Profit margins for ethylene rising toward record levels and could continue to climb, as boom of cheap shale gas in US creating oversupply of ethane feedstock, analysts say
October 17, 2012
– Profit margins for ethylene, a colorless gas used to ripen fruit, open flowers and make products from plastic bags to paint removers, are surging to near record levels and may climb further, reviving fortunes of U.S. producers.
Two of the commodity’s largest makers, LyondellBasell Industries NV and Westlake Chemical Co., have posted their highest-ever profits and their shares have gained 66 percent and 91 percent respectively this year. Their margins will continue to improve as constrained production capacity pushes up prices, say Brian Maguire and Bob Koort, analysts at Goldman Sachs Group Inc. in Houston.
The driver is cheap shale gas, which is rejuvenating the country’s chemical industry after a decade of decline. Hydraulic fracturing of shale rock formations, known as fracking, cut U.S. gas prices to a 10-year low in April. It has also produced an oversupply of ethane, a natural gas component that is converted to ethylene with heat and pressure in a process known as cracking. Gas liquids, mostly ethane, supply about 85 percent of the feedstock for U.S. ethylene makers.
Ethane at Mont Belvieu, Texas, the main supply hub for Gulf Coast chemical makers, has fallen 67 percent in a year to 31.6 cents a gallon.
Consumers and manufacturers alike benefit. Ethylene is the raw material used to make polymers -- sturdy chemical compounds that are building blocks for products in the transportation, electronics, textiles, construction and packaging industries.
Plastic bags and packaging are made from the polymer polyethylene. Cheap ethane has cut the cost of producing polyethylene-based products by about two-thirds from a 2008 peak, making the U.S. competitive with low-cost producers in the Middle East, according to an Oct. 9 report by PricewaterhouseCoopers LLP. The cost advantage may spur $30 billion of ethylene investments, Chevron Phillips Chemical Co. said in March, including the first U.S. plants since 2001.
While the global ethylene industry operated at 85 percent of capacity in August, the lowest since 2009, U.S. producers ran flat out.
“We could see peak margins in 2015-16, before we see a new wave of supply,” Maguire said in an interview. “It’s been 12 years since we built a new cracker in this country and we’ve never tried to build four or five at the same time, so labor and material constraints could cause these projects to be delayed.”
Producers in Asia and Europe, where fracking has yet to catch on, rely on naphtha, an oil-derived raw material that’s more expensive than ethane. LyondellBasell and Westlake produced ethylene this year for an average of about 18 cents a pound using ethane -- 20 cents less than naphtha-based producers -- while ethylene sold for about 49 cents a pound, according to Maguire. Ethane-based production costs are currently about 13 cents a pound, he said. U.S. producers including Dow Chemical Co. are changing their processes to use more gas-derived liquids such as ethane.
Ethylene margins will remain “very good” into early 2014 at least, said Jeffrey Burke, a New York-based portfolio manager at Goldentree Asset Management, which includes Westlake shares in $16.3 billion of assets.
Little new ethylene capacity will come on line in the next several years, so global operating rates must rise to meet demand, Maguire said. That will lead to higher prices that should boost margins another 25 cents a pound by 2015 or 2016, potentially doubling earnings for producers in the U.S., Maguire said.
“That is something we’ve never seen before,” he said.
Goldman recommends buying Houston-based Westlake, controlled by the billionaire Chao family, and LyondellBasell because both have more leverage to improving ethylene profit on a per-share basis than neutral-rated Dow, the biggest U.S. chemical company.
David Harpole, a LyondellBasell spokesman, declined to comment.
“We have recently announced a number of initiatives that expand our bottom line and take advantage of the low cost ethane feedstock that shale gas is providing,” said Dave Hansen, a Westlake spokesman. “This advantage will be with us for years to come.”
Westlake rose 7.8 percent to $77.78 in New York, the most intraday since Aug. 2. LyondellBasell climbed 5.7 percent to $54.36, the most since July 27. Dow gained 5.6 percent to $29.91, the biggest advance since Nov. 30, 2011.
Still, ethylene margins face tests. Tighter operating rates are relatively easy to forecast because new factories take years to build. Yet if gas prices rise, so will the cost of ethane and other feedstocks.
UBS Securities LLC recommends selling Westlake shares because of a looming increase in ethane costs that will narrow margins, Gregg Goodnight, a Houston-based analyst, said in an Aug. 27 note. Gas prices will rise in the fourth quarter and for years after, leading ethane prices to double to 70 cents a gallon by 2016, he said.
The correlation between gas and ethane prices isn’t as strong as some believe, Goldman’s Maguire said, noting recent price changes. Gas has surged 24 percent since touching a two- month low on Aug. 28 while ethane has gained 5 percent, according to data compiled by Bloomberg.
Higher gas prices aren’t a major threat to ethane prices because processors and pipeline companies such as Enterprise Products Partners LP are willing to invest in added output, even amid slim margins, Maguire said. That’s mostly because the chemical industry is dangling the prospect of increased ethane sales at higher profit when new ethylene plants open later in the decade, he said.
Ethane supply growth through 2015 will be more than twice demand growth from incremental ethylene expansions, keeping a lid on ethane prices even if gas prices rise, Maguire said. Average ethane prices may rise to 48 cents a gallon in 2013 from 45 cents this year, he said.
“The period of ethane oversupply is just beginning,” Koort and Maguire said in an Oct. 9 report.
Ethane supplies will get a boost starting in the second quarter when Enterprise and DCP Midstream LLC open separate pipelines to bring natural gas liquids from Conway, Kansas, to Mont Belvieu, Maguire said.
In the meantime, ethylene demand should increase about 5 percent a year, assuming 3.5 percent global economic growth, outpacing estimated annual supply growth of about 2 percent, Maguire said.
Tightening ethylene supplies will allow the highest-cost producers in Europe and Asia, which have coped with break-even margins at times this year, to raise prices. Because ethylene derivatives such as polyethylene, used in packaging and plastic bags, are globally traded, higher prices provide an “umbrella” under which U.S. producers can widen margins, he said.
When operating rates top 90 percent, ethylene buyers become concerned about supply scarcity, giving producers more power to raise prices, Maguire said. Cheap feedstock costs have led U.S. producers to export about 10 percent of polyethylene production and 40 percent of polyvinyl chloride, or PVC, used in pipe and vinyl siding, he said.
Ethylene supplies should get tighter through 2017 when Chevron Phillips opens the first of the new wave of U.S. plants, P.J. Juvekar, a New York-based analyst at Citigroup Global Markets, said in a report. In the meantime global operating rates should rise and feedstock costs should remain relatively low, he said in an Oct. 8 note.
Juvekar recommends buying shares of Dow, the world’s biggest ethylene producer, and LyondellBasell, and he doesn’t rate Westlake.
Westlake plans to expand the cost benefit by adding ethylene capacity in Lake Charles, Louisiana, and making adjustments to use more ethane, projects that will boost 2013 earnings by $1 a share, Maguire said. A new factory to make chlorine, an energy-intensive process, will open in mid-2013 and add another 60 cents to Westlake earnings next year, he said. That will help earnings increase 29 percent next year to $7.14 a share, Goldman estimates.
That’s higher than the rest of the estimates compiled by Bloomberg because other analysts aren’t fully accounting for Westlake’s expansions and a continued feedstock advantage, Maguire said.
Hassan Ahmed, a New York-based analyst at Alembic Global Advisors who shares Goldman’s optimistic view of U.S. ethylene, said rising operating rates combined with cheap ethane could double earnings over several years at Westlake, LyondellBasell and Dow, all of which he rates as a buy.
“The margin we are enjoying in the U.S. is exclusively because of the cost advantage,” Ahmed said in a telephone interview. “The next leg of the margin uptick will be because of the cyclical upswing in utilization rates.”
--Editors: Ken Wells, Simon Casey
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