US Ethylene – The Case For A Better 2014

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

December 16th, 2013

US Ethylene – The Case For A Better 2014

  • Ethylene capacity additions in the US in 2014 would not be sufficient to offset “normal” US demand growth, but we believe that demand growth will be below normal and see the potential for surplus ethylene from the second quarter and for the balance of the year. This would suggest that average margins in 2014 could be lower than 2013, which is not reflected in current consensus.
  • We also see increased chlorine availability in 2014, but not with the ethylene producers and consequently we may see some downward pressure on chlor-alkali pricing. Consequently, our view is that estimates for DOW, LYB, WLK, AXLL and OLN are all probably on the high side for 2014. Market tightness could last through Q1, but thereafter, absent unplanned supply disruptions we could see weakness.
  • Upside demand surprises could come if exports pick up, but we have seen minimal evidence of increases this year. The improving global economy may help, but the recovering trend in 2013 has not seen a return to trend demand growth for commodity chemicals. We think that pricing is the issue and that growth will remain weak while oil prices are high.
  • Within the Commodity Chemical space, only OLN looks attractively valued, but we are concerned that near-term estimates need to come down given expected imminent expansions in chlorine capacity in the US. Otherwise, only WLK, in our view has the margins and returns to support current prices. While DOW’s valuation looks less extreme, the story is less straightforward and exposure to Europe is a concern.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

While we tend to think about the current environment representing fantastic times for the US ethylene industry, in fact, the market is pretty lackluster. Ethylene is selling close to its marginal cost of production (most have a huge cost advantage versus that marginal cost), suggesting that there is no shortage of product, and demand growth remains very limited, a subject we have touched on several times this year.

In general, operating rates are quite high, close to 100% of available capacity at times and bouncing around 90% of nameplate, and in any “normal” historical demand growth context, pricing should be discounting fears of shortage. Historic peaks have occurred at nameplate operating rates around 95%, which in an historical average demand growth context would be 12-18 months away. Unfortunately we have not seen historically average annual demand growth for a while, and it is not expected. Near-term we have a couple of dislocations in the US market with a prolonged shutdown at Williams in Louisiana following the incident last May (2% of capacity), and the shutdown of one of the three pipelines that normally moves ethylene from Texas to Louisiana. As a consequence, Louisiana, which is generally short of ethylene supply, is today very short and marginal pricing in Louisiana is much higher than it is in Texas – by as much as 6-10 cents per pound.

We are seeing a fairly significant ethylene inventory build in Texas in the fourth quarter and we could go through year-end with 50% more ethylene inventory in the US than we had this time last year. While there will be the usual seasonal maintenance turnarounds in the spring, we will also see: the reopening of the pipeline, the return of the Williams unit (expanded) and a significant capacity addition from Lyondell. Baring any unexpected ethylene plant closures, this could lead to quite a surplus and some significant weakness in pricing by the second quarter. Lyondell will have the benefit of the additional pounds of ethylene, but others, such as WLK and DOW will not have a volume offset.

A step in demand would make all of this fairly irrelevant, but we see limited opportunity outside the EDC/PVC world and here the necessary assets are not in the right hands to make this happen easily. Chlorine expansions over the next couple of months could present the US with an opportunity to increase additional EDC or VCM, by combing surplus chlorine with low cost ethylene and this could mop up some of the ethylene surplus. However, unless Dow keeps its Freeport chlorine plant running for a while, post the start up of its new JV facility with Mitsui, the surplus chlorine does not sit with ethylene producers.

The other wild card is the budget agreement, but while this may have a positive impact on US investment and manufacturing growth, it is unlikely that it could happen quickly enough to solve an ethylene surplus in the US beginning as early as May.

Consensus estimates for all of the commodity impacted stocks do not anticipate a weakness after Q1 2014 and in our view this represents a risk to every name. Valuations are most stretched on a “normalized” basis for WLK and LYB, but against 2014 expectations are most stretched for POL and LYB.

A Small Surge In Supply In Early 2014

We are several years from the major chemical investments in the US, but some of the early expansions are adding to supply in the near-term. The US added around 750 million pounds of capacity in 2013 (Ineos, Chevron, Westlake), but will add as much as 2 billion pounds of capacity in 2014 (mainly Williams, LyondellBasell and BASF/Total). This compares with total capacity at the end of 2013 of a little under 60 billion pounds.

Add to this an inventory build in Texas right now in what looks like an over-anticipation of both the restart of Chevron’s ethylene pipeline and seasonal maintenance closures, and ethylene availability in Q2 2014 could be on a 2 billion pound higher run rate than it was in 2013. While this is only a little under 4% of capacity, in a no growth or slow growth world prices will respond negatively. Exhibits 2 and 3 show expected US ethylene production and operating rates assuming that 2014 demand growth looks like 2011, 2012 and 2013.

Exhibit 2

Source: IHS and SSR Estimates

Exhibit 3

Source: IHS and SSR Estimates

Production is expected to grow, but there really is not much improvement in operating rates and potentially things could seem worse as effective rates have been a couple of percentage points higher for most of 2013 because of the Williams shutdown which will continue into Q1 2014. Without significant unplanned closures or a kick up in demand, the market could “feel” much worse from Q2 2014 than it has recently. Pricing will still be set by the cost of the marginal pound (which will move up and down with the value of light naphtha in the US), but that could be as good as it gets. Under this scenario it is reasonable to assume that ethylene spot prices fall through the second half of the year

Below Trend Demand Set To Continue?

All things being equal we would support the idea that demand growth in 2014 would not be materially different than in the last three years – around 1.5-2.0%. We remain firmly in the camp that, absent changes in economic activity, there is price elasticity in this industry, particularly in packaging plastics, whereby higher pricing drive more conservation, substitution with cheaper materials and recycling. With high prices of crude oil setting high overall plastic pricing we think that this has been a constraining factor in demand growth for the last three years. Many of the indicators that we look at as proxies for demand trajectory, such as consumer spending, construction spending, auto manufacture and the ISM number itself have generally been on a positive trend through last year and this, and basic chemical demand has shown little if any real correlation. So all things being equal we see no difference in 2014.

But there are a couple of factors that could make a positive difference:

  • Increased derivative exports: we see a specific, but less than straightforward opportunity in the chlorine chain, given the imminent chlorine additions in the US, but as the expected chlorine surpluses are unlikely to sit with those that have surplus ethylene, it may be too complicated to make it happen. Dow Chemical could push up EDC or VCM exports if it does not close its Freeport chlorine facility immediately after its new plant starts operation. However, we remain a little skeptical about increased exports generally, given that we have not seen as much as we would have expected so far this year. There is some surplus polyethylene capacity (particularly HDPE) in the US and we could see additional HDPE exports as ethylene supply increases.
  • Increased economic growth: There are signs that the global economy is going to look better in 2014 than in 2103 and clearly this might provide a boost to global chemicals demand. At the same time there are plenty of producers around the world who would welcome increased demand and they will be aggressive competitors with producers in the US to share in that improvement in demand. The more interesting opportunity may come in the US, but while we think that the current budget deal might ease some of the business tensions in the US, resulting in greater business investment, we think that this will have a lag and will not meaningfully increase demand in 2014. We would probably need to get 4-5% demand growth in the US in 2014 to make the market more interesting and that does seem like a big ask in the current climate.
  • The high price of propylene: This subject deserves more time and attention that we are going to give it here, but ethylene demand, in our view will continue to benefit, and possibly meaningfully, from the high cost of and pricing of propylene in the US. In some end use markets propylene derivatives compete with ethylene derivatives, in some cases directly and in others indirectly. One of the more obvious areas is the packaging space where high density polyethylene can substitute for polypropylene and where polystyrene can substitute for polypropylene. There is competition in other derivatives also, which can increase demand for ethylene oxide and vinyl acetate relative to propylene oxide and acrylic acid. Integrated ethylene derivative producers with ethane based ethylene costs have an opportunity to steal share from propylene derivative producers forced to value propylene at market prices. This has had a marginal impact on ethylene demand in 2013, but could become more relevant if consumers see the change as more than just temporary and make any small investments/adjustments required to use a different material. Propylene and ethylene pricing is summarized in Exhibit 4 and the ratio of high density polyethylene to propylene pricing is summarized in Exhibit 5.

Exhibit 4

Source: IHS

Exhibit 5

Source: IHS

Accordingly, while a more traditional view of the world – which may be the right view – would cause us to be cautious about the ethylene chain in 2014, there are some genuine risks to the upside.

Consensus and Valuation Expects Only Good Things

In Exhibit 6 we show the seasonality of earnings for the commodity group taking as many years for as many companies as we can. Any one year is fairly meaningless given the volatility of pricing, but we have enough data to establish some rules of thumb. In the analysis we express seasonality as what percent of annual recurring earnings happens in each quarter. In Exhibit 7 we show seasonality of US ethylene margins. The exhibits show that we would probably expect, a better second quarter and a worse Q4 based on volume rather than margin as there is very little seasonality to margins.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

Consensus expects a better year in absolute terms and some interesting differences company to company. We would question whether some of these numbers should be positive at all if there is a risk that ethylene margins weaken starting in the second quarter. Lyondell has some new volume offset, and both DOW and WLK have the benefit of new chlorine capacity in 2014. DOW also has meaningfully lower interest costs. In our view WLK looks low, relative to LYB and DOW, though all look ambitious. OLN is in the right relative position in our view given that its chlorine sales volumes should fall in 2014 as others start new plants. DOW will be the greater beneficiary of any global recovery, though AXLL could benefit if the export vinyls markets improve. We would rank expected growth best to worst; WLK, DOW, LYB, AXLL, OLN, but at the same time would probably have the three ethylene players close to flat and AXLL and OLN showing slight declines.

Exhibit 8 shows annual expected EPS growth for each of the five exposed commodity companies and Exhibit 9 compares 2012, 2013 and 2014 expected EPS by quarter for each company. Given that the seasonality at Dow is impacted by the planting season within the Ag business, we do not see and issues with the pattern reflected in consensus. The LYB numbers reflect the new capacity in Q2 and Q3, but like WLK rely on the margin structure remaining intact. There is an inconsistency in the second half earnings estimates for AXLL and OLN and as we have indicated already we think the AXLL numbers are ambitious.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

Valuation Shows a Better Order

OLN looks cheap, while DOW looks marginally expensive and the others very expensive. Taking into account current earnings and profitability, rather than using a normalized framework, the order does not change much, but Westlake looks much less extremely valued on that basis and if we had to chose between WLK, LYB and AXLL, we would favor WLK. Valuations are summarized in Exhibit 11.

While we think that there is some near-term downside risk in OLN because of expected negative guidance for the first half of 2014, we would likely buy on any weakness.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

©2013, 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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