With the linked Ashland release, we see another example of a downstream chemical maker struggling with higher input costs and general logistic constraints, and an inability to push through pricing quickly enough to avoid a margin squeeze. The opaqueness that Ashland discusses concerning some of the planning metrics for the near-term is impacting forecasts and estimates for many more companies than just Ashland but given the costs and the supply chain challenges, all are encouraged to push through pricing aggressively, and this suggests that we are far from done with the materials inflationary pressures that we have discussed at length in prior reports and the higher costs of some of these specialty chemicals will start to impact customer margins through 2022. Almost all the earnings reports that we see discuss strong end-market demand and whether this is final customer pull-through or a need to address chain inventory or both, it should support further price initiatives. For more on our inflation views see Inflation (Especially Energy Costs) – Biggest 2022 Wildcard.
While it might be tempting (and perhaps easier) to focus on the negatives in the Dow earnings release – such as price declines in polyethylene and higher costs in Asia, we think it is much more interesting to focus on the positives. For a while now we have been suggesting that the industry is gearing up for a mega-cycle of profitability, perhaps as early as 2024 – see report – and we see nothing in the current macro environment or in Dow’s release to suggest we might be wrong. Demand growth is very robust across the industry, with consumer spending driving some quite impressive GDP growth numbers in the US in 4Q 2021, as an example. We often see companies suggest improving global operating rates in earnings calls, and while it is mostly hopeful and self-serving, the chart below, from Dow’s report may be conservative. The very high ratio of Asia costs versus US costs in the 2012 to 2014 period (second image below), because of high oil prices, effectively shutdown new naphtha based ethylene investment in Asia for several years and it is what prompted China’s move into coal-based and methanol chemicals (China has almost no ethylene capacity from methanol or coal in 2011, but close to 6 million tons by 2016). As the price of oil rises and the cost curve works against China and the rest of Asia again, the move to more coal is less attractive because of the environmental footprint – coal gasification creates a lot of CO2 emissions and elaborates CCS investment would be needed to justify further expansions, which increases the cost of ethylene production.
Following on from the core theme of today's daily report, demand could provide the lifeline that the US chemical industry needs to get through what looks like a potentially oversupplied 2022 – note the successful start-up of the ExxonMobil/SABIC facility in Texas, announced today. While we still think that the US market will be looser in 2022 than in 2021, barring any above-trend weather events, strong demand growth could offer some pricing protection for the industry – especially given the input inflationary pressures that we are seeing. If the customer base is looking for increases in deliveries, which we expect to be the case in 2022, it will be easier to defend pricing and gain pricing where costs are higher. Some of the momentum that we are seeing in the commodity stocks year to date is a function of a broader inflation trade, but some is likely in anticipation that 2022 will not be as bad as had been expected and on that basis, the sector looks particularly inexpensive – even today after the early year rally. It will be a little harder for the specialty and intermediate companies depending on how long they have to play a lagging catch-up game with costs. But if, and when, costs peak, they should see margin expansion as costs fall and will be able to keep some of the gains, especially if their demand is also growing.
Ethylene producers in Asia are cutting back production because of the negative margins that some are seeing for much of their production. This will initially lead to higher losses as lower rates will impact plant efficiencies and raise unit costs. Cutting operating rates only works if prices rise as a consequence and if other producers choose not to cut back and seek to gain share, things get worse before they get better. The margins we show in the exhibit below are exceptionally low for Asia and are certainly at levels that would have caused many shutdowns in the past, but there are so many new players in Asia, especially in China that it may either take time or government intervention to get enough of a cutback to move prices. But if ethylene prices do improve in the region the arbitrage for moving ethylene in from the US goes up, so the US may gain more than the local producers. Also, as prices rise, someone in the region could look at marginal economics and start increasing rates. See more in today's daily report.
The jump in expected US chemical production in 2022 versus 2021 and the more anemic growth in 2021, is in part due to new capacity in the US but is likely more a function of lost production in the US in 2021 because of the February freeze and the hurricane that hit the New Orleans area. These two weather events, especially the freeze, cause significant production cutbacks, and not only would production have looked better in 2021 without them, but the inventory decline shown in Exhibit 1 in today's daily might have been less severe. IF we assume that climate change is causing more severe weather, then perhaps it would be prudent to build more unplanned downtime into forecasting models and on that basis perhaps the production growth forecast in the exhibit below is too hopeful. However, if you model more unplanned downtime you are inevitably going to end up with a more volatile market as available capacity will swing around the forecast average by a larger amplitude, which would make production and inventory planning more complicated.
We are seeing pockets of real demand strength in some areas of chemicals, such as building products, and this is allowing producers to push through price increases to reflect higher costs and most likely add some margin. In other areas where the fundamentals might not be quite as supportive, we are still seeing attempts to pass on higher costs. Sika has supported what we have heard from many over the last few weeks, which is that the building products chain remains tight, as demand is strong, capacity is running hard and logistic issues continue to cause problems in some cases from a raw materials perspective and in others from getting finished products to market. Where there is limited ability to increase supply, those selling into the building products space are likely to make more money as they should have strong pricing power – in the US chemical space, we would favor Westlake as a potential big winner from this trend, but Huntsman should also be on the list.
We have seen relative stability in US spot ethylene and propylene prices for several weeks now, despite some volatility in feedstock markets. Ethylene likely has significant export support in that there are complexes in Asia that are net short of ethylene and where derivative production can be increased if ethylene is available at the right price. There are also displacement opportunities if US ethylene can be delivered to importers in Asia at lower prices than local production costs. This is broadly the case today and there may even be select opportunities in Europe. In Asia it is likely easier, as the buyer would be replacing an alternate supplier. In Europe, most potential buyers would be looking at cutting back their own local production and that is a more marginal decision given the impact on unit economics of lower operating rates. US propylene demand remains high, but prices are now settling closer to PDH costs, although not close enough to encourage anyone to slow production. See more in today's daily report!
Following on from the Enterprise comments covered in our daily report, the company is more likely to acquire something in chemicals than build it in our view, especially if a move into ethylene or polymers is on the table. Today, building capacity will come with all sorts of emission-related restrictions most likely, and many of the new build announcements we have seen since COP26 have come with a carbon plan (Dow, Air Product, and Borouge). While it is not obvious today that any Gulf Coast ethylene capacity is up for sale, we would imagine that most companies are reviewing strategy and evaluating whether they have assets of entire businesses that may have a better owner. This would be especially true if a basic chemical business is holding back the valuation of a more interesting core. In the recent past, we have talked about the relative value arbitrage open to LyondellBasell from separating its compounding, licensing, and recycling business from the core. Maybe the core would fit well with Enterprise? As the chart below shows, there is money in buying ethylene for export, but there is more money in the US in making ethylene, as discussed in our daily report.
We have been asked a couple of times in the last week how US polymer (polyethylene in particular) pricing can remain so robust in a market where there is an inventory build going on. The PMI numbers are part of the answer. While we may be in the seasonally weaker part of the year, customers are still looking for more material than a year ago, and this makes the “we need a lower price” argument much harder, especially when the memory of 1H 2021 acute shortages is still fresh in the memory and when, more than likely, they are getting signals from their customers of a further step up in demand in 2022. We have done some traveling recently and the incremental demand for packaging polymers is very evident in the travel and leisure business, even if the number of travelers is still down. There is more packaging on airline and airport food and hotels are offering pre-packaged food for breakfast that would previously have not been individually packed. The reasons are obvious – safety and hygiene from the consumers' end and costs from the providers' end, as prepackaged food, can be bought in bulk and more cost-effectively and they likely have a longer shelf life.
Following on from the LyondellBasell commentary in today's daily report, we would make one further, but very important point. With its refinery (granted the company is exploring opportunities to exit) and its huge commodity polyethylene, polypropylene, and propylene oxide business, any attempt to pursue a “specialty” strategy that encompasses the whole portfolio will be seen (crudely) as trying to put some lipstick on a pig! This rarely works in the chemical sector and the real transformation stories involve wholesale portfolio shifts, many of which have taken notable periods of time to develop. We still believe that the right path for LyondellBasell is to spin off the good piece – recycling, licensing, and compounding, or even better, find someone they can sell the business to through a Reverse Morris Trust. This strategy would likely allow the company to pay down (or shift) a significant amount of debt. The commodity business can then focus on the best strategy for a commodity polymer business in the face of energy transition, which might involve taking the business private or merging with another.