December Ethylene – A Proxy For 2018?

gcopley
Print Friendly
Share on LinkedIn0Tweet about this on Twitter0Share on Facebook0

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

December 11th, 2017

December Ethylene – A Proxy For 2018?

  • The year is ending well for US ethylene producers – robust oil pricing is combining with an oversupply of US natural gas and a greater oversupply of NGLs to steepen the cost curve in favor of US producers. This should improve Q4 earnings for DWDPLYB and WLK.
    • Oil is high based on demand, as the global economy churns at a higher rate, and as OPEC and Russia agree on production limits – which seem high enough to keep everyone happy and in check for a while.
    • Natural gas is cheap in the US but not elsewhere – US pricing would be higher if there was sufficient capacity to export, but today production (incrementally driven by the Permian) is outpacing demand.
    • NGL availability from the Permian is depressing ethane pricing relative to natural gas – although we do have two imminent ethylene plant start-ups in Q1 2018.
  • Polyethylene pricing, while off the post-hurricane highs, has held on to much of the increase given global demand strength – also assisted by better economic growth.
    • Integrated margins are the highest this year for ethane based US production.
  • A small positive for LYB and a major positive for WLK: the Conway/Mont Belview ethane spread has opened back up over the last few months – this is currently worth about 4 cents per pound of ethylene.
    • Also helping WLK is a robust chlor-alkali market, which seems unlikely to slow in 2018.
  • Is this better environment a proxy for 2018? Or will new ethylene plants from CPChem and Exxon soak up all the surplus ethane and at the same time swamp the polyethylene market?
    • The stronger economic growth is largely consumer led and this is very positive for ethylene consumption – the world needs the Exxon and CPChem capacity in 2018, but probably not all in the same month!
    • We expect volatility associated with these start-ups – but overall a better ethylene year in 2018 than 2017 for US producers. Despite moves in WLK and LYB, both have upside –DWDP has the better risk/reward profile given other positive levers – see research.

Exhibit 1

Source: IHS, Wood Mackenzie, SSR Analysis

Details

US ethane is falling relative to crude again in the near-term – Exhibit 2. Oil seems to have support both from demand and from production discipline and while global natural gas (LNG) is tight today, supply in the US is above the capacity to consume and export, with inventories building last week at a time of year when we would normally expect them to decline. Abundant natural gas is driving abundant NGLs, despite increased ethylene production and ethane is falling relative to natural gas, and further relative to crude.

Exhibit 2

Source: IHS, Wood Mackenzie, SSR Analysis

At the same time, the pull on natural gas in the Midwest and the limited need for NGLs in the South is opening up the Conway/Mont Belview ethane spread as shown in Exhibit 3. This is a bonus that is close to 4 cents per pound of ethylene for the 4 ethylene plants exposed to Conway – 2 for WLK and 2 for LYB. The leverage is much higher for WLK on a (local) pounds of ethylene per share basis, but the benefit to LYB should be enough to move the needle in Q4 and through 2018 if it continues.

Exhibit 3

Source: IHS, Wood Mackenzie, SSR Analysis

Polyethylene pricing is holding up following the increases that were triggered by the Hurricane – Exhibit 4 – and this should drive a good end to the year for all.

Exhibit 4

Source: IHS, Wood Mackenzie, SSR Analysis

Will This Persist?

There are several moving parts to the question. Oil should stay high in 2018 – US natural gas should stay low until more export capacity in the US opens, but that may not be enough given the increase in gas coming from the Permian (an exceptionally cold winter is always a risk, but no signs of that so far).

The Permian is also the swing factor for whether ethane will remain cheap once Exxon and CPChem’s ethylene facilities start up. We see the possibility for slightly higher ethane, but are not expecting anything material – with the possible exception of a spike or two, if there is instantaneous incremental need from the Marcellus. The reason why we do not expect a material move in prices, even if the Permian cannot meet the increased demand, is because we would expect a tactical swing to propane (even at higher prices) by those with flexibility, to keep the South long ethane. It is worth paying a little bit more for 5% of your feedstock to guarantee low pricing for the other 95%!

The more interesting debate is around supply/demand for ethylene derivatives and whether the new plants cause market weakness. As we have written since the US hurricanes, we do not believe that 2018 will see a glut of polyethylene and margin weakness – since that time we have seen nothing but positive economic data – all around the world – to support our strong demand thesis – Exhibit 5 (see our December Monthly).

Exhibit 5

Source: Bloomberg, Government Publications, ISM and SSR Analysis

While WLK has had a very good last three months we still see considerable upside to peak valuation and estimates still look too low for 2018 based on the strength in ethylene, the Conway advantage and the better chlorine/caustic environment – with the majority of its assets in the US, WLK is the ethylene play with the most to gain from the tax proposals.

Despite quite spectacular performance over the last few months and a stock price approaching an all-time high, WLK still looks cheap in our models – Exhibit 6. This is because our models are return on capital based and WLK had a step change in capital with the Axiall acquisition – the upside comes from driving similar returns from that asset base as WLK has managed with its legacy business – this looks likely to us and generates a “normal” value for WLK of around $120 per share.

Exhibit 6

Source: Capital IQ and SSR Analysis

LYB remains a little strategically adrift in our view, with news flow suggesting several possible paths under consideration – the ethylene leverage is unmatched and all things being equal this is the best way to get ethylene/polyethylene leverage today. As shown in Exhibit 7, the stock is not expensive: normal value is around $125 per share – peak would be much higher.

Exhibit 7

Source: Capital IQ and SSR Analysis

DWDP is the safe bet – lots of other good things going on (see prior research) plus more ethylene leverage per share than legacy Dow had in the peak of 1988/89. Our expectations for DWDP are summarized in Exhibit 8. The valuation line in the Exhibit does not assume the ethylene cycle earnings – if we get them 2018 could be a year of significant stock appreciation for DWDP – assuming synergies, normal value for DWDP is $86 per share.

Exhibit 8

Source: Capital IQ and SSR Analysis

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. 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.

Print Friendly