Polyethylene – The Fragile Last Line of Defense!

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

February 9th, 2016

Polyethylene – The Fragile Last Line of Defense!

  • Polyethylene remains one of only a few large volume, growing commodities with a reasonable level of profitability today
    • This has supported earnings for LYB, WLK and DOW in 2015 and contrasts the miserable decline that TiO2, PVC, steel and aluminum producers have seen
  • However, we think that polyethylene margins will shrink in 2016 as slow growth, new capacity and fewer unplanned production issues combine to push the market into surplus
    • Margins contracted in the US in 2015, but expanded in Europe and Asia – our view is that margins will contract everywhere in 2016
  • The leverage is much greater at LYB and WLK than it is at pro-forma DowDuPopnt and LYB could see an 18-20% contraction in EPS if polyethylene margins contract by 10 cents per pound
    • Globally margins are more than 10 cents per pound above a longer-term average and we are now at a global oil/US natural gas ratio where we have historically seen significant variability in polyethylene margins as well as volatility when the market is oversupplied
  • While earnings estimates look very ambitious for LYB, WLK and DOW for 2016 given this risk, stock valuations look like they are discounting much of the concern already
    • Based on our normal models:
      • Lyondell is discounting 2016 EPS of $8.15, consensus is $9.38 per share
      • Westlake is discounting 2016 EPS of $3.27, consensus is $4.48 per share
      • Dow is discounting growth in 2016 EPS versus consensus of $3.39 per share, but this is likely appropriate given the cost and synergy opportunities associated with the DuPont deal – see previous research
  • Despite valuation we would not expect the stocks to do well while polyethylene margins and estimates are falling, and would wait for a better entry point for both WLK and LYB

Exhibit 1

Note: for LYB some of the LLDPE and HDPE capacity is flexible and can produce either product so the sum is more important than the allocation.

Source: IHS, Wood Mackenzie, company reports and SSR estimates

Overview

Overbuilding in China has systematically destroyed one commodity market after another over the last 5 years, starting with aluminum in 2011 and most recently causing problems for the PVC and caustic soda markets. In between, steel, polyester and TiO2 have fallen victim, as have copper and iron ore, where China remains a net importer, but where local demand has slowed, creating global surpluses. Lower energy pricing – coal and oil – has helped pricing move lower and explains some of the negative trend in Exhibit 2, but margins have been squeezed across the board, and this is reflected in the relative valuation of companies focused in these segments – Exhibit 3.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

Polyethylene looks a little different today, with China pricing not showing the same relentless decline that we see for other commodities – Exhibit 4 – and the stocks are in slightly better shape – Exhibit 5.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Polyethylene has not fallen into the abyss (yet) for several reasons:

  • China remains a significant importer of polyethylene – in their World Petrochemical Conference presentation in March of 2015, IHS suggested that China is a net importer of more than 10 million tons of polyethylene per annum – around 45% of local demand
  • Polyethylene demand growth is more driven by consumer spending that industrial production, unlike steel, PVC and large segments of the aluminum market – consumer growth in China remains robust
  • The polyethylene industry in Europe and Asia suffered from an unusual level of plant production problems in 2015 and these resulted in inventory drawdowns, such that markets were finely balanced in 2015
    • Despite the decline in oil prices, polyethylene producers have been able to lag pricing declines relative to costs and margins have remained robust
    • A good indicator is the progression of earnings for Axiall (PVC), Tronox (TiO2) and Lyondell (Polyethylene) over the last 2 years – Exhibit 6

Exhibit 6

Source: Capital IQ and SSR Analysis

With slower growth around the world and new capacity for polyethylene coming on stream late in 2015 and into 2016 (IHS forecasts additions of as much as 7 million tons in 2016 – 8% of global demand), can the resilience in polyethylene continue? We think that it is unlikely and that we will see margin erosion in 2016, perhaps significant. US margins are already down significantly from their highs as shown in Exhibit 7, and the relative strength of Lyondell and Dow’s earnings in 2015 relative to WLK is because European and Asian margins have risen as crude oil has fallen. We note that current margins in the US remain well above the historic average.

Exhibit 7

Note: Integrated with ethane based ethylene at cost of production

Source: IHS, Wood Mackenzie, company reports and SSR estimates

A 10 cent decline in polyethylene margins in 2016 relative to 2015 is not an unreasonable scenario, and as the leverage in the table in Exhibit 1 suggests, the earnings risk for LYB and WLK is much greater than it is for DowDuPont. While consensus estimates are a long way from reflecting this risk in 2016, valuations for the stocks are much more in line.

Polyethylene Not Close To A Bottom

Despite the shape of Exhibit 7, the polyethylene market is a long way from a bottom based on history. US Integrated HDPE cash (EBITDA) margins today are in the range of 25-30 cents per pound using ethane as a feed for ethylene. This compares with a 1980 to 2016 average of just over 20 cents a pound and a 1980 to 2010 average of around 17 cents per pound.

Margins look high when compared to the current oil/natural gas ratio – Exhibit 8 – and while the correlation is poor, Exhibit 9 shows that we now have a low enough oil/natural gas ratio to remove some of the margin protection of the last 5 years, and we should expect quite a bit of margin volatility as a result.

Exhibit 8

Source: IHS, Wood Mackenzie, company reports and SSR estimates

Exhibit 9

Source: IHS, Wood Mackenzie, company reports and SSR estimates

Other Things to Consider

  • The historic low for an integrated HDPE/ethylene margin in the US was below 3.0 cents per pound and occurred in 1993. This was in a period when the global ethylene cost curve was very flat – the oil-to-natural gas ratio was 1.2-1.3 on a fuel equivalent basis versus 2.3 today.
    • While it is tempting to take the view that we cannot revisit these levels in the US again, it is important to note that aluminum, PVC, polyester, TiO2 and steel producers all had the same view at some point over the last 5 years, and they were all wrong.
  • Demand growth can help – the polyethylene market does not look as oversupplied as other materials on paper. That said, if you believed in demand and/or the economy surprising on the upside, you would rather own the real problem children today – CC, TROX, HUN, OLN.
  • The flatter ethylene cost curve – see Exhibit 10 on the following page.
    • Current US ethylene contract prices (24-25 cents per pound) are well above the theoretical price of 16.1 cents per pound, but spot prices are there or thereabouts.
    • If polyethylene fell to its historic average margin above global ethylene break-even costs, prices would fall to around 33 cents per pound. This would be closer to a 15 cent decline than a 10 cent decline.
    • Also note that for aluminum, steel, polyester, PVC, caustic soda and some other products, international pricing today is below the “theoretical” level created through a cost curve analysis.

Exhibit 10

Source: IHS, Wood Mackenzie, company reports and SSR estimates

©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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