Ethylene – Brave to Own Heading Into 2016

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

December 22nd, 2015

Ethylene – Brave to Own Heading Into 2016

  • Today, ethylene margins around the world are quite high and in all regions well above the cost of production – we struggle to see how this can be sustained.
    • US spot ethylene prices have come down ~20 cents per pound over the past six months while Asian and European prices are little changed – the differential is more than 25 cents per pound, encouraging significant increases in US derivatives exports in 2015
    • There are multiple forces at work here – a US export push to exploit the price differential, combined with a European/Asian pull given the heavy outages in 2015
  • Co-product prices have not adjusted downward commensurate with the decline in crude, and the credits have helped push high end of the cost curve much lower
    • Negative cash costs for some Middle East producers on heavy feeds
    • Production costs in Asia and Europe, which, were prices to fall to those levels, would curtail US exports dramatically, if not completely
  • The global pricing premium to costs suggests an ethylene shortage globally: operating rates in aggregate do not and here is the concern
    • US ethylene inventories are rising ahead of significant planned outages scheduled for the first half of 2016 – risk is that exports slow and the inventory build accelerates.
    • Only polyethylene is strong and new supply in China and Saudi Arabia could tip the balance to the long side early in 2016
  • If European and Asian ethylene prices fall, which they should, US pricing will need to fall closer to costs to maintain export viability
    • With a much flatter cost curve the impact on US profits could be severe
  • WLK is most at risk if the spot price differential between US and Asian/European ethylene prices closes
    • WLK does not have the European operations (and current margin benefit) that peers do (LYB, DOW)
  • We think LYB, WLK and DOW will be challenged to meet estimates if regional prices normalize and erode margins globally, risk also for DD, HUN and EMN
    • As we wrote recently, the deal makes DOW/DD by far the best relative play

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

Last week Axiall announced that the final investment decision on its US JV ethylene plant with Lotte Chemical had been made. This is a strategic move for Axiall and the JV is structured in such a way to limit risk for Axiall and preserve optionality. It is a deal that during its planning stages had been widely applauded by investors. Despite that, the stock traded down almost 16% during the course of last week.

The deal is still well constructed and probably an appropriate strategic move for Axiall, but the problem is that at current energy prices, and in an oversupplied global ethylene market the proposed plant would likely not return its cost of capital. We tend to focus on the data points in front of us, and today’s economics say “do not build”, in the same way that the economics of 18 months ago said “how can you not make money by building”.

Low international oil prices and relatively sticky prices for ethylene co-products have made international producers much more competitive today than at any point in the last 4 years, and our theoretical analysis of the global ethylene break-even clearing price is 15 cents per pound today – Exhibit 2. This compares with a 2015 average closer to 30 cents.

Exhibit 2

Source: IHS, Wood Mackenzie, SSR Analysis

If the world was awash with ethylene today, US producers would need to be selling ethylene at cash costs to remain in export markets for products such as polyethylene.

But the world is not behaving as if it is awash – at least right now. European and Asian producers are making good money in Q4 2015 with ethylene pricing well above those in the US, especially in December, and US spot and contract prices for ethylene remain well above costs of production. However, spot prices are falling quite quickly in the US, helped by lower ethane pricing (driven lower by much cheaper natural gas), but also to support incremental exports of ethylene derivatives from the US.

The lower US ethylene spot prices today are likely driven by what would be needed to support exports of PVC, styrene or ethylene glycol as polyethylene pricing remains quite strong in Asia and Europe. The bigger risk for US producers is if global polyethylene prices fall to reflect costs and we think this is likely – why? Because global operating rates are simply not high enough – Exhibit 3

Exhibit 3

Source: IHS, Wood Mackenzie, SSR Analysis

Prior ethylene peaks have required global operating rates above 90% and we are not there, even if we have an exceptional demand growth year in 2016, with new capacity in Saudi Arabia starting up and new capacity and new players in China in 2016, we see things as very fragile. Twenty years ago there was generally a year-end slowdown in demand to reduce year-end working capital, and demand would improve through Q1 and into Q2. Today you tend to see less of a year-end slow down because of better inventory management, but you also have a weak Q1 because Chinese New Year sees days of little activity in China and China is now a much bigger part of total demand.

Ethylene margins are very high in Europe and even if ethylene pricing moved down 20%, DOW and LYB would still generate acceptable margins. However, such a move down in global pricing would cause chaos in the US markets because of the export dependence and the flatter cost curves – as shown in exhibit 1 – US exposure is huge for LYB, WLK and DOW, with WLK having no international offset. Neither DD nor EMN has a lot of ethylene, but both have blamed ethylene for recent earnings misses – as has HUN. We would stay clear of the space generally and in the near-term this may put a cap on how well DOW can perform – as we addressed in recent research, it is the very obvious RELATIVE play.

Ethylene 101

The economics of ethylene are complicated and we try to depict some of the moving parts in Exhibit 4. There are a variety of feedstocks, which can have a variety of prices depending on where you are in the world. Complicating things further, unless you are using ethane as a feedstock you are making more than just ethylene (every process makes hydrogen, either sold or used as a fuel on site). The values of the “co-products”, most important being propylene and butadiene can be very influential. When crude oil prices and naphtha are cheap, while propylene and butadiene are strong, as is the case today in some major producing regions, incremental ethylene costs fall dramatically and have in the past been negative for short periods.

Exhibit 4

Source: SSR Analysis

Supply and Demand

Demand is another wild card.

  1. Large volumes of polyethylene – well over 50% are used on food packaging – positive from a consumer staples and consistent growth perspective but negative from an increased focus on recycling perspective. Good continued demand growth in China and developing world
  1. The rest of polyethylene is essentially consumer discretionary, as is some of the styrene chain. Slowing with the global malaise
  1. PVC, some styrene and some polyethylene are housing and infrastructure related. Was growing rapidly in China now going backwards – hence the huge PVC surpluses coming out of China
  1. Polyester is split between PET for bottles (staples, but recyclable) and fiber for clothing – China is awash with both and exporting.
  1. Others serve markets for coatings, adhesives, synthetic rubber – all largely irrelevant to main drivers of industry profitability.

Demand growth globally has been slowing for decades. Of course you have to have the decades of data to know this! Exhibit 5. To expect anything heroic from 2016 on the demand front would be to bet against what 50 years of data is telling you – the volatility in 2009/2010 was a major inventory swing caused by the financial crisis. Current low crude could force extreme weakness over the next few weeks as buyers drop inventory for year-end.

Exhibit 5

Source: IHS, Wood Mackenzie, SSR Analysis

Why we do not think 2016 can be that strong:

  • Outside polyethylene (mostly consumer staples driven for food packaging), demand grow is weak, in line with general economic growth. The consumer durable market is ok in some areas but construction is very poor.
  • Demand growth in 2016 would need to be 7.5% versus our assumed 3.5% to get operating rates to a level that might support prices meaningfully higher than costs.
  • In 2016, we have new capacity in the Middle East – Saudi (Sadara) and Iran. New supply in India and new supply and new participants in China.

In the short term the market has been recovering from some major production outages in Europe and Asia – one in Europe likely to continue for a while and it is likely that aggregate storage levels remain below normal. In the US we are building inventory for expected plant maintenance closures starting in February – Exhibits 6 and 7. But this could all be very temporary. Slower demand in Q1, better operating rates around the world, fewer unplanned outages and we will have a surplus pretty quickly and pricing will reflect that equally rapidly.

Exhibit 6

Source: Wood Mackenzie, SSR Analysis

Exhibit 7

Source: Wood Mackenzie, SSR Analysis

Trade and Pricing

The most important driver of US pricing today and an increasingly important driver going forward is/will be international pricing of ethylene derivatives. Like the Middle East, the US (and Canada) has a huge ethylene surplus with exports (as derivatives) from North America roughly 7-8 million tons per year – roughly 20% of the ethylene produced in the region. Polyethylene is the largest export by far, but PVC, styrene and ethylene glycol are more important to ethylene pricing as they tend to be the marginal pound or ton of demand. Spot ethylene pricing below 15 cents today is supporting marginal PVC exports not polyethylene.

As long as the cost curve is steep everyone is happy – if the current price differentials in Exhibit 8 are driven by relative costs then the market is stable and the US can continue to export. But cash costs in Asia and Europe are barely higher than US pricing today. If Asia and European prices fall closer to costs, US spot pricing will continue to erode and bring domestic prices down also. Consultant forecasts today are a best case in our view and rely on “market discipline” that we have rarely seen in any large commodity market. More likely that ethylene could have a 2016 which disappoints meaningfully

Exhibit 8

Source: Wood Mackenzie, SSR Analysis

Risks for US names – Upside

  • Demand surprises on the upside globally – would need to be meaningful – unlikely
  • Oil prices recover back to the $50-60 per barrel range – possible 2H?
  • Propylene and butadiene prices falling Europe and Asia lifting the top end of the cost curve and limiting how far ethylene prices can fall – quite possible
  • US ethane falls further versus natural gas – possible short term, but unsustainable with export terminals nearing completion and the possibility that drilling slows given low prices

Risks for US names – Downside

  • US natural gas prices rise – weather dependent – possible in Q1
  • Asia and European ethylene prices collapse to cost – US export markets disappear – prices and operating rates fall – estimates for 2016 to high for LYB and WLK by more than 50% – possible.
  • US exports of ethane and or LNG drive up pricing relative to crude – same effect as bullet above – possible

In short – it’s complicated!!

©2015, 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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