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Graham Copley / Nick Lipinski



November 28th, 2016

Whyondell ?

  • Even if ethylene/polyethylene fundamentals weaken materially over the next 18 months we believe that the risk/reward profile for LYB remains very biased to the upside
    • Detailed cost curve analysis suggests that trough earnings would be protected by the US natural gas advantage, likely providing sufficient coverage for the dividend and some flexibility to continue with a share buyback – supporting current valuation
    • A sale of the refinery would also allow the company to buy-back stock or retire debt and would be accretive given current refining income
    • The stock already discounts negative revisions and is trading below “normal value”
  • While we expect some negative revisions for 2017/2018, we are significantly less bearish on the market than LYB’s and WLK’s share prices would imply
    • Absent any Trump or other catalyst driven global economic slowdown or trade chaos, we do not see a mismatch between supply and demand going forward for ethylene on a global basis
    • It is easy to be distracted by the expected wave in the US, and not place it in the context of the global market – increased US exports may lead to lower US prices relative to the rest of the world, but not meaningfully lower margins
  • LYB is the most attractive way to play a 2017/2018 upside surprise in ethylene
    • The stock looks inexpensive – although so does WLK – and a US infrastructure bill would help WLK’s PVC business
    • The LYB dividend and buyback strategy is very shareholder friendly and should put a floor under the share price
  • We continue to believe that we could see a polyethylene “super-cycle” post 2018 as we do not think the world will add capacity fast enough to meet demand growth – LYB has the most leverage per share – Exhibit 1
    • Our analysis suggests that LBY has as much as 20% upside near-term and could easily double in a strong polyethylene cycle
    • Anyone wanting to acquire exposure to the US ethylene advantage might see LYB as an interesting target at current values – see recent Aramco blog

Exhibit 1

Source: Company Reports, SSR Analysis


Our more bullish stance on the ethylene/polyethylene cycle, and LYB in particular, has met with some not unexpected skepticism. Consequently, we thought we would lay out the thesis in a more concise and focused format. We focus on the following:

  • Fundamentals – short-term volatility versus longer-term growth
    • Very tight global ethylene supply is easing – but does that simply mean a transfer of margin to polyethylene
    • Supply addition timing does not look significantly out of line with expected demand growth
  • Risks to fundamentals
    • Economic – Trump related or otherwise
    • Energy
  • Valuation – is the sector in general, and LYB in particular, cheap enough today to offset the risks
  • Company specific risks – downside

The investment controversy today has much more to do with fundamentals than company specific concerns in our view. There seems to be consensus around the idea that LYB will continue to buy back stock and will continue to pay its dividend with its free cash – with the uncertainty surrounding how low polyethylene margins could go and therefore how limited a share buyback might become and whether the dividend could perhaps be at risk. The same argument applies to WLK, but the company is now more focused on the PVC chain than the polyethylene chain, and here it is a question of PVC recovering from a low and the timing and magnitude of such a recovery.

  • If polyethylene maintains some relative stability and PVC stages a recovery at the same time, WLK may be a better story than LYB (liquidity is the issue with WLK, given the small float)
  • Dow/DuPont is also significantly exposed to the ethylene/polyethylene – DuPont is not materially exposed if the deal should not go through – see recent research
    • Dow is discounting the synergies of the deal to a degree in our view and consequently does not have the same leverage to a better than expected market as LYB and WLK

Lyondell remains the best steward of capital in the group – managing a substantial share buy-back, while still adding to ethylene capacity incrementally in the US. The buyback is dramatic, when compared to others – Exhibit 2

Exhibit 2

Source: Capital IQ, SSR Analysis

Only Westlake has grown its dividend more quickly than LYB in recent years – Exhibit 3. There is a fairly tight correlation between dividend growth and performance in the chemical space (Exhibit 4) and while we would advise LYB to keep going with the share buyback, some dividend growth consistency is also important.

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: Capital IQ, SSR Analysis

Risks – Reasons not to buy today:

  • Generally, commodity stocks do not perform well in a period of negative revisions, and we do think there is risk of this over the next 9-12 months – we do not believe that the revisions will be as negative as the stock price discounts.
    • Consequently, we believe that the downside is limited relative to the potential upside – but the stock could get as much as 10-15% cheaper in a period of significant downward revisions.
  • The Trump presidency causes a trade war, which not only slows US exports of polyethylene but causes inflation and global economic stagnation, resulting in commodity down cycles
    • However, hard to see how this could drive LYB earnings much lower than around $4.00 per share, unless we also see crude oil prices fall relative to US natural gas
    • LYB’s US margin protection with crude assumed to be $50 per barrel and natural gas at $3.00 per MMBTU drives an earnings estimate approaching $5.00 per share.
  • A change of strategy:
    • A major dilutive acquisition from LYB would not sit well with investors given general market nervousness. We believe this to be unlikely, but a departure from the buyback path would not go down well.
    • A merger would depend of which whom and the structure of the deal, but we cannot see a better and less risky strategy than sticking with the current plan.

Fundamentals – Easier to Focus on What We Can See Than What We Cannot

Everybody knows that the US is adding as much as 30% to its ethylene capacity base between now and 2020, with further possible additions post 2020. The driver is abundant NGL feedstocks in the US driven by the “shale wave”. A Trump presidency will not slow this down, given an even greater desire for energy independence than the Obama administration. If anything, the Trump administration’s view on trade may limit (although unlikely) LNG and NGL exports from the US which would make ethylene feedstocks even more abundant and attractively priced in the US. By contrast, of course, any bold trade move will likely limit the ability of US based producers to export all the chemicals and plastics which these investments require.

Assuming no change on the trade front, let’s put what we can see into perspective.

The US has 5 new ethylene facilities expected to begin operation between now and the end of 2018 (according to WoodMac).

  • OxyChem – 544,000 tons per annum – start-up in Q1 2017
  • Dow – 1.5 million tons – start-up mid-2017
  • CPChem – 1.5 million tons – start-up September 2017
  • ExxonMobil Chemicals – 1.5 million tons – start-up end 2017
  • Formosa Plastics – 1.0 million tons – Q1 2018

While they show a chance that Indorama will restart an old facility in late 2018, they expect all other projects – Shintech, Sasol, Westlake/Lotte, Total, Shell etc. – to slip into 2019/2020 and beyond.

In Exhibit 5 we show additional available ethylene capacity by year, based on the most recent WoodMac analysis and also show what each yearly increment means in relation to total global capacity. The availability is based on the timing of start-ups and 2018 is more a function of the later 2017 additions having a full yearly impact than new plants starting in 2018. For 2019 we have assumed the full effect of the small Indorama restart and we have assumed one additional new large facility for the full year – more likely part years for Shintech and Sasol.

The odds of this chart being correct are limited – as it is almost inevitable that we will see delays. Dow and Exxon are employing new technology around furnace design in attempts to meet stricter carbon abatement rules around their locations, and it is likely that CPChem has the same issues. Also these are very large facilities and while we may get one on time, the odds of all three coming up as planned is very low, while the odds of an early start-up is likely zero.

Exhibit 5

Source: Wood Mackenzie, SSR Analysis

As we put the US start-ups into a global perspective we get a picture that could look like Exhibit 6. The key word is could, for a number of reasons – mostly related to things we cannot see or foresee accurately. Note that the large capacity jump in 2016 is greater than 2017. This includes the large Sadara complex and the new Mexico complex as well as significant new capacity – much of it coal based – in China.

  • Capacity additions outside the US are limited post 2017 and we may even see some declines if China is serious about curtailing coal production and use. Ethylene is not as material as many other products – such as PVC, methanol and urea – when we look at China coal based capacity, but it is not insignificant.
  • Capacity additions may slip – they are never early – this is just as true of other locations as it is of the US.
  • Demand is the real wild card. Given the more heavily weighted consumer focus of the ethylene chain, versus propylene and others, we are assuming a higher than trend demand growth in our assumptions – though not inconsistent with the last couple of years – Exhibit 7.
    • The very high demand growth experienced in the 1970s for ethylene was driven by fast food and supermarkets – packaging for food as Europe and the US moved from a local market culture to a large supermarket culture.
    • The argument that recent above trend demand (Exhibit 4) is being driven by the same rapid moves in Asia and other developing markets – with consumers wanting more choice, more convenience, greater food longevity and greater food safety – makes sense to us and may be relatively inelastic with regard to overall economic growth.
    • The big swings in the demand growth of the ’70s and ’80s were largely due to inventory and very inefficient supply chains with the US and Europe essentially supplying global demand – we do not think that these risks exist today to the same degree although over a few months, inventory changes can make a material difference to apparent demand.
  • Clearly economic growth still matters given the impact of 2008/2009 on the demand line in Exhibit 4, but since that time we have recovered to trend, or above trend growth with anemic global economic growth.

Exhibit 6

Source: Wood Mackenzie, SSR Analysis

Exhibit 7

Source: Wood Mackenzie, IHS, SSR Analysis

Summarizing all of the data above we get the operating rate profile shown in Exhibit 8. There is a decline in operating rates – as implied in Exhibits 6 and 7 – in both 2016 and 2017, but the overall picture does not show either the troughs or the rapid declines that have been associated with prior collapses in ethylene pricing and margins. “Peak” operating rates appear to be trending down over time and some of this can be explained by longer plant shutdowns – in part because of increased complexity but also in part due to stricter regulations on emissions/safety etc., which add more time for inspections and other testing. Our analysis suggests a bump in the road for ethylene in 2017 and into 2018, but it is unclear whether the bump is severe enough to impact the overall strength and structure of the market and materially dent margins.

Exhibit 8

Source: Wood Mackenzie, IHS, SSR Analysis

The US Advantage – Important When Assessing Trough Earnings Today Versus Prior Cycles

If we are wrong and if there is enough of an overhang for the global ethylene/polyethylene market to retreat to cost curve driven economics – something we have not seen since 2014 despite the capacity additions of 2016 – the US still has a cost advantage. Prior “zero” or “near-zero” margin troughs in the US occurred in periods of relative parity between crude oil and US natural gas. The US Crude oil to Natural Gas ratio is well off its peak – Exhibit 9 – but it is also well above its trough and with NGL’s abundant – the US still retains a significant margin umbrella.

Exhibit 9

Source: Capital IQ, SSR Analysis

Our cost curve model for ethylene is sufficiently complex to draw the sort of broad conclusions that we require for this analysis. Our work gets us 90-95% of the way to the right shaped curve and the right answers and that given all of the variables in the ethylene business, that is as close as you will ever get when trying to forecast. Our model is constructed on a plant by plant basis. If we assume $50 for Brent Crude and $3.00 for US natural gas we get the curve outlined in Exhibit 10. This is based on what we believe will be operating capacities in Q1 2017 and global demand for ethylene in 2017 of around 153 million metric tons.

Exhibit 10

Source: Wood Mackenzie, IHS, SSR Analysis

In Exhibit 11 we summarize what our model generates for LYB in the US on a cash cost basis – with this cost assuming ethane trades at fuel value plus extraction costs – this inflates the costs versus recent history because ethane has traded below its full cost of extraction. We are trying to paint a worse picture here and we are assuming that ethane exports push prices higher relative to fuel equivalent value. In Exhibit 12 we show LYB US costs (as calculated by us) relative to current WoodMac price forecasts and the break-even number generated in the cost curve.

Exhibit 11

Source: Company Reports, SSR Analysis

Exhibit 12

Source: Wood Mackenzie, Company Reports, SSR Analysis

The cost curve floor gives LYB a 16 cent per pound margin on its US facilities. If we assume that the European business falls to zero, as the costs sit at the break-even point on the curve we can create an estimate of trough earnings – as shown in Exhibit 13. We make the following assumptions with accompanying clarifications

  • We assume the European O&P business falls to zero EBIT – this is conservative – the business had positive EBIT in 2012
    • European naphtha based ethylene is the break-even point in our cost analysis along with some of the naphtha based capacity in China
    • There will still be margin in LYB’s Middle East equity investments
    • Higher China coal prices might allow for some small margin in Europe
  • The intermediates business is assumed unchanged from recent levels
    • There might be some benefit from more methanol capacity in the US
    • There might also be benefit from better polyurethane demand driven by US infrastructure investment
  • In the US we drop margins to those generated by the analysis above – assume polyethylene margins fall to zero and that all the profitability is in ethylene
    • We could be too low if ethane continues to trade at a discount to full extraction value
    • We could be too high if ethylene starts subsidizing polyethylene to allow for greater exports
  • We assume that the refinery is sold for $1.5 billion and the proceeds used to buy back stock – hence the lower than current share count assumption
    • We assume no tax liability from the sale of the refinery

Exhibit 13

Source: Capital IQ, SSR Analysis

Valuation – Supported by Dividend/Buyback Policy

Almost any valuation metric we use shows LYB as attractively valued today. LYB is a stand-out when we compare return on tangible capital with value, and while tangible capital is low at LYB because of the chapter 14 reorganization, not that this impacts both sides of the analysis. Exhibit 14

Exhibit 14

Source: Capital IQ, SSR Analysis

Only TSE looks cheaper than LYB today on an EV/forward EBITDA analysis – Exhibit 15. Clearly this implies an expectation that forward EBITDA estimates are too high. Our trough analysis above would give a trough EBITDA of around $4.0 billion and a trough multiple of just over 10x, which is not unreasonable and low versus other commodity names in prior troughs.

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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