- General euphoria over the opportunity presented to the US by the abundance of shale gas – estimates of expected investments in the sector 30-40% higher than they were a year ago.
- There have been plenty of basic chemical investments announced but it is clear that there are more in the feasibility phase. Forecasts of forward oil and natural gas prices in the US will do nothing to deter such moves. IHS has oil rising from 2017, with natural gas flat, suggesting that ethylene margins will rise from current levels as new facilities start-up.
- However, the IHS forecast assumes only 6 new ethylene facilities by 2018/19 (10 announced), and admit that ethane supply becomes an issue if more are built and that ethane pricing would increase above its extraction value with more demand.
- Still plenty of capacity coming on line in China and the Middle East over the next 5 years – IHS tracking 53 coal to olefin plants in China which they believe will be built. IHS also very cautious from a macro perspective about growth in China – citing debt/GDP and the quality of that debt as a major concern.
- In our view the biggest mistake being made is forecast growth – ethylene demand growth ratio to GDP has broken down in the last three years, in our view because of the high prices, and is not an anomaly. Growth shortfalls could make the 2017-2020 landscape much less friendly for all.
- Near-term it is hard to see what will trip up the margins and cash flows. This is priced in to WLK and LYB without consistent and “assured” return of cash to shareholders. DOW supported by possible break-up value – otherwise expensive. AXLL looks more interesting and Q1 earnings pullback presents an interesting entry point.
Unmatched optimism from the US companies and unmatched pessimism from the Europeans. This is probably the best way to describe an industry gathering that I have been attending in Texas off and on for the last 26 years. The Americans are more optimistic than they were in the late 1980s. That was a period of misplaced confidence because the US did not have much of a cost advantage and the Middle East was emerging. Today, even taking into account the lessons of the past, it is hard to poke holes in the optimism – which in our mind makes it far more dangerous.
We remain very concerned that the consensus view of forward demand is incorrect, with consensus choosing to use an historic ratio to GDP growth which has clearly been incorrect for the last three years. As we have written now ad-nauseam, price elasticity explains the breakdown of the relationship and all forward estimates have pricing as high as it is today or higher for many years. This will continue to encourage recycling and down-gauging and cut into organic growth. Consensus views do not have high operating rates at any point in the future and if demand growth is out by 100-150 basis points a year, the operating environment will look increasingly poor as new US capacity is commissioned. In such an outcome, you could see North America, the Middle East and possibly China trying to move incremental molecules to Europe and Latin America. None of this will happen without real price pressure, everywhere, and it is unreasonable and naïve to assume that European higher cost producers will simply roll over to accept imports. In the chart we show our base case for operating rates and how they would look in a 2.5% growth environment – versus the historic average of 4.15%. Note that the global operating rate does not decline to the lows seen in the early 80s even in a lower growth environment. As we indicated in research last week, if the US loses its competitive feedstock position, much of the surplus would be in the US and US operating rates could return to their lows of the early 1980s.
Source: IHS, Wood Mackenzie and SSR Analysis
Even with this fear, the bulls can justify building in the US because of the oil/natural gas differential. If margins in the US fall by 40-50% (because ethane prices rise relative to natural gas) you may go from a 40% return on capital to 15%, which still beats the industry’s single digit historical average.
As we indicated in research last week, the wheels only com off if the US oil/natural gas ratio collapses back to fuel value. The most likely cause, in our view, would be increased US LNG exports, enough to raise natural gas prices domestically. If we had a scenario in which US natural gas increased to $8 per MMBTU and crude fell to $80, which is a long way from where we are today, but by no means a crazy idea, the US would no longer be a competitive exporter, and the oversupply in the US would result in increased local competition and much lower pricing.
Today there is not much to do as an investor – except to keep pressuring the existing US players to return cash to shareholders rather than participate in the capital spending frenzy. We would like to see the following:
- LYB should undertake – explicitly – to behave like an MLP and return a high fixed proportion of its cash to shareholders – dividends are better than buybacks because you are buying the stock at a peak, even if you are buying it at a great cash flow yield.
- WLK should do the same as LYB. Both would have some upside on that basis, but not without in our view.
- AXLL should look for ways to achieve as much of the ethylene “cost economics” that they want, while spending as little cash as possible. AXLL’s share price looks interesting at these levels as most of the pull-back post Q1 guidance is in response to a one-time event. The caveat here is that the winter has continued on the poorer than average trend since the guidance, so there could be further earnings slippage.
- DOW should focus on whether, with the expected cost inflation around the US projects – skilled labor etc. – they still makes sense, particularly if other participants help bid up ethane prices after 2018. Dow may be able to buy the ethylene capacity it needs cheaper in the future. Investor focus will be on a possible restructure of the company in the short term and while we see the stock as more than fully valued in its current configuration, an Ag spin could generate some further upside. We see no evidence that DOW is yet ready to tackle its higher costs.