NPRA supplement: The case for a US petrochemical supercycle

26 March 2011 00:00  [Source: ICB]

A global petrochemical supercycle would have a disproportionate benefit for US producers, who are enjoying a huge cost advantage thanks to the shale gas revolution

The stars appear to be aligning for a "supercycle" for the US petrochemical sector. Along with the tightness emerging from supply constraints and recovering domestic and global demand, the shale gas revolution has handed producers a sustainable competitive advantage in the form of abundant and cheap feedstocks.

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"We are set to enter the strongest period of ethylene [C2] demand growth witnessed during the past 20 years, which will coincide with the slowest period of capacity increases, thus resulting in global utilization rates tightening from 85%, currently, to 92% in 2014," says global financial advisor Morgan Stanley analyst Paul Mann.

"Coinciding with this global tightening, US input costs will likely trend lower, driven by an oversupply of ethane, allowing US petrochemical producers to earn cash profits 2.5 times those earned during the previous 20 years," he adds.

The spike in crude oil costs in late February to more than $100/bbl (€72/bbl), propelled by political unrest in the Middle East, has only increased the cost advantage for US producers, as natural gas prices have remained historically low at less than $4/m Btu.

The US crude oil/natural gas price ratio - the higher the better for US producers - stood at about 25 times as of late February. This compares with a range of between five times and below 15 times during much of the past six years.

"This deviation is beneficial for companies such as [US-headquartered] Westlake Chemical, LyondellBasell and Dow Chemical, which use more NGLs [natural gas liquids] as their feedstocks, although LyondellBasell also buys crude for refining," says US-based BB&T Capital Markets analyst Frank Mitsch.

Illustrating the impact on global competitiveness, there is a close correlation between the oil-to-gas ratio and US exports of thermoplastics, according to Kevin Swift, chief economist at the American Chemistry Council, which hails shale gas as a "game changer" for the US chemical industry.

"In 2010, the US Gulf Coast cost position improved so much that the region now follows the Middle East. As a result, US plastics exports were up 15% due to this improved position," says Swift. "Furthermore, ethane supplies are tightening in the Middle East and the era of low-cost feedstocks is over for some producing nations. This will also aid US competitiveness and may induce capital investment in the US," he adds.

CAUTION FLAGS AND TIMES TO WORRY
While a number of analysts have made the case for a coming supercycle in petrochemical profitability - not only for US producers - not everyone agrees with this view. "We do not share the views of the super-cyclists," says J.P. Morgan analyst Jeffrey Zekauskas. "We think instead that the trajectory of the petrochemical cycle over the coming four years is a long, profitable plateau bending upward or downward with the price of oil," he adds.

He points out that ethane crackers are profitable because of the large gap between ethane and naphtha (oil-based) cracking margins, while naphtha crackers are profitable because of high co-product values.

"The typical profit degradation that comes with low global capacity utilization rates has not occurred this cycle. Forecasts of large capacity exiting the industry are now less certain, lowering projected utilization rates," Zekauskas says.

Laurence Alexander, analyst with global securities and banking group Jefferies & Co., says rising commodity prices and general concern over inflationary pressures are a flag that the chemical sector was moving out of the early-cycle sweet spot. "Debate has shifted from operating leverage to risks to growth," he adds.

"We should start thinking about the US producers, with the huge cost advantage they have now, as being more similar to Middle East producers in terms of operations" Hassan Ahmed Analyst, Alembic Global Advisors

However, he says chemical stock returns "should remain positive so long as demand remains strong enough for chemical companies to pass through raw material pressures It is probably too early to shift to an aggressive underweight [position for chemical stocks]."

In the meantime, investors should keep an eye out for slumps in general growth indicators, widening corporate debt spreads and an inverted yield curve. These indicators "will likely prove better signals for when it's time to worry," Alexander says.

Hassan Ahmed, analyst for New York-based Alembic Global Advisors projects a global petrochemical supercycle propelling profits upwards, especially for US producers, through 2013-2014. There will be an evolving "capacity vacuum" after 2011 as Saudi Arabia and Qatar - "the culprits behind the recent capacity addition flood virtually stall adding capacity" because of the lack of ethane supplies, he says.

"I haven't seen anything change for the worse on the supply side," Ahmed says. "Further unrest in the Middle East only creates more of a negative bias on future supply additions and availability of feedstock," he adds.

The analyst projected global ethylene capacity utilization rates would rise from 86% in 2010 to 87% in 2011; 89% in 2012; 90% in 2013; and 92% in 2014.

In the US, producers have become even more cost-competitive on a global basis as Brent crude oil, the benchmark for European and Asian naphtha prices, has "gone through the roof," while US natural gas prices have declined, Ahmed notes. "What was already looking good for the low-cost producers is looking even better," he points out.

COST ADVANTAGE
While the rising price of crude oil is handing US natural gas-based producers a greater cost advantage, a too-high level of prices could slow global economic growth. What that level actually is remains to be seen. Another concern is that China, which has been the driver of the world economy, could experience slower growth as its government tightens credit to stem inflation.

However, Ahmed expects the higher-cost petrochemical producers in Europe and Asia to take the brunt of the beating in a lower demand scenario. "The way I see it, with 50-60% of global capacity still in the hands of naphtha-based producers, if there is demand destruction, those are the companies in greatest jeopardy," he says. "We should start thinking about the US producers, with the huge cost advantage they have now, as being more similar to Middle East producers in terms of operations. Even in a downturn, the Middle East players tend to run their facilities flat out," he adds.

With varying degrees of bullishness, Wall Street analysts are projecting robust profit growth in 2011 and beyond for the major commodity chemical players with substantial petrochemical and polymer operations in the US.

Mann highlights LyondellBasell as the most leveraged to the upcycle, capable of generating cash from operations of $8bn-10bn between 2011-2014, equivalent to about 40-50% of the company's current market capitalization of more than $20bn.

The analyst's base-case scenario calls for LyondellBasell to boost earnings per share (EPS) strongly over the next three years. This scenario is based on US ethane remaining relatively cheap, at about $0.60/lb, and its European operations remaining profitable.

However, in Mann's bull-case scenario, EPS shoots up even further for 2013 on strong global plastics demand supporting higher polyethylene (PE) prices and margins, and assuming US ethane prices are $0.35-0.50 cents/gal.

Alembic Global also projects LyondellBasell's earnings before interest, tax, depreciation and amortization (EBITDA) rising strongly between 2010 and 2013. If there is anyone vying to be a consolidator in the petrochemical industry, few are better positioned than LyondellBasell. For a company that generated $41.2bn in sales in 2010, it ended the year with only $1.9bn in net debt.

Westlake Chemical blew away Wall Street estimates with stellar fourth quarter (Q4) results, buoyed by record performance in its olefins business. Earnings per share came in at $1.26, versus consensus estimates of $0.74. After the big earnings beat, analysts rushed to boost 2011 profit expectations.

BB&T Capital's Mitsch raised his 2011 EPS estimate and introduced an even higher 2012 forecast.

Susquehanna International Group analyst Don Carson also boosted his 2011 EPS estimate on Westlake on expected high ethane-polyethylene spreads. He also raised his 2012 number, but the level indicates an expected drop in profitability from peak earnings in 2011. The Susquehanna analyst views 2011 as a near-term earnings peak, and 2012 as a mid-cycle profit year.

By: Joseph Chang
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