We reflect back on our BASF comments of last week and see Covestro falling into the same trap, by underestimating the potential slowdown in discretionary spending in Europe (and the US) and consequently putting too much hope into revised guidance. At the same time, we are not sure what would be gained by painting a picture of doom and gloom, but we would hedge much more overtly if we were offering guidance around the business outlook today.
The margin weakness in PVC, as shown in Exhibit 1 from today's daily report, suggests that the market might be weakening, but higher prices would suggest that it is not. The integrated margin weakness is mostly the result of rising costs, and the US PVC market may be strong enough to allow producers to pass on these costs fully over time. We still see PVC as the least risky way to play the US polymers market as infrastructure and manufacturing investments should keep demand strong even if we see a decline in consumer durable related spending. The Westlake chart below highlights one of the primary drivers behind our mega-cycle view – no new capacity. The supply shortfalls that are implied in the chart will be mirrored in other basic chemicals in our view but PVC is likely the most acute example – creating what could be a prolonged period of strong margins for the industry.
We focus on the building products industry today and it is interesting to note the convergence of the S&P Building Products index and Westlake over the early part of this year, as Westlake has been recognized for its building products footprint, partly aided by the company’s re-segmenting with the last quarterly earnings. The company has reached an all-time high stock price over the last few weeks and has certainly been a great preferred pick for us over the last two years. As interest and mortgage rates rise, we may see a slowdown in home buying as there is generally a good correlation, but this often leads to more home projects as consumers choose not to move and improve what they have.
As we have been suggesting for some time, there are pockets of real strength in chemicals; identifying them is the hard part. It is not enough to have pricing strength in a market where raw material prices are volatile daily and we have seen plenty of examples of companies with very strong end demand dynamics missing earnings because of a cost squeeze. We continue to highlight the competitive strength in the US in basic chemicals because of the decoupled and relatively low natural gas price and this is likely a large piece of the Dow earnings strength – strong polyethylene demand against a backdrop of relatively stable and lower costs. While polypropylene (Braskem) remains extremely profitable in the US, it has seen more sequential weakness than polyethylene – as we show in Exhibit 1 of today's daily report. That said, both polyethylene and polypropylene margins in the US are significantly higher than was likely expected this year and certainly what has been reflected in stock valuations, even with the commodity chemicals rally. Dow is also seeing the benefit of a very strong silicones market – something that was covered in detail in Wacker’s release earlier this month.
As noted in Exhibit 1 from today's daily report, the jump in oil prices has plunged the European polyethylene producers into the red and pushed Asian polyethylene producers further into the red. This will inevitably result in price increases as basic chemical and polymer producers will shut down at negative margins, and these price rises offer an opportunity for the US, Middle East, and select other producers.
Westlake Chemical began today at a 52 week high on the back of very strong earnings but has retreated with the market. Westlake has been one of our favorite ideas since founding C-MACC in part because we believe in the diversification strategy into building products and in part because the PVC market has not seen the same level of overinvestment as polyolefins globally over the last 3 years. Westlake’s view of the housing and construction market aligns with ours and by breaking out this segment of the business Westlake should see some valuation benefit from the more stable earnings that this segment should provide. Note that the focused building products companies trade at significantly higher multiples than chemicals. We expect Westlake to get earnings and multiple boosts from here.
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.
While the Shell headlines today are probably the biggest news, it should not be a surprise to anyone that earnings are lower in 4Q than they were in 3Q, as all of the market indicators have been telling us this for months, and Dow made a statement to this effect in early December. Given the location of Shell’s Norco facility, it took a full hit from Hurricane Ida and the company made several statements at the time regarding delays to restarts. We expect other chemical companies to post meaningful declines in earnings for 4Q relative to 3Q 2021, but unless, like Shell, they experienced meaningful production outages, we would still expect 4Q results to be above “normal” and higher than earnings in 2019. We still see share prices for the public companies as very low looking at values relative to 2019 and earnings relative to 2019, but the negative momentum in earnings is more important to investors today than the absolute level of earnings. As we have stated in prior work, we need to get through negative revisions before the sector could look interesting. The exception, as noted in our Daily Report today, could be PVC, where pricing could look better than is already implied in 2022 estimates and valuation. A positive tone in upcoming conference calls may be a turning point for the PVC-related stocks – Westlake primarily. We could see the trend in the chart below reverse.
With the rapid rise in energy prices, we are seeing price increase announcements for many intermediate chemicals, especially in regions of the world where margins were already very slim. The energy inflation issue is hard to call, with more and more commentators suggesting that it could be prolonged (which generally means it will be short), but lots of dislocations support duration. We would certainly be pushing prices today on the back of energy costs that could move higher again, and given that many chemical and polymer buyers have price protection in their contracts (for at least a month), producers could face a margin squeeze and an uphill climb to get adequate price coverage. Seasonally, demand for chemicals and polymers is at its weakest for the next couple of months, so the price hikes may be difficult. However, because of supply chain constraints, buyers may feel less confident and concede more easily. We could see a significant swing in sentiment from the chemical companies on 3Q earnings calls over the coming weeks as they talk about how good results were in 3Q but throw up all sorts of cautionary statements concerning 4Q.