C-MACC Macro Matters

• Importance of Feedstock Flexibility As A Driver Of Higher Long-Term Chemical Returns
• Our Mega-Cycle View Continues To Gain Appreciation
• Why Counting Carbon Is Important
• More Inflation Repercussions

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Weekly Catalyst - Global Markets Update: From our Global Chemical Update – For All The Wrong Reasons and Global Chemical Update – Train of Consequences

Western polymer price premiums reflect strength WoW, as global supply chain, logistic, and feedstock issues continue to favor regional disconnects. We foresee a 2H22 loosening before our mega-cycle view gains steam in 2023/24. We show the strength in NW Europe spot polyethylene (PE) relative to the US and Asia as evidence of the considerable feedstock, supply chain, and logistic issues facing global markets that are causing regional disconnects.

Source:  Bloomberg, C-MACC Analysis, April 2022

The broader setting favors Western market price (and profit) support, though below 2021 peak levels, based on price hike acceptance among buyers amid low product availability. While current market trends suggest robust Western integrated producer profit reports among those currently operating, we think it also indicates that the inventory builds in the US, the potential for looser shipping channels in 2H22/1H23, and any consumer demand cut hold risk for Western profitability in 2H22 as global product availability returns more toward normal.

In our view, Western markets are likely to loosen and prices trend lower on a QoQ basis into 2H22 before prices likely turn higher in 2023/24 as our mega-cycle outlook gains traction. See our research, Ride Wit Me – Global Mega-Cycle Development To Remain In Support of US Commodity Chemicals. We generally view Dow, LyondellBasell, Borealis, CP Chemical, Nova Chemicals, Westlake, Olin, ExxonMobil, and Ineos, as examples of commodity producers in a good position to benefit from our long-term, constructive outlook.

US commodity chemicals outperformed YTD, and 1H22 profit will likely beat expectations. A 2H22 commodity price/margin pullback remains a risk, but we argue that this will make our mega-cycle outlook even more likely.

Our final research report of 2021, Turn The Page – A Case For US Commodity Chemical Equity Outperformance; Mega-Cycle View Emerging, argued that numerous constructive factors, after more than a year of relative underperformance, were moving in favor of commodity chemical outperformance in 2022. After the Dow 1Q report posting, we revisit the pros and cons surrounding our constructive view of US commodity chemical equities.

Source:  Bloomberg, C-MACC Analysis, April 2022

As shown in the exhibit above, the commodity chemical sector has greatly outperformed the specialty group year to date, and readers of our work will note that this was a trade we were calling for late last year – we did not anticipate the additional upside that has come as a result of the energy price spike. But these macro-driven rallies can be short-lived, and they do not take away from the fact that Dow and others remain very cheap, whether you are looking at the more elaborate valuation models discussed above, or current free cash flow yields. 

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Daily Chemical Reactions: From our report "The Paper Chase – 2Q22 Sector Indicators In Focus, Feedstock Flexibility A Plus For European Producers" and "Ride Wit Me – Global Mega-Cycle Development To Remain In Support of US Commodity Chemicals"

European ethylene producers with feedstock flexibility, such as Dow, are well-positioned to outperform most peers consuming mostly a naphtha feedstock. Dow’s European crackers switch to propane from naphtha. Within the Dow earnings results presentation yesterday [see slide 6 in LINK], management highlighted the benefits of feedstock flexibility and highlighted its European ethylene cracker flexibility in the slides. We highlight this price chart to show the difference between NW Europe naphtha and LPG to display the cost benefits of shifting between these feeds, though realizing that the feeds produce different ethylene and co-product yields. NW European Naphtha currently reflects a US$140/mt higher price than NW European LPG, which compares to a US$75/mt average premium since the start of 2011.

Source:  Bloomberg, C-MACC Analysis, April 2022

The history of Dow’s propane flexibility in the Netherlands is quite interesting. The import terminal and the spheres were built in the mid-1980s when oil prices were high due to OPEC production controls. Either coincident with the terminal completion or shortly after that, the oil price collapsed, and the propane arbitrage disappeared. The tanks sat empty for years, and at times the investment was hailed by many as a colossal mistake. Today it is worth a great deal to Dow, and the company has subsequently built more propane flexibility into its European system. The exhibit above shows how much this flexibility is now worth to Dow and the few others that can import propane. Those importing ethane are also much better off. The volumes of ethylene that have this flexibility are too small to impact the overall pricing mechanism in Europe, which is naphtha cost-driven.

Bespoke Work - Advisory Services!

All thematic knowledge base enables us to be very well placed for Bespoke services.

We have experience in every aspect of chemical and finance industries and a deep understanding of these businesses. We add the most value where the problems are the most difficult. Some ways we help our clients include:

• M&A IDEA CREATION & DUE DILIGENCE
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ESG, Recycling, Sustainability, Climate Change: From our report titled "The Need to Count Carbon – All Things Renewable Are Not Good" and "Optimism Has Created Plenty Of Wind Problems – It Could Spread"

• The route to renewable fuels and materials is not as simple as using a plant-based input, and carbon sources and sinks matter. The need for audits will rise.
• Global accounting firms are staffing up – some dramatically – because they see a need to verify ESG claims, and we think carbon intensity will be top of the list.
• Our research and analysis suggest that aviation fuel will be the most significant renewable need from a volume perspective, and demand should exceed supply.

For many, the climate rhetoric comes down to “fossil fuels bad”, and “renewables good”, and while there may be some broad truth to this simplification, it is not that easy. Climate change is not caused by fossil fuels, it is caused by the emissions that are generated from finding, transporting, and burning fossil fuels. A natural gas power station where all the emissions generated in producing and transporting the natural gas are avoided and where the CO2 on the power plant is captured and stored has a carbon footprint close to zero. At the same time, a fuel made from corn or soy or waste fat, where the agriculture or transportation and collection are carbon inefficient and where the power made to produce the fuel is not renewable or otherwise carbon-free, could have a high life cycle carbon footprint, despite the renewable label. It is a complex topic and without focus, mistakes and false claims will be made – verification will be key – especially for certain end-users – like airlines.

Aviation fuel consumption in the Sustainable Development Scenario, 2025-2040 – Billion Gallons

Source:  EIA, C-MACC Analysis, April 2022

Airlines do not want renewable fuels and neither does California – both want low or zero-carbon fuels, and the LCFS system in California is specifically designed to reward fuels suppliers for their low carbon intensity. We have spent quite a bit of time talking about aviation fuel in past reports, as we see the aviation market as one of the most challenging in terms of getting to a lower carbon footprint. Planes need to burn fuel, as electric power has weight issues and hydrogen looks like a long shot and a long time away. Unlike a power plant, you cannot capture the CO2 and so the only path for the airlines is to burn a fuel that consumes as much CO2 in its production as it creates in its combustion. That, or the airlines will need to buy a lot of expensive credits. Counting carbon will be critical for the airline industry to deliver a clean(er) bill of health to its stakeholders, and it is why we are seeing an increasing number of sustainable aviation fuel (SAF) announcements – both on the production side and the purchasing side. The chart above from the IEA only shows 20% of aviation fuel as sustainable by 2040, roughly 20 billion gallons. This is well below many of the targets that the airlines have already set – so there is a disconnect.

• The wind power industry is in significant trouble and the last couple of years have been plagued with negative revisions, despite a strong demand outlook.
• In 2021 and 2022, material shortages, supply chain disruptions, and increasingly higher input costs have also hurt, but overconfidence has played a major part.

It is hard to see how the wind industry – like the solar suppliers – gets out of the squeeze it is in today. Demand is extremely high, and backlogs should continue to grow if expectations like those expressed in the chart below are real.

Source: Wood Mackenzie, April 2022

While the industry has some pricing power and may be able to pass on some raw material costs, the thirst for more wind capacity is predicated on its attractive installation and operating costs and we would expect to see some projects delayed or even canceled – very much to the annoyance of the climate lobby – should costs move up materially. This leaves the wind companies stuck between higher costs and limited ability to move prices higher – so not a good investment. This then becomes a bit of a vicious circle, as the industry will not have the capital needed to expand capacity nor will it have the margins to attract more debt. While the stock market has priced quite a bit of downside into the sector, it is hard to see where the upside comes from – as we have stated in many recent reports, we need accommodative policy around the industries that support energy transition more than we do the specific front line industries today – so E&P more than LNG, agriculture more than renewable fuels/materials, and metals and other materials more than renewable power and EVs.

Looking Ahead: Meet with Graham Copley in London this Summer!

Mr. Copley will be in London from June 9th through the 15th. We invite you to schedule a meeting by viewing his availability  here.

This invitation provides you the opportunity to gain insight into relevant chemical market themes, strategies, and investment trends, which are discussed in C-MACC research and form the base for our consulting services.

Sunday Thematic and Weekly Recaps: From our reports titled "Power To The People – But Clean Energy, And Industry Wants It Too" and "Dow – The Path To Private – A Viable Option For The Unloved?"

The inflation data is getting harder to ignore – a demand correction is inevitable

In our Sunday Thematic last week, we talked about the impact of inflation on consumer spending, the likely slowdown in discretionary spending, and the ramification for materials demand. When added to fuel/power costs and borrowing rates, the food element of inflation is one of our major concerns when added to both fuel /power costs and borrowing rates. The exhibit below shows how much food prices have moved this year, especially in the last couple of months. We see this as a leading indicator of what the consumer will do next: spend less on other stuff! If you look at the components of the food data below, oils are leading the charge with the loss of sunflower oil from the Ukraine and Russia pulling up prices for other oils – this has consequences for overall food prices but may also throw a curveball at those renewable fuel producers looking to make products like SAF from vegetable and seed/bean-based oil. While the spike in prices may only be temporary, it will likely overly influence potential investors/lenders into the space today. SAF was one of the focuses of our ESG and Climate report last week.

Exhibit : Supply chain woes to worsen, high food prices potentially ‘tragic’. The FAO food price index trend shows that it estimates World Food Prices on average have increased nearly 60% since the start of 2020, and we flag an article discussing this issue.

Source:  Bloomberg, C-MACC Analysis, April 2022

Inflation in power equipment prices, while not good for the consumer, could help drag the wind and solar providers out of the stock price slump that has been associated with recent earnings shortfalls. These shortfalls have been driven by both project delays and cost overruns. Some pricing power would give the wind and solar companies the ability to cover costs, but would also give investors confidence that they can afford to expand to meet the escalating demand – this will not happen if the power market is unwilling to accept a reversal of the direction of power costs and the delays will continue and eventually scarcity will drive pricing much higher than today. The recent rally in the sector (Exhibit  below) is driven largely by the hope that the group can get pricing and the demand support needed for capacity expansion and the umbrella of very high-priced hydrocarbon-based power in many parts of the world will be supportive. The losers could be projects like Neom where the wind and solar capacity gets bid away by someone who can afford more as zero cost power is not a requirement.

Exhibit: The sector has rallied over the last few weeks with the rise in oil and natural gas prices globally, but is still well below peaks in 2021.

Source:  Bloomberg, C-MACC Analysis, April 2022