Ethylene – Discounting Too Much Downside, Despite the Trump Trade Risk!!

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

November 14th, 2016

Ethylene – Discounting Too Much Downside, Despite the Trump Trade Risk!!

  • US Ethylene equities are discounting market weakness. LYB in particular, shows strong earnings and cash flows – a continued focus on repurchases; yet the equity is weak
    • Emotionally driven near-term by relative swings in crude oil and natural gas
    • Analyst driven by any signs of weakness in results and an expectation that things get much worst in late 2017 – something we are challenging in this piece
  • DOW continues to show strength, focused on above trend growth in polyethylene globally and especially in consumer related food packaging in the developing world
    • Others support this view – polyethylene producers and packaging companies alike
  • If polyethylene demand remains strong and continues to grow at 3.5-4.0% globally in 2017 we have potential for a short ethylene market for most of 2017 and potentially very high pricing
    • Ethylene expansions from LYB and Oxy increase supply near term, but with higher polymer exports, ethylene could remain tight, through Q3 and possibly for the full year
    • Sasol, CP Chem and Dow all have polymer units that will be ready to go before ethylene and if the margins justify buying or borrowing ethylene to ship the polymer they will do so
  • A pull on ethylene to feed new polymer units in 2017 could result in much lower than expected 2017 ethylene inventories, high ethylene prices and lower polyethylene margins, but good integrated margins overall
    • The losers would be arm’s length buyers of ethylene such as Westlake (for the Axiall business), Trinseo, and possibly Olin
  • The DOW, CP Chem and Exxon ethylene start-ups late in 2017 could swing the balance dramatically in the other direction if they are on-time, which is unlikely, meanwhile, if polyethylene remains as strong in 2017 as in 2015 and 2016, 2017 could be tight for ethylene
    • LYB looks most interesting on valuation and because of continued focus on share buyback – WLK has a tailwind of better caustic and PVC prices, but is now a big buyer of ethylene
    • DOW remains our favored way to gain exposure both because of the deal but also because of the recent results of both DOW and DD, setting themselves apart from the pack

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview and Q3 Summary

On the assumption that US President-Elect Donald Trump does not send the world into a negative economic spiral, we are suggesting that investors take the plunge into the ethylene market, with LyondellBasell (LYB) the obvious way to play the upside. While the market is clearly looking ahead to three or four large US ethylene start-ups in late 2017/early 2018, we believe that the currently tight global market could remain so through 2017, and get tighter, and that the impact of the start-ups could be much more muted than expected. The likelihood of any of the plants starting up early is close to zero and the likelihood of some delay is very high.

Q3 commentary from DOW and LYB specific to ethylene/polyethylene is summarized below in Exhibit 2 and is supported by packaging companies, who confirm the strong consumer led growth in China.

Exhibit 2

Source: Company Presentations, Capital IQ, SSR Analysis

While revenues were a very mixed bag, most companies in the commodity space, including the ethylene producers met or beat earnings – Exhibits 3 and 4. Dow was the stand-out beating on both the top and bottom line – others with earnings beats were very reliant on cost cutting, Dow benefitted from top line growth and cost reductions.

We believe that part of the significant revenue miss at WLK was poor modeling of the one month impact of adding Axiall to the numbers and not anything wrong with the business – the disconnect between revenue and earnings estimates suggests that consensus models were based on poor guidance from the company or possibly some seasonality within the quarter with Axiall revenues that would not have been picked up from Axiall quarterly reports.

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: Capital IQ, SSR Analysis

Fundamentals – Some Perspective on the Capacity Additions in 2017

Domestic ethylene inventories are at multi-year lows as 2016 winds down – Exhibit 5 – compounded by a larger than usual outage schedule in the back half of the year – Exhibit 6. Coupled with a continued demand pull from international markets and the startup of derivative units in the US, we could potentially see very high ethylene pricing in the new year – good on an integrated basis for LYB and DOW, less so for WLK with its higher ethylene requirements post-AXLL.

What is missing from the inventory chart is how much ethylene other producers may have borrowed from Sasol since the middle of the year and may plan to borrow near-term. Sasol is “building inventory” physical and through swaps, to feed its polyethylene JV unit with Ineos, which it plans to start up in early 2017. The inventory rise predicted by WoodMac in 2017 suggests a weakening market but does not take into account both ethylene owed to Sasol/Ineos and the internal desire to build inventories by both, as well as others looking at a possible early start of polymer units – we do not believe that it is indicative of a likely weaker ethylene market.

Exhibit 5

Source: Wood Mackenzie, SSR Analysis

Exhibit 6

Source: Wood Mackenzie, SSR Analysis

Perspective

Global ethylene demand is around 150 million tons per annum and conservatively is growing at 3% per annum – so 4.5 million tons per annum.

  • Each of the Dow. Exxon and CPChem units is 1% of world demand, and together they account for one year of global demand growth if they run at 100% of capacity.
  • The US has other capacity additions and from January 1 2017 to December 31st 2018 will likely add 6% to global capacity – two years of growth
  • While others are also adding capacity outside the US in the same time frame, the additions are small and may be more than offset by reductions in China as coal based production is impacted by new coal production rules
    • This is already impacting the Urea market and the chlor-alkali through PVC chain, but will likely have more of an impact on methanol, propylene and C4s markets than ethylene as the coal based capacity for these products is more pronounced.
  • Some pause for thought on the big three additions in the US.
    • Dow, Exxon and CPChem are all large global marketers of polyethylene and they are not going to start-up their new capacity and suddenly expect to sell all the new product in the spot market. They have plans! They will likely run everything else they have flat out in 2017 with minimal planned shutdowns – driving sales gains that will in part be met by the new capacity. They will then likely take ethylene and polyethylene shutdowns around the globe once the new capacity is running such that they gradually add to their global supply
    • Separately, each one of these units is capable of producing 100 thousand tons of ethylene a month – 25% of average US inventories – so a delay of a few months on any of these units will have a very negative impact on expected ethylene availability. In each case the companies may choose to delay derivative start-ups until the ethylene units come up, but if they have already committed to sell the polyethylene, they are more likely to attempt to buy incremental pounds of ethylene.

Estimates

Current estimates do not suggest that expectations for 2017 are for a collapse in ethylene margins – Exhibit 7 – even though we would argue that the stocks are reflecting that risk, or perhaps a risk post 2017. While in general investors lead the sell side – i.e. the movement of the stocks suggests that negative revisions are ahead, we see a greater chance that estimates are too low for 2017, and that 2018 may not be materially different from 2017 – though better for Dow because of more capacity.

The risks are obviously well understood on the economic side and on the raw material side:

  • If the global economy slows further and consumer confidence drops we could see a pullback in demand growth, exposing the additional capacity in the US, and creating an overhang – margin risk could be as much as 20 cents per pound on an integrated polyethylene basis – see Exhibit 8 for leverage to integrated polyethylene margins.
  • Swings in relative energy prices could change the shape of the cost curve making US capacity less competitive and making US polyethylene exports far less profitable. This would require oil to keep weakening while natural gas stays strong.

But there is now a third and possibly larger risk which relates to President-Elect Trump’s possible trade moves. We do not think that he can make this as early an agenda item as he likes, but retaliatory moves by others, should he impose tariffs and quotas, could impact the very large US exports of plastics, predominantly polyethylene. This would be bad for LYB, DOW and WLK and is a risk that investors should consider when buying these names.

Exhibit 7

Source: Capital IQ, SSR Analysis

Exhibit 8

Source: Capital IQ, Company Reports, SSR Analysis

Valuation

Particularly if the company continues its focus on dividends and share buybacks, LYB is the obvious way to play belief in the ethylene market. Not only is valuation attractive on most traditional metrics, but the discipline of return of cash to shareholders is an added “guarantee” of returns (unless the strategy changes). Should LYB have the cash flows suggested in current estimates in 2017 as well as a successful sale of its refining assets, the company could buy back another 8-10% of its shares before the end of 2017.

In Exhibit 9 we show a scatterplot that we have used elsewhere in the Chemical space and for other Industrials/Materials sectors. Returns on tangible capital typically show a close relationship with a firm wide valuation multiple relative to tangible capital – all the major ethylene stocks are below the best fit line, implying valuation upside – LYB most significantly so. Exhibit 11 shows enterprise value on a more conventional EBITDA multiple, where the commodity stocks look inexpensive versus the Chemicals group at large.

Exhibit 9

Source: Capital IQ, SSR Analysis

Exhibit 10

Source: Capital IQ, SSR Analysis

Exhibit 11

Source: Capital IQ, SSR Analysis

Our “normal” value approach is summarized in Exhibits 12 through 15. We are hampered in the analysis in all three cases – LYB because of lack of history, WLK because of the AXLL deal and DOW because of the DD deal. If we give WLK the benefit of the doubt of $200m pre-tax synergies from the AXXL deal the stock is nearly 1 SD cheap today. If we give 50% of $3bn of pre-tax DD synergies to DOW the stock looks 0.3 SD cheap today.

Exhibit 12

Source: Capital IQ, SSR Analysis

Exhibit 13

Source: Capital IQ, SSR Analysis

Exhibit 14

Source: Capital IQ, SSR Analysis

Exhibit 15

Source: Capital IQ, SSR Analysis

©2016, 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.

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