the balance has been bouncing between surplus and deficit. 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.
  • Year over year the Russian ruble has been the hardest hit of major currencies, down 15% versus the dollar – continuing sanctions in the aftermath of the Crimea grab have exacerbated this decline. Fellow BRIC currencies, the Indian rupee and Brazilian real, have also devalued by over 10% each over the past year. Midway through May, the second quarter of 2014 has seen the euro 5.7% stronger year over year versus the dollar – Exhibit 25.

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.

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.

Capacity is expected to grow by more than 2 billion pounds in 2014 versus 2013, which means that demand needs to grow by more than 3.5% in 2014 just to maintain current operating rates. However, as is shown in Exhibit 27, the second quarter will show quite low operating rates as a number of facilities are closed, not just for annual maintenance, but also to tie in expansions. Despite the added capacity, it is noteworthy that Wood Mackenzie expects almost no production growth in 2014 and declining operating rates year on year in the second half. We would concur that demand growth is lackluster at best in the US and exports are opportunistic, such that the ethylene market could be quite oversupplied from June with inevitable consequences for pricing.

US ethylene inventories remain very high and this is keeping downward pressure on spot ethylene prices despite the significant current outages. While ethylene contract prices fell significantly in March they recovered some of the decline in April, and spot prices are higher during this period of extreme production cutbacks.

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

Exhibit 26

Source: IHS and SSR Analysis

Exhibit 27

Source: IHS and SSR Analysis

Pricing

Energy – Exhibit 28

The oil market has been very stable since 2011, with Brent essentially in a 5-10% range centered around $105 per barrel and WTI similarly range bound but at a discount to Brent. Crude oil has not been this consistently priced for this long since the mid-90s.

Natural gas is discussed in more detail in the overview.

Exhibit 28

Source: Capital IQ and SSR Analysis

NGL pricing continues to track natural gas, but ethane has weakened over the last couple of months and the discount of extraction value has reopened back to the levels seen at the end of last year. This is a function of significant ethane oversupply and high levels of rejection. Today this is both a supply and demand problem, with supply continuing to climb as new natural gas liquids gas wells are brought on line, and demand weak because of the high number of current ethylene plant shutdowns. Ethane extraction units are currently at break-even on a marginal cost basis only. With the ethylene expansions expected later in the quarter, ethane demand will pick up, but we expect the oversupply to continue and pricing should remain very weak relative to Natural Gas – Exhibit 29. What is different is that the Conway ethane advantage has reappeared meaningfully from the low in February – Exhibit 30. This difference was a major benefit for Westlake and Lyondell in Q4 2013 as both operate ethylene units in the Mid-West.

Exhibit 29

Source: IHS, Mackenzie Wood and SSR Analysis

Exhibit 30

Source: Midstream Business and SSR Analysis

Propane and Butane prices are a little weaker in May than in April, but have been fairly stable since a significant step down in February. The longer-term trends relative to crude appear to be stabilizing somewhat as alternative values are reached for both. 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 is relatively stable, all over the world, though the US has seen some significant differences in production in the first quarter of 2014 with high density polyethylene production down by more than 5% while other grades saw increases. This is partly a function of plant and ethylene availability in Louisiana, but it is interesting that pricing has not moved materially as a result of the lower supply.

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 Chemical companies are over-earning by roughly one standard deviation, yet are some of the cheapest in the Chemicals space, giving the group the highest Skepticism Index value – most of this is driven by DuPont. Agricultural Chemical stocks are only slightly under their historical earnings trend but investors are discounting a fall in returns. The Specialty group is being afforded a high valuation premium despite earnings that are actually slightly below the long term trend. See Exhibits 37 and 38.
  • LYB is the only company currently at an all time Skepticism Index high – POL is at its 10 year high and we have highlighted it as well – Exhibit 39.

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

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

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