US Ethane Based Chemical Companies, A Way to Play the US Natural Gas Industry - Lyondell (LALLF) and Westlake (WLK)

Commodity Chemical Background

The global chemical industry's backbone is producing a few major building blocks - ethylene and propylene.  These molecules go into most plastics (durables like bumpers and non-durables like water bottles) and compose the lion share of volumes in the industry.  These building blocks are produced from basic hydrocarbons, generally oil and natural gas liquids.  Due to the relative ease of transporting downstream derivatives of ethylene and propylene, the highest commodity input cost usually dictates pricing for the entire industry (which at this time is naphtha, a gasoline equivalent product sourced from oil).  The facilities (called crackers) are generally large (coming online in increments of 1% of global supply) and take 3-4 years to build.  The industry usually faces 6-8 year cycles (peak to peak) as new supply comes online in big chunks and it takes time for the industry to digest the capacity. 

Up until a decade ago, most of the capacity was located in the developed nations.  Due to the limited supply of natural gas in both Europe and Japan, these nations geared most of their plants to process naphtha.  The US built their industry based on naphtha and natural gas liquids (ethane, propane and butane).  In the last 10 years, the Middle East began developing their chemical industry due to their desire to create new industries outside of oil exports (which are not labor intensive) and their vast sources of stranded natural gas.  This push really accelerated post 2004 when oil prices moved up, allowing a zero value product (natural gas in the Middle East) to be exported at prices set by oil.  Saudi Arabia and Iran made the largest push, and their thought process was fairly basic, they don't need a healthy chemical margin to make money.  They are making money selling natural gas as an oil equivalent.  This supply began entering the market in 2008 and has really started to impact the market now in 2010.  Additionally, China and the surrounding region have built several crackers to put ethylene/propylene supply closer to the biggest consumer (though this capacity is still largely naphtha based).

The current thinking in the market (which we don't disagree with) is that this market is now entering a prolonged trough that won't really end until 2013 with a peak in 2015/2016.  Chemical margins should stay depressed with several naphtha based crackers shutting down as chemical margins are insufficient to breakeven (finding shorts here are difficult as most of the public companies are not pure plays).  I attached this cost curve to show the disparity in ethylene costs based on different feedstocks (Enterprise Product has good investor presentations on the NGL/chemical markets as they control a good portion of it).

Global Ethylene Cost Curve (In the Enterprise Products Presentation (Slide16) - http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9NDc5NDF8Q2hpbGRJRD0tMXxUeXBlPTM=&t=1)

US Natural Gas Liquids Background

I am not going to go into the natural gas markets too extensively for the US as it is well discussed in CHK thread aside from saying the natural gas supply in the US has sufficiently allowed it to disconnect from oil permanently.  Essentially all the major producers (including CHK) can drill aggressively at $6/MMBtu natural gas (In my opinion $5 sounds like the right number long term, which is becoming validated with the 2011/2012 futures curves), while oil is currently trading somewhere near $75/Bbl (depends on OPEC).  Oil and natural gas have an energy equivalency of 6:1, which means if we are just paying for energy, $75 oil should equal $12.50/MMBtu natural gas, instead natural gas has been firmly under $5 and now under $4 recently.  Fortunately for the natural gas drillers like CHK, they have found a new alternative to drilling for low return natural gas shales.  The new revelation is drilling natural gas liquids rich shales which produce ethane, propane, butane, condensate (collectively called NGLs) along with natural gas.  Due to the historical decline in supply of US crude and lower Gulf of Mexico gas production, NGLs needed to be imported into the US (as we can see by this chart below).  The new push for NGL rich gas drilling has changed this picture dramatically, rewriting the direction of US NGL supply. 

US NGL Import/Export Balance (from a Bentek Presentation showing strong net imports of NGLs moving to future net exports of NGLs post 2013.  Historical information can be found on the EIA website as well)

Though NGLs are discussed together when it comes to production, we will focus on ethane, which usually composes 45% of the NGL barrel.  Ethane is similar to natural gas in that it is gaseous and difficult to transport outside of using pipelines.  Propane, butane and condensate can be transported with relative ease and can be linked with world markets through import/export terminals.  When supplies were tight for the entire NGL suite, we saw pricing move directionally with oil as all these commodities compete with some form of oil.  This should continue for most of these products except ethane (and possibly propane, but we will not get into that here).  Ethane's end market is the petrochemical industry to make ethylene.  The only alternative is ethane is blended back in with natural gas in those rare instances where natural gas trades below the 6:1 ratio.  Due to the lack of ethane supply, ethane priced close to naphtha, eroding any feedstock advantage.  The US chemical industry produces ethylene from naphtha (oil) crackers as well as ethane crackers due to this indifference.  Without growing feedstock supply, the US had no advantage developing additional crackers (the US had been exporting chemicals to China, furthering the cause of developing incrementally in China), and actually declined during industry troughs due to this lack of competitiveness over the past 10 years.

With the increase in NGL supply, ethane is growing at a rate where it will be well oversupplied by middle of next year (and we have seen signs of this already).  The indicator to see if the ethane markets are oversupplied is to look at the profitability of ethane fractionation plants (who separate out the different NGLs).  When they produce $0/MMBtu spreads, the markets are oversupplied (or natural gas and oil are trading at parity which was largely the case until 2006).  The cap on profits are dictated by oil prices (ie competition with naphtha crackers).  Currently with oil and natural gas prices strongly disconnected (and have been for the entire year, and getting wider), we are starting to see those fractionation spreads come down, from $7/MMBtu earlier this year to now $3/MMBtu (see chart below).  This means if natural gas is $4/MMBtu right now with the fractionators taking a $3/MMBtu margin, the chemical producer buys ethane at $7/MMBtu.  With oil trading at $75/Bbl, this means that it is roughly $12.50/MMBtu.  If we assume oil = naphtha prices (which it should be a bit lower), the chemical producer makes $12.50-7.00 = $5.50/MMBtu less their costs to convert it into chemicals (+ the chemical margins at the time, which aren't great right now).  If we look back to 12/31/2009, gas closed at $5.83/MMBtu, crude was $79/Bbl and the fractionation margins were $6/MMBtu.  So the ethane based US crackers bought ethane at roughly $12/MMBtu and crude was at $13.20/MMBtu, leaving a commodity margin of $1.20/MMBtu.  Therefore the ethane based producer is now making 4x more on the commodity spread.  This is overly simplistic as there are many other aspects to the chemical industry (and several other co-products which naphtha crackers provide), but it is indicative of the trend, especially when looking at the US chemical market.

Ethane Extraction Margins ($/MMBtu) - Bloomberg - HHMBPEMM Index

How to Play

The pure play commodity chemical industry has become quite thin in recent years as most chemical companies have tried to diversify into "specialty" chemicals (i.e. more downstream) or merged with other companies.  Therefore, the only real pure plays commodity chemical companies in the US are Westlake Chemicals and LyondellBasell Industries (DOW has some leverage as well, but more muted). 

The analysis is a bit simple, probably too simple, but we can take the capacity of ethane based US ethylene production and multiply it by the advantage relative to the marginal price setters in Europe/Asia.  We see there is a significant advantage ($400/ton or so), and actual European/Asian costs are probably higher but they are selling ethylene at a loss to produce downstream products that subsidize the loss (especially with oil prices in the $70s, ethylene cash costs are probably closer to $1000/ton+).

Big Risks