Ethylene – Rewind to the ’90s

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

March 29th, 2016

Ethylene – Rewind to the ’90s

  • Entering a period of widespread ethylene capacity additions, operating rates and profitability will come under pressure (as in the early 1990s), even with demand growth estimates above 4.0% (an optimistic outlook given history)
    • Estimates for the back half of 2016 and beyond are not fully discounting this possibility
    • LYB’s 2H ’16 EPS estimates are $0.30 below actual results for 2H ’15, which may not be enough of a reduction given the $0.40-$0.60 quarterly decline that would come from a 10-15 cent per pound integrated polyethylene margin hit
    • WLK likewise shows an estimated $0.30 year over year EPS decline in 2H ’16, but similar share leverage would reduce EPS by $0.30-$0.45 per quarter
    • Both companies show year over year growth in 2017 and 2018, which may not allow for anticipated weakness or further deterioration
  • A margin downturn will likely drive another round of industry consolidation (again, as in the early 1990s) – particularly among those with incomplete strategies or stressed balance sheet – we think those with “long” ethylene positions are most at risk
    • AXLL’s best move may be to take the WLK deal, as the optionality and integration benefits from its JV cracker with Lotte may shrink if the US is forced to export ethylene derivatives and reverts to its role as global price setter (see: 1990s)
    • We think LYB should be a buyer not a builder – see accompanying research on the company
    • Expect some further divestments/JVs from oil majors (except Exxon)
  • Looking out further, after we have grown through this capacity surge in the period beyond 2019, the outlook for new capacity still favors the US because of the feedstock availability
    • Further ethylene builds in the US will require significant derivative exports given low domestic growth rates, and reestablish the Gulf Coast’s role in setting marginal pricing – regional political/economic ambitions may not allow for this
    • Ethylene growth dominated by polyethylene; the technology leaders, Dow, Exxon, Borealis, Etc. will want to keep their share – through product improvement and new capacity. Expect to see more investment in North America, with Dow and Exxon leading the charge again

Exhibit 1

Source: Wood Mackenzie, SSR Analysis

Overview

Over the next several years, US investments will add around 10 million tons to global ethylene capacity – around 6% to a base already in excess of 165 million tons. The US investments are remarkable only in their intensity of both timing and geographic focus, not by what they will add to the total – 2 years of global demand growth in a best case, 3 in the worst case. They are being added over a time frame from mid-2017 to mid-2019 which again smooths out the impact. The worries for the market with these additions are two-fold:

  • The US additions are unusual in that the US has not really added meaningful capacity in 20 years and these new facilities come on stream at a time when the rest of the world continues to build – especially, China, India and the Middle East. As such, without unprecedented demand growth, it looks likely that the ethylene market will weaken from today through 2019/2020.
  • The US additions come into a regional market which is not growing as fast as the global market, and consequently will require significant ethylene derivative exports in order to consume the new capacity. This is a subject we have written about at length and the success for US producers will depend on the steepness of the global ethylene cost curve – essentially the delta between international crude oil prices and US natural gas prices.

The chart borrowed from WoodMac below shows the near-term details of the US ethylene additions – Exhibit 2

Exhibit 2

Domestic demand will be insufficient to absorb the new capacity, which will lead to a rise in derivative exports – but even on a global level, the most aggressive estimates of 4.5% demand growth would still result in pressure on operating rates and margins given the expectation of additional capacity builds outside the US over the same time frame. Our belief is that we could see a 10-15 cent per pound decline in polyethylene margins over the next 12 months (PVC margins are already close to zero for all but the most cost advantaged). Consensus estimates for LYB and WLK do not appear to be reflecting this possibility, all else equal. Estimates for the back half of 2016 are about $0.30 below actual results from 2H ’15 for both companies. Yet a 10-15 cent decline in ethylene/polyethylene margins would have a negative quarterly impact of $0.40-$0.60 for LYB and $0.30-$0.45 for WLK. In the years ahead, consensus anticipates year over year growth in 2017 and 2018 for both companies, which looks increasingly optimistic.

Exhibit 3

Source: Capital IQ, SSR Analysis

Near to Medium Term

Downturn Promotes Consolidation

In an oversupplied world, with poor margins for those with expensive feedstocks and poor margins for all if the cost curve is as flat (as it was earlier this year), we would expect another round of (global) industry consolidation – much like we saw in the early to mid-1990s. A downturn will expose those with incomplete strategies – either the wrong feedstocks, or the wrong levels of integration, or possibly simply the wrong products. It will also expose those with stressed balance sheets.

On the IOC side we are unconvinced that either Shell or Total has a strategy/portfolio that would be robust in a severe cyclical low. We also believe that the CPChem partners could have divergent views of the JV in a downturn; leading to ownership change. Williams will not want its ethylene plant in a weaker margin environment where all of its customers are building capacity. With a steep cost curve (which would result from higher oil prices) the usual suspects will suffer – high cost producers in Europe and in Asia. We could see a dramatic wave of government mandated consolidation in China, similar to, but larger than, what we saw in South Korea in the 90s. The South Korean industry would suffer as would the Europeans (particularly those unable to access cheap NGL’s) in a high oil environment.

Balance Sheets Come in Focus

Looking at balance sheets we think Lyondell is heading down the early stages of a very risky path – choosing to buy back shares and borrow at the margin to do so and also looking to invest in an expensive PO/TBA unit in the US. High levels of debt are a problem in a downturn as the Lyondell of old discovered to its severe detriment. At this point it is much more prudent to conserve cash in our view, pay down debt and have the balance sheet flexibility in a downturn. Even if WLK is successful in its attempt to buy AXLL, both WLK and DOW (or the DOW/DD materials spin off) should have very unlevered and flexible balance sheets through 2018-2020, possibly putting them both in very strong positions to do the best deals in any future consolidation.

Longer-Term

Demand Growth

Demand growth will likely remain focused in the developing world, with food and beverage packaging likely to be the most dominant driver. Other packaging applications will also be important, as will auto production and fibers. However, the developing world does not have the feedstocks and the last few years (current market being an exception) will have shown producers in those regions that you have to have the feedstocks to drive best in class economics as well as the demand growth. We think this set of poor economics could be repeated again between 2017 and 2019.

New Capacity

So as we enter the next wave of ethylene investment decisions – the one which will address capacity needs post 2021 – it is likely that the US will still see a seat at the table, despite the need for rising exports of derivatives and the possible perils that can bring when oil is volatile. Balance sheets should be better in the US and the Middle East, than in the rest of the world in 2020/2021, as any near-term downturn should be less severe in these regions than the rest of the world because of the feedstock edge. Furthermore, it is likely that a feedstock advantage should remain in the US, unless oil remains very weak and US E&P activity remains subdued.

Other shale development could make a difference – but this is hard to predict today. Countries with significant opportunities include Argentina, Germany, Poland, China, the UK, and Saudi Arabia. How much will be developed and whether there are attractive volumes of NGLs at attractive prices are even harder questions to answer today. Consequently we expect the US to look as attractive as any other location for the next wave of investment despite the need to export almost every additional pound of chemicals or polymers manufactured.

How Much Ethylene Do We Really Need?

The mood at the IHS World Petrochemical Conference was relatively negative for ethylene for the near to medium term, which is more worrying given IHS’ consistent overestimation of global ethylene demand growth for the last 4 years and a current demand forecast (above 4% per annum), which defies historic precedent. In Exhibit 4 on the next page we show global ethylene demand growth from 1965. Even if you ignore the very volatile period from 1965 to 1985, there is still a negative slope to the trend line and while the shorter time period may not trend to a current point of just below 3%, it does trend to a number lower than the 35 year average, which is 3.8%. As the population expands and as the Middle Income bracket within the population rises, one might expect faster growth and plenty of consultants use this logic to project stronger growth – they have been wrong for 3 decades, we believe for the following two reasons:

  • The “value in use” of ethylene is growing much more rapidly than the volume. This is more evident in food and beverage packaging than anywhere else, but the auto space becomes more and more interesting as CAFE and other fuel standards kick in around the world and more plastic replaces metal.
    • The issues are technology advances on the part of the chemical companies themselves and the experience curve of the user.
    • The producers keep making better products – stronger – more adhesive or more adhesive friendly – subject to less waste in any given process – thinner. At the leading edge this is achieved through both the base production capacity and through the use of co-monomers and compounding.
    • At the same time the consumer gets more efficient at using the product – less volume per application – less waste etc.
  • Recycling – while many suggest that lower polymer pricing around the world will reduce the level of recycling, past cycles show that this is not the case.
    • High polymer prices cause investment in infrastructure and capacity to collect, separate and find uses for the recycled materials. This investment is made because recycling margins are high because polymer prices are high. Once the infrastructure is in place it is a “sunk cost” and polymer pricing can fall significantly before the recycling slows down.
    • Recycling tends to hit one of three areas:
      • The low end of the polymer market where quality and composition are unimportant – beverage crates for example.
      • Non-polymer markets – so new markets where the recycled polymer is not substitution virgin resin – temporary road dividers (replacing concrete) and some wood applications
      • Specific niche applications where the end user wants to be able to state that some or all of the material is recycled and where this is a marketing intent.
    • In past pricing downturns companies have called for declines in recycling as a possible boost to virgin resin demand – these projections have been wrong in the past (except at the margin and not enough to move any needle) and we expect them to be wrong now.

We would be surprised to see global demand growth for ethylene average more than 3% per annum between now and 2020/2021. If demand for ethylene in 2017 is 150 million tons – as projected by IHS – then global demand will be 170 million tons by 2021, suggesting that we need a maximum of 22 million tons of capacity over 4 years – 5.5 million tons per year (based on a 90% operating rate). As shown in Exhibit 5, we are already overbuilding in 2016. Going forward from 2017, WoodMac shows 11 million tons being added in the US alone in this timeframe, 7 million tons in the Middle East, 1.5 million tons in Latin America and 10 million tons in Asia – in total, almost 50% more capacity than we need. Or, demand would need to grow by close to 5% per annum to absorb the new capacity.

Exhibit 4

Source: IHS, Wood Mackenzie, SSR Analysis

Exhibit 5

Source: Wood Mackenzie, SSR Analysis

Near-Term Issues – Consolidation

It is likely that the world will add as much as 6-7% more ethylene capacity from today through 2018 than the market can absorb, pushing operating rates below 85% – Exhibit 6. In the shaded areas the marginal producer made no money and until the most recent shaded area the cost curve was flat enough such that very few made any money. It is a real stretch of imagination/analysis to suggest that the three years in front of us will not be a problem and that the high margins we see today around the world in polyethylene and ethylene can last. Polyethylene is less oversupplied than PVC and as those with ethylene surpluses seek to find customers, ethylene and PVC prices will likely come under severe pressure.

Exhibit 6

Source: IHS, Wood Mackenzie, SSR Analysis

In the disastrous operating period of the early 80s there was some consolidation but there was more interest in investing downstream to try and get the benefit of integration or diversification. The real consolidation came during the downturn of the early to mid-1990s – in Europe and the US first and then in Asia with the financial crisis there. The major oil consolidations came as ethylene was peaking in the late 1990s.

We believe that the coming operating rate downturn, if coupled with a flattish cost curve will drive another major round of consolidation – voluntarily in the West and likely forced in China. See our recent broader piece on US consolidation for more of the industrial logic, but deals in ethylene and primary derivatives will likely center around the following – note that the suggestions are our own and not based on any specific knowledge

  • Scale and cost reduction opportunities:
    • So Far – DOW/DD, WLK/AXLL, OLIN/Dow chlorine
    • To Come Possibly – LYB/?; Shell and Total possibly together; Borealis/Nova possible combination; CPChem sale or further JV; Repsol and Versalis both weak in ethylene trough could combine
  • Attempts to integrate
    • So Far – WLK/AXLL, OLIN/Dow Chlorine
    • To Come Possibly – Williams sale of Ethylene; someone else buys AXLL; OXY Chem sale; Trinseo ethylene deal; HUN sale of company
  • Global Consolidation
    • So Far – Lotte/Samsung; Indorama/BP; Ineos/Solvay
    • Other Possible Consolidators – Reliance; SABIC; Indorama; Braskem; BASF; Dow; Aramco; Lyondell
    • BP – sells rest of chemical portfolio

Longer Term – Someone Still Needs To Build Ethylene

Without more capacity additions, the upward slope at the end of Exhibit 5 will continue – unless growth stagnates. Consequently someone else needs to build at some point. The downturns have told all producers that you can lose a lot of money very quickly in this business if you do not have the cost advantage. The recent construction experience in the US is telling companies that the engineering expertise void coupled with the advanced controls and modular based designs are making it a lot harder to build ethylene plants than it was 20 years ago. Costs are higher and the risk of construction delay is higher.

So who builds? Where? And When?

  • We will continue to see the occasional speculative emerging market build – but we think these will make up a much smaller portion of the total than in the past – the last ten years has clearly shown that if you do not have the feedstock you should not be in the business of making ethylene. India will likely be the exception (because of rapid local demand growth), but will still try to maximize a feedstock opportunity by importing ethane or propane where it makes economic sense.
  • The big integrated product market leaders will continue to invest – driven by a desire to sell higher value added proprietary derivatives rather than a desire to own more ethylene capacity – DOW, Exxon Chemicals, Borealis, BASF (perhaps).
  • Location is everything from a feedstock perspective, and while there may be some interesting shale ideas outside the US, only Argentina looks like it has real medium term potential – look for DOW to continue to be part of that development.
  • Absent any major change in energy dynamics and assuming that US oil prices rise enough to encourage more US development (we do not think this requires a significant price rise any more), we would expect to see another round of ethylene investment in the US – for completion in the 2022/2024 timeframe.
    • Dow and Exxon are the natural leaders here but expect other (non-US) companies to keep probing for footholds in the way that Lotte is doing.

©2016, 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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