INSIGHT: ADNOC Covestro approach underlines Middle East appetite for diversification

LONDON (ICIS)–ADNOC’s reported takeover offer for Germany’s Covestro this week underscores the growing appetite to diversify downstream through large-scale acquisition, particularly as difficult operating conditions in Europe drive down company valuations.

• Diversification, sustainability efforts to drive M&A spending
• Likely to accelerate as peak oil draws closer
• European firms in a weaker competitive position than pre-2022 era

TAKEOVER REPORTS
Reuters reported this week that the Abu Dhabi state oil major had approached the Leverkusen, Germany-based isocyanates, polycarbonates and solvents specialist about a potential takeover valued for over €10bn.

The mooted offer price is eyebrow-raising in light of Covestro’s projected earnings even in 2023, set to be another difficult year for Covestro and the chemicals sector as a whole.

Covestro has guided for full-year earnings before interest, taxes, depreciation and amortisation (EBITDA) of €1.1bn-1.6bn, meaning that the purchase price would 6-9 times 2023 EBITDA.

For 2021, when the company posted full-year EBITDA of €3.1bn, ADNOC’s reported takeover price would equate to three times earnings.

The price may reflect a slight dip in valuations in chemicals M&A, or the weaker outlook for European sector players in the wake of the rise in energy pricing following the onset of the Russia-Ukraine war, but Covestro is not a motivated seller.

RESILIENCE
Despite the challenges Covestro has seen in recent years through weaker demand and the cost impact for the company, which stood at €1.8bn for energy in 2022 compared to €1bn in 2021, the firm’s balance sheet remains strong and it reportedly rejected ADNOC’s approach on Thursday.

“Covestro’s balance sheet is in good shape. It doesn’t have to sell in the sense that if any deal fails there’s an existential question about whether the company continues operations,” noted Sebastian Bray, chemicals analyst at Berenberg, speaking to ICIS before news of Covestro’s rebuff of the ADNOC offer emerged.

Both Covestro and ADNOC declined to comment on any aspect of the deal this week.

Despite the setback or cancellation of any marriage between ADNOC and Covestro, the deal highlights many of the factors making such tie-ups between Middle Eastern oil majors and European chemicals firms attractive to both sides – diversification and insulation.

A POST-OIL FUTURE
While ‘peak oil’- the high point of historic global oil consumption before demand starts to taper – has been slow to arrive, it is starting to hove into view.

The International Energy Agency projects that consumption growth will decline to 0.4m bbl/day in 2028 from a projected 2.4m bbl/day this year, and moves by Saudi Arabia to almost single-handedly balance crude markets are having limited impact on price.

Fitch has downgraded its crude price average for the year from $85/bbl to $80, and that is expected to slip in coming years.

Middle Eastern oil majors are starting to look increasingly strongly towards a post-oil future that will require radical investment in diversification.

The petrochemicals sector is a natural fit to that process, slotting into oil and gas operations while offering higher margins and resilient demand. The industry is also expected to be the key source alongside transportation of oil demand growth through the 2020s, offering potential to bridge the shift from an oil-driven world to a post-oil one.

There is also a growing push on sustainability in the Middle East, on the back of the state oil firms’ deep pockets and the strongly competitive conditions in those countries for growing sectors such as green hydrogen.

Sustainability is often viewed as complementary to petrochemicals, according to Borouge CEO Hazeem Sultan Al Suwaidi in an interview with ICIS in March.

“A transition to cleaner energy sources will drive the development of renewables, increasing the demand for energy storage and transport infrastructure. Therefore, while polyolefin demand will not change as a result of the energy transition, consumption requirements will,” he said.

“For the UAE’s leadership, sustainability and economic growth do not exist in silos. I believe both to be complimentary,” he added.

DIVERSIFICATION
The desire for strong footholds in new markets could drive bets that prioritise access and capacities over synergies. ADNOC does not have a strong presence in polycarbonates or isocyanates but Covestro has top-three positions globally in its key markets, and has made sustainability the core of its growth strategy since 2020.

“ADNOC is a diversified oil and gas group with existing activities in petrochemicals. Like many such groups it faces the dilemma that growth rates for fossil fuels are going to be negative at some stage in future,” Bray said.

While vertical integration opportunities are limited beyond potential for cheaper feedstocks for Covestro, the deal would immediately make ADNOC one of the world’s largest producers of its key materials with strongly defensible positions.

Despite the current demand malaise afflicting those markets, both isocyanates and polycarbonates have strong underlying growth fundamentals, even if the pace of expansion may be less than might have been expected a few years ago.

“One day we’ll be in a post oil world and competitors and Covestro’s end markets still growing even if they’re at a slower rate than perhaps was hoped for three years ago,” Bray said.

INSULATION
What European producers stand to gain from a relationship with a Middle Eastern oil and gas major is security, insulation from economic cycles and the rigours of quarterly reporting pressures.

Covestro is one of the largest remaining listed cyclic plays – although the churn as companies carve out commoditised operations may change that – and has suffered from lower demand and high costs since mid-2022.

But even players such as LANXESS that have spent the last decade pushing towards defensible positions in high-margin cycle-resistant specialties are feeling the pinch in the current demand trough.

There is also a growing sentiment among market players that the changes in the energy price landscape may have been the dawn of a new era in Europe, raising questions about the future of petrochemicals in the region.

Coupled with the weakening demand since 2022, no sign of improvement in the mid-term, and weak share price valuations, shareholders may be more amenable to strong takeover bids.

“A combination of a slower growth outlook in China and a relatively higher cost asset base than was the case a few years ago in Europe means that, from a Covestro shareholder perspective, the idea of just taking a big premium and [accepting a buy-out] is probably more attractive than it was two or three years ago,” Bray said.

“Think from the perspective of shareholders, it just means that there’s upside now and they don’t have to worry about the long-time growth outlook or cost structure of the urethane or polycarbonate industry,” he added.

OUTLOOK
Not all tie-ups between Middle Eastern giants and European chemicals firms are as fruitful as those involved may have hoped, or as quickly. SABIC is a substantial shareholder in Clariant but closer integration for the two companies such as a joint venture containing certain operations have foundered.

Plans to establish a governance board to determine the firms’ “long-term strategic relationship” were shelved in mid-2022 after four years.

Nevertheless, appetite for acquisition-based growth, whether for stronger growth through Asia acquisitions or for greater specialisation through Europe purchases, is set to continue, and the rocky outlook and lower valuations for the latter may accelerate the pace of those purchases.

Insight by Tom Brown

Front page image shows Covestro Germany at Brunsbuettel Industrial Park, Schleswig-Holstein, Germany (image credit: Olaf Doering/imageBROKER/Shutterstock)