C-MACC Macro Matters

Source:  Bloomberg, C-MACC Analysis, April 2022

The largest disruption to corporate plans is in Europe, where the Ukraine conflict has changed supply/demand patterns for some commodities/materials and where energy costs are the most concerning.  It is hard to focus on a “nice to have” project or any M&A process when you are not sure you will have enough power to operate for the rest of this year and when it is hard to judge how cost curves will look for the medium term.  We have seen the IPO markets dry up over the last couple of months, but it is likely that the M&A markets will also take a long breather and it is possible that some of the deals already announced will get repriced.  Below we offer two lists – things that will likely slow down and things that will likely press ahead. 

The Slowdown List

1. M&A – both because of valuation uncertainty today and because of diverging views of relative costs going forward
2. Capital spending for industrial capacity expansion – lots of questions about both future demand growth and where the best place to build might be
   1. This is further compounded, and has been for some time, by increased uncertainty about the absolute and relative cost of ESG compliance – especially environmental
3. New product trials or introductions – too much of a distraction – stick with what works and worry about possible product enhancement when things have calmed down
4. Some collaborative projects where there is not a pressing ESG or energy security need
5. Some larger clean energy projects, especially where there is not a mandate driving the project – some clean hydrogen for industrial use – some CCS – all could see timelines stretched
6. Most reshoring initiatives, especially where there are questions about lower consumer spending and demand expectations fall.  Also, where we might see a near-term flood of cheap products from China which would impact the economics of any new local project – see paragraph below.  

The Unaffected/Boosted List

1. Renewable Power – Wind and solar mainly but other sources may get a boost as wind and solar costs increase
2. LNG – but likely accompanied by lower carbon initiatives – investments will include liquefaction capacity (mostly in the US) and regasification projects in Europe – Asia may see lower investment because of the needs in Europe   
3. Some reshoring where there are national security priorities – although the US is now wobbling on its earlier semiconductor stimulus plan
4. Defense spending – likely to see a boost in Europe
5. Crop and food production
6. Ammonia and fertilizers – hydrogen production for decarbonization may see delays, but the food issues are pressing.

In terms of commodity price recovery, we would rank underlying supply/demand strength in the following order – tightest to weakest:

1. Natural Gas and Power – especially in Europe but the US may get pulled up by Europe
2. Fertilizer – very short because of the loss of product from Russia and Ukraine
3. Materials – especially those focused on energy transition – copper, nickel, lithium, solar modules
4. Crops – global food shortage will keep upward pressure on prices
5. Crude oil – demand destruction from pricing could be further impacted by recessionary pressures
6. Other metals – steel, aluminum
7. Chemical in general – lower freight costs will expose global surpluses
8. Polymers – especially polyethylene and polypropylene – too much new supply against a dip in demand

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ESG, Recycling, Sustainability, Climate Change

From our latest report titled "ESG Investing Stinks! We need something different to drive change".

First: ESG – “NIMBY” Investing Is not responsible ESG Investing – it’s a cop-out

We try not to use other people’s charts as our first exhibit, but this one is too important to ignore. It shows for the energy sector a clear inverse correlation between energy transition efforts and stock valuation – those companies doing nothing (or very little) are seeing premium values to normal – reflecting the higher energy prices – while those with the strongest energy transition commitments, who are also still producing high valued oil and gas, are seeing very low valuations – well done ESG investment community, you must be very proud! The chart shows that those with ESG investment mandates are more focused on avoiding trouble than they are affecting change and they need to be clear with their investors that this is the case – they are not doing good, they are simply passing the buck – “NIMBY” at its best. This behavior, of course, presents major challenges for those trying to transform businesses.

Exhibit 1: The more plans you have the more penalized you are

Source: Wood Mackenzie – July 14 Report, July 2022

As the chart above indicates, you are not being paid today for a greening strategy in the oil and gas sector. In fact, based on the Wood Mackenzie rankings, the better job you are doing at articulating a green plan the more likely you are to be penalized. Part of this is the very high prices of oil and natural gas that are supporting earnings and valuations of the traditional players, but the other piece is the expectation that all things related to energy transition are getting more expensive, and consequently may have lower returns. Costs are rising for solar and wind projects, but not by enough to make a material difference to some project economics. However, the change in direction in costs, from a continuous decline to a flattening and slight rise has spooked investors. There is the additional factor of uncertainty for all those companies that are signaling significant portfolio shifts. As energy prices remain high it seems unlikely that any fossil fuel divestment plans for the higher valued companies can be done accretively – and most oil companies have divestment plans. For the cheaper names, selling an oil asset for 5x earnings when you are trading at 2x is accretive if you buy back stock. If you want the cash to invest elsewhere it is hard to do that if what you invest in will be valued at a low multiple.

Exhibit 2: Our valuation analysis supports most of the conclusions in the chart above

Source: Bloomberg and C-MACC Analysis, July 2022

Company Conclusions

Any of the energy companies to the right on Exhibit 1 looks interesting to us because there are a number of triggers that could materially impact valuation.

1. They could say “screw the public markets”, sell a piece of their oil business and at the same time start a leverage buyout process to go private. In some cases, this is not much of a financial stretch if energy prices stay high
   1. We don’t necessarily need to see a “take private” move as a very substantial share buyback might work – again if associated with a high-priced E&P divestment.
2. They could choose to separate the companies, although likely not along an energy transition pure play line yet. The more obvious would be to separate upstream from downstream – possibly in combination with taking the upstream business private.
3. M&A – despite what we wrote about on Sunday – companies in the same position and with similar valuations might unlock significant value through large-scale combination, especially if that accelerated a more substantial break-up – a bit like the Dow/DuPont move.
   1. Given the wide multiple difference between the companies to the right and left on Exhibit 2 we could see some of those perceived not to have a good transition story buy those that have – again possibly prior to separation.
   2. That said, if transition stories are being penalized by the markets then maybe you do not want to buy the guys with the best transition plans.

The risk here is that we are looking at the wrong group of investors. The ESG crowd is mostly not interested in fossil fuels and the investment group that is interested in fossil fuels is not interested in energy transition.

On the private side, we see a much bigger role for venture capital with a higher risk appetite and would expect a flood of money to appear once the macro uncertainty subsides and if we ever get a climate policy in the US. This is not something that will happen quickly and any new company needing funding over the next couple of years could struggle and will need strong established customer backing to get it, in our view.

Daily Chemical Reactions

From our report titled "After The Fire Is Gone – Commodity Chemical & Agricultural Chemical Equities Take A Breather, Expectations Reset Lower"

• U.S. commodity, fertilizer & agricultural chemical equities have underperformed other chemical sub-sectors since March, after considerable outperformance in 1Q22. We discuss our 2H22 concerns and also why we maintain a positive long-term outlook.
• We highlight pertinent energy, chemical, and other corporate updates (e.g., Shell, TotalEnergies, EMS Group, Hexpol, Worley, Repsol, BP, Kemira, Braskem, & others).
• We discuss ESG items ranging from a view of energy sector equity performance with low-carbon initiatives considered to the EV battery recycling chain. We also flag our latest ESG weekly, The Fuel Ethanol Market Could Self Destruct – Good For SAF/Gevo.
• We discuss numerous other pertinent chemical sector items in this report.

U.S. commodity, fertilizer & agricultural chemical equities have underperformed other chemical sub-sectors and the overall market since the start of 2Q22, though these sub-sectors have still notably outperformed YTD (see Ex. #2). We follow our research at the close of 2Q22, Burned Like A Rocket – U.S. Commodity Equities Outperformed In 1H22, Face Headwinds In 2H22, to provide a few incremental thoughts based on early 3Q developments.

Source: Bloomberg, C-MACC Analysis, July 2022

At the start of July, we published research titled, Burned Like A Rocket – U.S. Commodity Equities Outperformed In 1H22, Face Headwinds In 2H22. Our general views are unchanged since the publication of this report, but there are several factors that we want to discuss today that are worth considering ahead of the 2Q financial result reporting season that will pick up for the Chemicals sector during the next ~2 weeks. A major item worth considering is that 2Q profit headwinds will not be as severe for most as spot market trends suggest because of lagging contract prices and commodity spreads not notably declining until late in the quarter. With this in mind, we think that 2H22 profits on average will be notably worse for many relative to 2Q22 levels.

Exhibit #2: U.S. Commodity Chemical and Fertilizers & Agricultural Chemical equities have outperformed other Chemical sub-sectors YTD, with most of the relative strength being seen following the Ukraine/Russia conflict in 1Q22 that spurred commodity prices higher amid a global cost curve steepening and scramble for many commodity products.

Source: Bloomberg, C-MACC Analysis, July 2022

Weekly Catalyst - Global Market Updates

From our report titled "Global Chemical Update – Heartache on the Dance Floor"

• Global commodity chemical producers faced headwinds WoW, as monomer and polymer prices on average fell relative to feedstock costs. Western markets saw the most pronounced price declines.
• In energy & feedstock markets, U.S natural gas and USGC ethane notably increased relative to Brent Crude and Ex-US naphtha values – this setting reflects cost headwinds for U.S. producers.
• A stand-out item in commodity chemical markets is the significant U.S. polypropylene (PP) price decline WoW relative to overseas markets, U.S. polymer grade propylene (PGP), and U.S. propane.
• U.S. crop prices continue to reflect downward pressure, and North American fertilizer margins broadly shrunk WoW amid a combination of lower prices and higher production costs WoW.
• We also flag our research, A Change Is Gonna Come – Commodity Chemical Availability Improvements Are Now Well Anticipated, And That’s An Issue, that argued U.S. commodity chemical producers facing a tough 2H22 is now the consensus view, and positive surprise risk lacks appreciation.

Exhibit #1 – Chart of the day: Global spot ethylene production margins were negative last week on a global scale. US ethylene production on a c-product integrated basis is cost-advantaged, as shown in Ex. #14 & #15 (below).

Source: Bloomberg, C-MACC Analysis, July 2022

Given a still wide profit spread between monomer and polymer levels, we foresee downward pressure on domestic US polymer prices even considering potential export market support due to curbed production in some markets. US polymer prices, on average, continue to reflect a price premium to export markets.

Ex. 14 Global Ethylene Co-product Integrated Cost Curve

Source: Bloomberg, C-MACC Analysis, July 2022

Ex. 15 Asia Naphtha (MINUS) US Ethane Cracker Cash Costs

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