One of the most important features of the US shale oil and gas revolution has been the rolling wave of oversupply that has moved through the energy value chain, creating market imbalances and distorting long-standing price relationships between various hydrocarbons.
After surging domestic output of natural gas weighed on the commodity’s price in the wake of the Great Recession, upstream operators shifted their drilling activity to “wet” plays that also produced significant volumes of higher-value natural gas liquids (NGL) that enhanced wellhead economics.
The price of a mixed barrel of NGLs, some of which can replace naphtha and other oil derivatives in industrial and petrochemical processes, historically has tracked movements in the price of crude oil.
However, surging NGL production from prolific shale oil and gas fields swamped the domestic market and sent prices tumbling in early 2012. Oil prices, on the other hand, continued to hover around $100 per barrel, until growing US output catalyzed a precipitous selloff that began in summer 2014.
This rolling oversupply has created opportunities downstream, with an abundance of inexpensive natural gas in the US encouraging the development of export capacity and prompting electric utilities to accelerate the retirement of older coal-fired power plants.
In the crude-oil market, US refiners initially benefited from wide regional price differentials that lowered their feedstock costs relative to international competitors. Over time, new pipeline infrastructure in North America and the end of the US ban on exporting domestic crude oil have compressed these price differentials. Meanwhile, the collapse in oil prices has spurred growth in US gasoline demand after an extended fallow period.
Over the past several years, oil and gas companies’ overzealous production of natural gas and NGLs has restored the fortunes of domestic petrochemical producers, an energy-intensive industry that relies on these commodities to generate power and as feedstock.
Within this space, olefin producers have benefited the most thus far, thanks to extraordinarily low feedstock prices. The two most prominent olefins, ethylene and propylene, serve as the building blocks for three-quarters of all chemicals, plastics and synthetic fibers. Petrochemical firms produce these commodity chemicals in cracking facilities that heat ethane and propane with steam. The bulk of US olefin capacity is located on the Gulf Coast.
Depressed natural-gas and ethane prices gave major US olefin producers such as LyondellBasell Industries (NYSE: LYB), Westlake Chemical Corp (NYSE: WLK) and Dow Chemical (NYSE: DOW) a significant competitive advantage over their international peers—especially when oil prices traded at elevated levels. Naphtha and other crude-oil derivatives account for about 71 percent of the typical feedstock slate in Western Europe and 81 percent in Asia.
Check out this graph depicting the transfer of profit margins from US ethane production to ethylene and from ethylene to high-density polyethylene (HDPE).
The multiyear boom in profit margins for US polyethylene producers appears to be winding down.
The first blow came with the collapse in oil prices that began in summer 2014, which shrank the cost advantage for US-based olefin producers and improved the economics of operators in Asia and Europe.
Although US ethylene producers still enjoy lower costs than their international peers, lower oil prices improve the competition’s resilience and give plants that could be candidates for closure a new lease on life. This dynamic makes it more difficult for American companies to take market share.
More worrisome, the impending wave of incremental petrochemical capacity on the Gulf Coast—projects approved in 2011 and 2012, when the price spread between oil and NGL remained at historically wide levels—will come onstream and ramp up over the next few years.
Although expected cracker start-ups in 2017 imply an incremental 300,000 barrels per day in ethane demand at a utilization rate of 90 percent, much of this capacity will come onstream in the back half of the year. Thus far, US olefin producers have benefited from polyethylene capacity coming onstream in advance of new crackers, helping to keep the market relatively tight.
These crackers also take time to ramp up, setting the stage for the wave of oversupply to hit the polyethylene market in 2018 or 2019. The start-up of this new capacity will compress the profit margins of producers at this link in the petrochemical value chain and resulting in lower utilization rates.
The US Gulf Coast already exports significant amounts of polyethylene resin and other derivatives, suggesting that stepped-up production will force operators to rely more on international shipments to clear the glut. At these levels, North American polyethylene prices would need to retreat for the arbitrage window to open.
Finally, as new US olefin crackers come onstream and ramp up their operations, ethane prices on the Gulf Coast will need to increase to levels that incentivize gas processors to stop rejecting the NGL into the natural-gas stream.
Any uptick in ethane prices likely would prove temporary, as producers would respond to higher prices by ramping up drilling and completion activity. Nevertheless, this transitory uptick in ethane prices could squeeze US ethylene and polyethylene producers’ profit margins in the near term, especially those that lack the flexibility to crack propane or butane.
Near-Term Risk, Intermediate-Term Promise
Given this outlook, we prefer to stand aside on US olefin producers for the time being, though the three largest have taken some measures to offset these headwinds through diversification.
Westlake Chemical, for example, last year closed the $3.54 billion acquisition of Axiall Corp, a transaction that made it the No. 2 producer of polyvinyl chloride (PVC) and the No. 3 chlor-alkali producer in North America. In addition to potential cost synergies, these businesses offer exposure to better near-term fundamentals. Now the company generates about 40 percent of its operating income from vinyls and 60 percent from olefins.
Although Westlake Chemical’s management has earned its reputation as an adept allocator of capital, the stock’s recent rally skews the risk-reward balance to the downside as 2018 approaches.
Meanwhile, Dow Chemical’s blockbuster merger of equals with EI Dupont de Nemours & Co (NYSE: DD) is expected to close later this year, setting the stage for the chemical giant to split into three discrete publicly traded entities focused on agriculture, materials science, and specialty chemicals. Synergies from this combination could unlock value for shareholders, as investors prefer purer plays in the petrochemical space. How the material science business fares will depend on the extent to which the benefits of added scale and volume growth offset margin pressure in the olefin value chain.
The potential valuation uplift from the combination with EI Dupont de Nemours & Co and subsequent division into three discrete companies makes Dow Chemical a buy up to $67 per share for aggressive investors.
Thus far, LyondellBasell Industries hasn’t been as active as Westlake Chemical and Dow Chemical on the acquisition front, though we do like the Houston-based company’s purchases of polypropylene compounding capacity in India. Nevertheless, management has acknowledged that mergers and acquisitions activity is on the table, likely after the company monetizes its refinery in Houston.
Although we expect management to set its sights on a strategic deal with plenty of synergies, the potential for any deal to disappoint, coupled with concerns about profit margins in the olefin chain, skew the risk-reward balance to the downside.
On the plus side, the near-term supply surge in ethylene and polyethylene will dissipate over time, thanks to global demand that grows by about 1.5 times the run rate for global gross domestic product (GDP). Much of this upside comes from emerging markets, where higher household incomes translate into greater use of plastics and other chemicals in consumer goods, construction products and automobiles.
This steady demand growth, combined with the abundance of short-cycle hydrocarbon supplies in the US, bodes well for the Gulf Coast petrochemical complex taking market share over time.
Recent developments in the petrochemical market support this view. This year has brought a second wave of potential petrochemical projects that will source their feedstock from prolific shale plays—implying some confidence among operators in Europe and the Middle East that US output will continue to grow and that NGL prices will remain attractive over the long haul.
A joint venture between Exxon Mobil Corp (NYSE: XOM) and Saudi Basic Industries Corp, for example, continues to explore the feasibility of siting a world-scale ethane cracker on the Texas Gulf Coast, while Dow Chemical plans to expand its Freeport ethylene plant’s capacity by 500,000 metric tons by 2020.
Total (Paris: FP, NYSE: TOT) also has a joint venture with Borealis and Nova Chemical—companies in which Abu Dhabi’s IPIC sovereign wealth fund owns at least a majority interest—to build an ethane cracker in Port Arthur, Texas.
Switzerland-based petrochemical outfit INEOS recently announced plans to build a world-scale propane dehydrogenation unit, likely in Antwerp, that will have a nameplate capacity of 750,000 metric tons and will run propane imported from the US. The company also aims to expand its ethylene production facilities in Grangemouth, Scotland, and Rafnes, Norway—both of which source their ethane feedstock from US exports.
The announcement of these projects came on the heels of a May 2017 press release highlighting INEOS’ plans to build a massive butane storage facility in Antwerp that will supply its petrochemical operations in Koln, Germany, with inexpensive feedstock imported from the US.
Bottom Line: As the market digests the coming boom in US ethylene and polyethylene output, the supply-demand balance could tighten before the next wave of capacity expansions hits, improving the risk-reward balance for some commodity chemical producers. We could look to rotate into names like Westlake Chemical and LyondellBasell Industries when this outlook improves.
Pipes, Rails, Barges
Midstream names that offer exposure to growing US NGL production remain our preferred way to play the expansion of the Gulf Coast petrochemical complex.
Enterprise Products Partners LP (NYSE: EPD) offers exposure to this trend and an impressive array of other upside drivers that should play out over the next few years.
The blue-chip master limited partnership (MLP) stands to benefit in coming quarters as ethane exports from its Morgan Point facility on the Houston Ship Channel ramp up. Equally important, the partnership has amassed an industry-leading fractionation position at Mont Belvieu, Texas, where these facilities separate the mixed NGL stream into individual components. Enterprise Products Partners also boasts an impressive portfolio of NGL pipelines that should enjoy solid throughput growth as ethane recovery rates increase.
Although the conservatively run MLP tends to favor fee-based midstream assets, its gathering and processing assets would also enjoy improved profitability from reduced ethane rejection.
Management has estimated that, all told, increasing ethane recoveries could drive a 5 to 10 percent uptick in Enterprise Products Partners’ operating cash flow. Finally, Enterprise Products Partners’ valuable dock space on the Gulf Coast—one of the highlights of its purchase of Oiltanking Partners LP several years ago—gives the partnership a leg up on developing export capacity for propylene and other chemical products.
To this end, the MLP recently announced a letter of intent with shipping outfit Navigator Holdings (NSDQ: NVGS) to develop ethylene export capacity on Houston Ship Channel. This facility would connect to Enterprise Products Partners’ under-construction ethylene storage and pipeline capacity. Management emphasized that a final investment decision on the ethylene export terminal would hinge on securing sufficient long-term contracts with customers.
Other near-term upside drivers include potential deleveraging after a major investment campaign and the potential for strong inflows into MLPs by investors seeking exposure to the recovery in US oil and gas production.
Enterprise Products Partners LP remains a foundational holding, trades at a reasonable valuation, rates a buy up to $33 per unit on our Focus List.
Whereas the upsurge in US ethylene production will create opportunities to transport these volumes via pipeline, polyethylene pellets and other derivatives usually move via rail, truck or barge.
Union Pacific Corp (NYSE: UNP) offers exposure to this trend, though this potential upside driver is offset by the likelihood of further weakness in crude by rail, the development of in-basin fracking sand in West Texas and longer-term declines in coal shipments. Given these headwinds and the stock’s valuation, we prefer to stand aside on Union Pacific Corp.
The same goes for Kansas City Southern (NYSE: KSU), which offers exposure to the petrochemical boom as well as Mexico’s strengthening manufacturing industry and growing demand for US refined products. Kansas City Southern could become more interesting on a pullback related to President Donald Trump’s push to renegotiate the North American Free Trade Agreement. We’ll continue to monitor Kansas City Southern, but the stock looks like a potential candidate for profit-taking at these levels.
Tank barge operator Kirby Corp (NYSE: KEX), which boasts a roughly one-third market share in US inland and marine shipping, also stands to benefit from increased demand from the petrochemical industry in 2018. The company is twice as large as the No. 2 competitor in these markets, and petrochemicals account for about half of the inland segment’s revenue. A strong balance sheet likewise sets Kirby apart from its peers.
However, the market for coastal barges remains oversupplied, with prevailing spot prices significantly lower than contract rates; as these fixtures roll off in coming quarters, the segment’s revenue and profit margins will remain under pressure. With Kirby’s utilization rate hovering below 70 percent in the first quarter, management reiterated that this business line will continue to struggle.
A new requirement for coastal barges to add ballast-water treatment systems during the next major maintenance periods could help to accelerate the retirement of older vessels, but this process will take several years. Meanwhile, the potential for a demand-side recovery remains limited, as depressed oil prices and pipeline start-ups have reduced demand to transport crude via barge.
Although Kirby’s guidance calls for the inland segment’s utilization rate to range between 85 and 90 percent, pricing traction has remained elusive thus far—in part because of undisciplined behavior on the part of some MLPs and financially stressed competitors. Increased demand from the petrochemical industry could help to tighten this market in 2018, setting the stage for potential price increases. Kirby also has the financial wherewithal to grow its inland barge fleet via acquisitions.
That said, Kirby’s recent acquisition of privately held Stewart & Stevenson, a company that specializes in the manufacture and repair of pressure-pumping equipment, doesn’t inspire much confidence in the outlook for its core business lines.
Moreover, Kirby Corp’s stock continues to trade at mid-cycle valuations, making it less interesting for deep-value investors looking for profitability in inland barges to surprise to the upside. Further downside in the back half of the year could skew this risk-reward profile in our favor, so we’ll continue to monitor this opportunity.
Moving Down the Petrochemical Chain
The $5.1 billion acquisition of Dow Chemical’s chlorine business in 2015 tripled Olin Corp’s (NYSE: OLN) chlor-alkali capacity and made the company the world’s leading producer of chlorine and caustic soda, markets that appear to have room to run in their current up-cycle. All told, Olin accounts for about one-third of global supply and operates roughly double the capacity of its closest competitor.
In addition to its superior scale, Olin’s presence in the US gives the chlor-alkali producer a significant leg up on the competition, thanks to its access to inexpensive electricity (a product of the shale gas revolution) and ethylene (via a five-year, at-cost supply agreement with Dow Chemical).
Chlor-alkali companies produce chlorine from brine (salt) and electricity, a process that rivals only aluminum production in terms of power consumption. This electrochemical reaction also yields sodium-hydroxide, commonly referred to as caustic soda, in a 1.1-to-1 ratio. Caustic soda has applications in a wide variety of downstream markets, including pulp and paper, alumina refining, soaps and detergents, textiles, water treatment and metal processing.
Olin converts a large proportion of its chlorine output into ethylene dichloride and other vinyl intermediates that are used to make PVC resin. For this reason, the company’s fortunes hinge on developments in the markets for caustic soda and PVC.
The supply-demand balance in the global chlor-alkali market appears favorable, with minimal capacity additions planned and end-market demand growing in line with global GDP.
More important, environmental concerns will lead to capacity attrition in Western Europe this year and are expected to lead to future closures (or outages for upgrades) in China. Not only do these trends bode well for Olin’s future profitability, but also any unexpected capacity outage can tighten the global chlor-alkali market dramatically.
One commercial process for producing chlorine and caustic soda—mercury cell production—has encountered regulatory obstacles because of its negative effects on the environment. The European Commission’s Industrial Emissions Directive concluded that plants using the mercury-based electrolysis process must convert to a more environmentally friendly process by the end of 2017 or cease operation. In addition to supply outages that occur while operators complete these upgrades, some facilities—representing about 1 percent of global chlor-alkali supply—will shut outright.
European operators’ efforts to comply with this environmental ruling have reduced chlor-alkali exports from the Continent, tightening the market for caustic soda and temporarily turning the EU into a net importer. These developments have dovetailed with strong sodium-hydroxide demand among alumina refiners. Spot prices for caustic soda could moderate as European capacity comes back onstream in the back half of the year and early 2018, but the global supply-demand balance still appears sanguine for the intermediate term.
The intermediate-term outlook for the PVC market also appears bullish. As part of China’s participation in the Minamata Convention on Mercury, the country’s PVC complex will need to transition to catalysts that don’t include the heavy metal; the cost associated with compliance likely will result in the closure of older, less-efficient production capacity. Stricter regulations on carbon dioxide emissions as part of China’s 13th Five-Year Plan could also pressure PVC producers, which rely on coal for electricity, to shutter some capacity.
Although trends in the chlor-alkali market (73 percent of operating cash flow) will drive Olin’s earnings and the performance of its stock, investors shouldn’t overlook the potential for the epoxy division (12 percent) to recover market share lost when it was still part of Dow Chemical. A potential spin-off of ammunition and firearm manufacturer Winchester (16 percent of operating cash flow) could also help to accelerate Olin’s effort to deleverage after purchasing Dow Chemical’s chlor-alkali business.
Olin Corp rates a buy up to $33 for aggressive investors. Prospective buyers should consider easing into this position to take advantage of any pullback that might occur in response to the restart of European chlor-alkali capacity.
Elliott and Roger on Aug. 31, 2021
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