Ethylene: A Tough 12 Months to Model – Likely Very Volatile

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

July 17th, 2017

Ethylene – A Tough 12 Months to Model – Likely Very Volatile

  • As we head into “start-up” season in the US we would expect ethylene, and possibly polyethylene, pricing to be quite volatile and very hard to predict.
    • There are three large ethylene plants coming on stream – Dow shortly and CPChem and Exxon in Q4/Q1 – all three have more than 3bn pounds of capacity each.
    • There are 5 large polyethylene facilities starting up (1bn each – approximately); all mechanically complete or close to it – Dow, Exxon, CPChem x2 and Sasol/Ineos.
    • We have around 1.0 billion pounds of inventory to play with, in the system.
  • This presents opportunity for physical and futures traders in ethylene – with both positive and negative data points likely to create significant swings in pricing.
    • Inventories rose in June, Dow announced mechanical completion of its ethylene facility and the beginning of start-up testing, and while 3 polyethylene producers also announced mechanical completion – the market focused on inventories and ethylene fell 5 c/lb.
    • Spot price based margins are well below reinvestment levels – the green line in Exhibit 1.
  • Further modeling complications include the ability to export ethylene from the US – if the price is right – and what Westlake might do with forward purchases to exploit low pricing:
    • If Westlake and others buy for inventory or for PVC/other exports at low prices and Enterprise increases ethylene exports just as polyethylene capacity comes on line, we could see inventory swing down and pricing swing upwards dramatically this quarter.
    • A rush of new polyethylene could undermine polyethylene pricing also, but we are less concerned about polyethylene as all the new capacity sits with established sellers.
  • These uncertainties will make it very difficult for the ethylene majors to provide second half guidance as they report earnings over the coming weeks.
    • It also means that the stocks could be quite volatile based on incremental data points.
    • Both LYB and WLK look cheap, and cheap enough to offset the risk, especially LYB based on yield. Dow only looks attractive if credited with all the expected synergies from the DuPont deal.

Exhibit 1

Source: Wood Mackenzie, SSR Analysis

Details

The near-term ethylene landscape looks complicated – Exhibit 2 – with far too many moving parts to make an educated guess around where pricing could be at any time over the next 12 months. The energy market uncertainty does not change from what the industry has been dealing with forever, but we have so many US start-ups over the next 12 months, both of ethylene producing and consuming capacity, that the market could swing from long to short in a matter of days and vice-versa.

Exhibit 2

Source: SSR Analysis

While current spot margins may appear very low in Exhibit 1, when contrasted with reinvestment margins (and we are being conservative with this reinvestment estimate – some new facilities justify higher numbers), we would remind all that recent history is not a good reflection of the longer-term – Exhibit 3. The industry has seen significant periods of zero or negative cash margins; why nothing has been built in the US until now.

Exhibit 3

Source: SSR Analysis

In addition to the simple facts with respect to which company has what capacity scheduled to start up, and when, we add the following complicating overlays:

  • Start-up issues – will the completed facilities start up on time? History has shown examples of problem-free on-time operations as well as significant delays, though generally not for DOW and Exxon.
  • Strategy – whether companies choose to keep mechanically complete polyethylene units shut down until ethylene plants are running or whether they have already bought/borrowed ethylene or will enter the spot market to start-up ahead of new ethylene capacity.
  • What the majors may do with other facilities to help accommodate new production:
    • Will DOW, Exxon and CPChem choose to close other capacity around the world for scheduled maintenance as new US capacity starts running, to dampen the supply effect.
  • The other uncertainty is demand – global demand growth for polyethylene consumed two very large start-ups in North America in 2016 (Nova and Braskem), suggesting that demand growth remains very robust. If the growth rate continues we should be fine; any demand stall and the new supply will have a magnified impact.

Right now, this is happening in a period of lower spot pricing for US ethylene – at 22-23 cents per pound spot pricing is well below what is needed to justify reinvestment, but it is attractive for export. 23 cents per pound is around $500 per metric ton. At these prices the US can export any ethylene derivative and ethylene itself with significant margins. The result will either be lower derivative and ethylene pricing in other parts of the world or an ethylene surplus that is quickly consumed.

Polyethylene exports can currently pay as much as 35 cents per pound for ethylene – versus a spot price 10 cents lower. Ethylene exports can command an even higher price, with European prices still over $1000 per ton and Asian prices just below $1000 per ton – Exhibit 4.

Exhibit 4

All of this new capacity will result in a steady increase in net exports from the US of ethylene, polyethylene, PVC (and its precursors), styrenics and ethylene glycol. The trend is already evident in Exhibit 5, but the new capacity additions should add around 5 million tons of ethylene at normal operating rates (this includes LYB’s expansion already complete and the new Oxy facility which started in the first quarter). With slow domestic demand, this could add as much as 400 thousand tons per month to the current totals in Exhibit 5 almost doubling US monthly exports.

Exhibit 5

Source: Wood Mackenzie, SSR Analysis

Furthermore, the US will have to look further afield than Mexico, as the Braskem/Idessa start-up in Mexico last year has caused a significant drop in US polyethylene exports to Mexico, as shown in Exhibit 6. The US is likely to move material all over the world to consume the new local ethylene.

Exhibit 6

Source: Wood Mackenzie, SSR Analysis

Hard to look through the noise – Why the stocks are cheap!

We remain in the bullish camp on ethylene and do not see the global market oversupplied as a consequence of the impending US additions. We are a bit lonely, as we do not have much company on our side of the fence right now, and given the potential for volatility, as well as estimates that still look too high for this year and next (for LYB in particular), we see no rush to chase what are some very cheap stocks.

Both LYB and WLK look very attractively valued today, whether it is on a normalized value basis, an EV/EBITDA basis or an asset replacement value basis (LYB looks more fairly valued on this basis unless you use the recent Nova/Williams deal as a proxy for replacement value multiples) – Exhibits 7-10. Dow only looks cheap if you add the synergies from the DuPont merger – Exhibit 11.

Exhibit 7

Source: Capital IQ, SSR Analysis

Exhibit 8

Source: Capital IQ, SSR Analysis

Exhibit 9

Source: Company Reports, SSR Analysis

Exhibit 10

Source: Company Reports, SSR Analysis

Exhibit 11

Source: Capital IQ, SSR Analysis

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