LyondellBasell LALLF
August 26, 2010 - 4:53pm EST by
pathbska
2010 2011
Price: 20.01 EPS $0.00 $0.00
Shares Out. (in M): 564 P/E 0.0x 0.0x
Market Cap (in $M): 11,336 P/FCF 0.0x 0.0x
Net Debt (in $M): 3,557 EBIT 0 0
TEV ($): 14,893 TEV/EBIT 0.0x 0.0x

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Description

 

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

To get this writeup including all the graphs, open this link:
https://docs.google.com/fileview?id=0B0Hi2Z2S-0BmYTE1ZTZlYzctYTA3Mi00YTBmLWE3MDMtOGE4MDU5YmYyYjJm&authkey=CKXxkbUB&hl=en

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

 

As ethane becomes more oversupplied, margins should approach $0/MMBtu, so shouldn't E&P producers stop producing ethane?  Not really, the other NGL co-products, such as propane, butane and condensate still get premium pricing, therefore the erosion in ethane profitability will only dampen returns a few percentage points (and still well above natural gas shale drilling returns).  Chemical companies are not going to rush to build as the industry here has been so challenged for so long, plus it will take at least 4 years to build a new plant (the retired ethane crackers are mostly dismantled, but some might be available to be reactivated).

 

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+).

Ethylene Cash Cost

 

 

 

 

 

 

 

Ethane Cost (cents/gallon)

      49.38

As of 8/25

 

Conversion to Lbs

      2.970

Conversion Factor

Ethane Cost (cents/lbs)

      16.62

 

 

Lbs of ethane/lb of ethylene

      1.289

Conversion Factor

Ethylene Cost (cents/lb)

      21.43

 

 

US Ethylene Cost ($/ton)

        480

Conversion Factor to $/metric tons

 

 

 

 

Marginal Price Setters ($/ton)

 

 

 

Asian

        900

 

 

W Europe

        850

 

 

 

 

 

 

US Ethane based Ethylene Margin Advantage ($/ton)

 

 

Asian

        420

 

 

W Europe

        370

 

 

 

 

 

 

 
Additionally, if the thesis is proven correct where ethane supplies become extremely oversupplied, the fractionation margin should approach $0.  This allows further advantages (close to another $200/ton of ethylene). 

Additional Margin if Ethane is Oversupplied

 

 

 

 

 

 

 

Current Fractionation Margin ($/MMBtu)

       3.00

 

 

Conversion to cents/gallon

6.595

Conversion Factor

Ethane Frac Margin (cents/gallon)

      19.79

 

 

Conversion to Lbs

      2.970

Conversion Factor

Ethane Frac Margin (cents/lbs)

       6.66

 

 

Lbs of ethane/lb of ethylene

      1.289

Conversion Factor

Frac Margin in Ethylene Units (cents/lb)

       8.59

 

 

Ethane Frac Margins in Ethylene Units ($/ton)

        192

Conversion Factor to $/metric tons

 
Applying this to the companies, we can then project EBITDA levels during these trough periods (ie no chemical margins, just margins due to this ethane/naphtha spread).  The easier analysis is Westlake Chemicals.  Westlake has two crackers in the US and produces downstream derivatives of LDPE (a form of plastic) and PVC (used in construction, etc).  Since the housing bust, Westlake has been losing operating income in the PVC division and making money in the LDPE business.  It supplies ethylene to these two businesses from their two crackers (only one really matters, Lake Charles) and purchases some spot ethylene to make up some shortfall.  To make this simple, disaggregate the downstream profits to the profits of the cracker.  PVC is on track to be EBIT breakeven, but let's assume EBITDA breakeven (in 2005 this division produced $215MM of EBITDA).  The plastic downstream divisions are earning roughly $0.07-0.10/lb right now, I assume those will come down as the chemical industry prepares to slug it out.  So net net, the company should produce EBITDA of $400MM+ assuming no chemical margins (this is pure trough numbers).  Once the ethane industry is firmly oversupplied, this number escalates to $575MM.  Assuming 6x trough numbers (DOW is at 6.3x current numbers), WLK trades towards $49/share.  These numbers are much higher than what WLK peaked at during the peak ($35), but this shows the impact the commodity price has to these chemical processors.  The downside of WLK is the liquidity, 70% of the company is controlled by the Chao family and they don't plan on selling down anytime soon.  On the plus side, they run the business tight and don't appear to be aggressive capital allocators (though they IPO'd in 2004 to create a currency for acquisitions). 

 

 

 

 

 

 

 

 

 

 

Westlake

Annual Capacity

Light Feed %

NGL Feed Capacity

% Ethane

Ethane Feed Capacity

 

 

 

 

Lake Charles

      1,134

100%

                    1,134

86%

                           975

 

 

 

 

Calvert City, KY

        200

100%

                       200

0%

                             -  

 

 

 

 

Total Capacity (M Tons)

 

 

                    1,334

 

                           975

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Current Margin Advantage ($/ton) - Since end of June

 

 

 

                           400

 

 

 

 

EBITDA ($MM), 90% Capacity Factor

 

 

 

 

                           351

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Additional Margin from Current Ethane Fractionation Margin Collapse ($/Ton)

 

 

                           192

 

 

 

 

EBITDA ($MM), 90% Capacity Factor

 

 

 

 

                           169

 

 

 

 

Total Potential EBITDA Impact ($MM)

 

 

 

 

                           520

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Downstream Profits

 

 

 

 

 

 

 

 

 

LDPE Profits (cents/lb)

 

 

 

 

                          0.07

 

 

 

 

LDPE Capacity (MMlbs)

 

 

 

 

                        1,500

 

 

 

 

HDPE/LLDPE Profits (cents/lb)

 

 

 

 

                          0.03

 

 

 

 

HDPE/LLDPE Capacity (MMlbs)

 

 

 

 

                        1,000

 

 

 

 

LDPE, HPDE, LLDPE EBITDA ($MM)

 

 

 

 

                           135

 

 

 

 

PVC EBITDA ($MM)

 

 

 

 

                              0

 

 

WLK Price Assuming 6x Trough Multiples

SG&A ($MM)

 

 

 

 

                           (80)

Current EBITDA Multiple

 

Net EBITDA from Downstream + SG&A

 

 

 

 

                            55

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Projected Trough EBITDA

 

 

 

 

 

 

 

 

 

Current Margin Advantage Case ($MM)

 

 

 

 

                           406

4.7 x

 

          33.41

 

With Additional Margin from Current Ethane Frac Margin Collapse ($MM)

 

 

                           575

3.3 x

 

          48.73

 

 

 

 

 

 

 

 

 

 

 

Highest Quarterly EBITDA Annualized (4Q05)

 

 

 

 

                           532

3.6 x

 

 

 

2011 FC EBITDA Estimate

 

 

 

 

                           343

5.6 x

 

 

 

 

 

 

 

 

 

 

 

 

 

Market Valuation

 

 

 

 

 

 

 

 

 

Stock Price

 

 

 

 

                        25.64

 

 

 

 

Fully Diluted Shares

 

 

 

 

                            66

 

 

 

 

Equity Value

 

 

 

 

                        1,696

 

 

 

 

Net Debt

 

 

 

 

                           227

 

 

 

 

Enterprise Value

 

 

 

 

                        1,922

 

 

 

 

 
LyondellBasell is a bit more complicated as it is not as levered to this theme (but meaningful, and if the vague capacity numbers we receive from CMAI consulting are wrong, this could be 2x levered to this theme than I think it is...ie, I think they are using more ethane than CMAI thinks).  The company just emerged from bankruptcy in April after a ridiculous buyout in 2007 from a private European company.  The issue now is that it is trading on the pink sheets, and hopefully will be listed on the big board in the next few weeks (or days) which would allow mutual funds to purchase the equity.  LyondellBasell contains a lot of assets around the world, including refining and petrochemical facilities.  Alembic did a really good report on it (its on Bloomberg under the news feed for LALLF), which essentially points to a trough EBITDA of $3,278MM.  Instead of trying to do some real mathemagic sum of the parts analysis, my belief is that the company can clear $3.5Bn of EBITDA annually in this trough period considering the company earned $2.3Bn in 2009 and now the ethylene feedstocks are now working in their favor.  If we put a 6x multiple here, the stock could be as high as $30, and probably a bit less considering it is a recent bankruptcy stock.  More importantly, the company is significantly delivering ($3/share last quarter!) and with the new management gearing the company to be fiscally more stable, this could be significantly better than what I am projecting here.  The technicals are terrible as the holders of LALLF (and LALBF, a ticker that will probably go away once the stock trades above $21 for a while) are all the former bondholders.  To date, only 47% of the shares have traded hands despite being out for 85 trading days.  This has kept a lid on meaningful share appreciation (especially after 2Q10's $1.4Bn EBITDA number).  Once the stock lists, this will be a real cheap alternative relative to DOW, so expect the big boys stepping in.

LyondellBasell

Annual Capacity

Light Feed %

NGL Feed Capacity

% Ethane

Ethane Feed Capacity

 

 

 

 

Channelview

      1,746

80%

                    1,397

21%

                           367

 

 

 

 

Clinton, IL

        476

100%

                       476

86%

                           409

 

 

 

 

Corpus Christi

        771

80%

                       617

23%

                           177

 

 

 

 

La Porte

        789

95%

                       750

77%

                           608

 

 

 

 

Morris, IL

        549

100%

                       549

94%

                           516

 

 

 

 

Total Capacity (M Tons)

      4,331

 

                    3,788

 

                        2,077

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Current Margin Advantage ($/ton) - Since end of June

 

 

 

                           400

 

 

 

 

EBITDA ($MM), 90% Capacity Factor

 

 

 

 

                           748

 

 

 

 

 

 

 

 

 

 

 

 

LALLF Price Assuming 6x Trough Multiples

Additional Margin from Current Ethane Fractionation Margin Collapse ($/Ton)

 

 

                           192

Current EBITDA Multiple

 

EBITDA ($MM), 90% Capacity Factor

 

 

 

 

                           360

 

 

 

 

Total Potential EBITDA Impact ($MM)

 

 

 

 

                        1,107

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Projected 2011 EBITDA Estimate

 

 

 

 

                        3,500

4.3 x

 

          30.93

 

 

 

 

 

 

 

 

 

 

 

Market Valuation

 

 

 

 

 

 

 

 

 

Stock Price

 

 

 

 

                        20.10

 

 

 

 

Fully Diluted Shares

 

 

 

 

                           564

 

 

 

 

Equity Value

 

 

 

 

                      11,336

 

 

 

 

Net Debt

 

 

 

 

                        3,557

 

 

 

 

Enterprise Value

 

 

 

 

                      14,893

 

 

 

 

 

Big Risks

1)  Oil prices collapse - this margin will erode and the companies will be challenged to find much margin
2)  Natural gas industry stops drilling - The companies will have to slow down drilling, but I think the companies will direct most of their capital towards these higher return NGL plays
3)  Hurricanes - Can shut down plants (Lake Charles) which might help chemical margins around the world, but not help our companies.  WLK is really a single asset company, so there are inherent risks with that as well

Catalyst

Listing on the NYSE coupled with significant sellside research coverage
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    Description

     

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

    To get this writeup including all the graphs, open this link:
    https://docs.google.com/fileview?id=0B0Hi2Z2S-0BmYTE1ZTZlYzctYTA3Mi00YTBmLWE3MDMtOGE4MDU5YmYyYjJm&authkey=CKXxkbUB&hl=en

    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

     

    As ethane becomes more oversupplied, margins should approach $0/MMBtu, so shouldn't E&P producers stop producing ethane?  Not really, the other NGL co-products, such as propane, butane and condensate still get premium pricing, therefore the erosion in ethane profitability will only dampen returns a few percentage points (and still well above natural gas shale drilling returns).  Chemical companies are not going to rush to build as the industry here has been so challenged for so long, plus it will take at least 4 years to build a new plant (the retired ethane crackers are mostly dismantled, but some might be available to be reactivated).

     

    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+).

    Ethylene Cash Cost

     

     

     

     

     

     

     

    Ethane Cost (cents/gallon)

          49.38

    As of 8/25

     

    Conversion to Lbs

          2.970

    Conversion Factor

    Ethane Cost (cents/lbs)

          16.62

     

     

    Lbs of ethane/lb of ethylene

          1.289

    Conversion Factor

    Ethylene Cost (cents/lb)

          21.43

     

     

    US Ethylene Cost ($/ton)

            480

    Conversion Factor to $/metric tons

     

     

     

     

    Marginal Price Setters ($/ton)

     

     

     

    Asian

            900

     

     

    W Europe

            850

     

     

     

     

     

     

    US Ethane based Ethylene Margin Advantage ($/ton)

     

     

    Asian

            420

     

     

    W Europe

            370

     

     

     

     

     

     

     
    Additionally, if the thesis is proven correct where ethane supplies become extremely oversupplied, the fractionation margin should approach $0.  This allows further advantages (close to another $200/ton of ethylene). 

    Additional Margin if Ethane is Oversupplied

     

     

     

     

     

     

     

    Current Fractionation Margin ($/MMBtu)

           3.00

     

     

    Conversion to cents/gallon

    6.595

    Conversion Factor

    Ethane Frac Margin (cents/gallon)

          19.79

     

     

    Conversion to Lbs

          2.970

    Conversion Factor

    Ethane Frac Margin (cents/lbs)

           6.66

     

     

    Lbs of ethane/lb of ethylene

          1.289

    Conversion Factor

    Frac Margin in Ethylene Units (cents/lb)

           8.59

     

     

    Ethane Frac Margins in Ethylene Units ($/ton)

            192

    Conversion Factor to $/metric tons

     
    Applying this to the companies, we can then project EBITDA levels during these trough periods (ie no chemical margins, just margins due to this ethane/naphtha spread).  The easier analysis is Westlake Chemicals.  Westlake has two crackers in the US and produces downstream derivatives of LDPE (a form of plastic) and PVC (used in construction, etc).  Since the housing bust, Westlake has been losing operating income in the PVC division and making money in the LDPE business.  It supplies ethylene to these two businesses from their two crackers (only one really matters, Lake Charles) and purchases some spot ethylene to make up some shortfall.  To make this simple, disaggregate the downstream profits to the profits of the cracker.  PVC is on track to be EBIT breakeven, but let's assume EBITDA breakeven (in 2005 this division produced $215MM of EBITDA).  The plastic downstream divisions are earning roughly $0.07-0.10/lb right now, I assume those will come down as the chemical industry prepares to slug it out.  So net net, the company should produce EBITDA of $400MM+ assuming no chemical margins (this is pure trough numbers).  Once the ethane industry is firmly oversupplied, this number escalates to $575MM.  Assuming 6x trough numbers (DOW is at 6.3x current numbers), WLK trades towards $49/share.  These numbers are much higher than what WLK peaked at during the peak ($35), but this shows the impact the commodity price has to these chemical processors.  The downside of WLK is the liquidity, 70% of the company is controlled by the Chao family and they don't plan on selling down anytime soon.  On the plus side, they run the business tight and don't appear to be aggressive capital allocators (though they IPO'd in 2004 to create a currency for acquisitions). 

     

     

     

     

     

     

     

     

     

     

    Westlake

    Annual Capacity

    Light Feed %

    NGL Feed Capacity

    % Ethane

    Ethane Feed Capacity

     

     

     

     

    Lake Charles

          1,134

    100%

                        1,134

    86%

                               975

     

     

     

     

    Calvert City, KY

            200

    100%

                           200

    0%

                                 -  

     

     

     

     

    Total Capacity (M Tons)

     

     

                        1,334

     

                               975

     

     

     

     

     

     

     

     

     

     

     

     

     

     

    Current Margin Advantage ($/ton) - Since end of June

     

     

     

                               400

     

     

     

     

    EBITDA ($MM), 90% Capacity Factor

     

     

     

     

                               351

     

     

     

     

     

     

     

     

     

     

     

     

     

     

    Additional Margin from Current Ethane Fractionation Margin Collapse ($/Ton)

     

     

                               192

     

     

     

     

    EBITDA ($MM), 90% Capacity Factor

     

     

     

     

                               169

     

     

     

     

    Total Potential EBITDA Impact ($MM)

     

     

     

     

                               520

     

     

     

     

     

     

     

     

     

     

     

     

     

     

    Downstream Profits

     

     

     

     

     

     

     

     

     

    LDPE Profits (cents/lb)

     

     

     

     

                              0.07

     

     

     

     

    LDPE Capacity (MMlbs)

     

     

     

     

                            1,500

     

     

     

     

    HDPE/LLDPE Profits (cents/lb)

     

     

     

     

                              0.03

     

     

     

     

    HDPE/LLDPE Capacity (MMlbs)

     

     

     

     

                            1,000

     

     

     

     

    LDPE, HPDE, LLDPE EBITDA ($MM)

     

     

     

     

                               135

     

     

     

     

    PVC EBITDA ($MM)

     

     

     

     

                                  0

     

     

    WLK Price Assuming 6x Trough Multiples

    SG&A ($MM)

     

     

     

     

                               (80)

    Current EBITDA Multiple

     

    Net EBITDA from Downstream + SG&A

     

     

     

     

                                55

     

     

     

     

     

     

     

     

     

     

     

     

     

     

    Projected Trough EBITDA

     

     

     

     

     

     

     

     

     

    Current Margin Advantage Case ($MM)

     

     

     

     

                               406

    4.7 x

     

              33.41

     

    With Additional Margin from Current Ethane Frac Margin Collapse ($MM)

     

     

                               575

    3.3 x

     

              48.73

     

     

     

     

     

     

     

     

     

     

     

    Highest Quarterly EBITDA Annualized (4Q05)

     

     

     

     

                               532

    3.6 x

     

     

     

    2011 FC EBITDA Estimate

     

     

     

     

                               343

    5.6 x

     

     

     

     

     

     

     

     

     

     

     

     

     

    Market Valuation

     

     

     

     

     

     

     

     

     

    Stock Price

     

     

     

     

                            25.64

     

     

     

     

    Fully Diluted Shares

     

     

     

     

                                66

     

     

     

     

    Equity Value

     

     

     

     

                            1,696

     

     

     

     

    Net Debt

     

     

     

     

                               227

     

     

     

     

    Enterprise Value

     

     

     

     

                            1,922

     

     

     

     

     
    LyondellBasell is a bit more complicated as it is not as levered to this theme (but meaningful, and if the vague capacity numbers we receive from CMAI consulting are wrong, this could be 2x levered to this theme than I think it is...ie, I think they are using more ethane than CMAI thinks).  The company just emerged from bankruptcy in April after a ridiculous buyout in 2007 from a private European company.  The issue now is that it is trading on the pink sheets, and hopefully will be listed on the big board in the next few weeks (or days) which would allow mutual funds to purchase the equity.  LyondellBasell contains a lot of assets around the world, including refining and petrochemical facilities.  Alembic did a really good report on it (its on Bloomberg under the news feed for LALLF), which essentially points to a trough EBITDA of $3,278MM.  Instead of trying to do some real mathemagic sum of the parts analysis, my belief is that the company can clear $3.5Bn of EBITDA annually in this trough period considering the company earned $2.3Bn in 2009 and now the ethylene feedstocks are now working in their favor.  If we put a 6x multiple here, the stock could be as high as $30, and probably a bit less considering it is a recent bankruptcy stock.  More importantly, the company is significantly delivering ($3/share last quarter!) and with the new management gearing the company to be fiscally more stable, this could be significantly better than what I am projecting here.  The technicals are terrible as the holders of LALLF (and LALBF, a ticker that will probably go away once the stock trades above $21 for a while) are all the former bondholders.  To date, only 47% of the shares have traded hands despite being out for 85 trading days.  This has kept a lid on meaningful share appreciation (especially after 2Q10's $1.4Bn EBITDA number).  Once the stock lists, this will be a real cheap alternative relative to DOW, so expect the big boys stepping in.

    LyondellBasell

    Annual Capacity

    Light Feed %

    NGL Feed Capacity

    % Ethane

    Ethane Feed Capacity

     

     

     

     

    Channelview

          1,746

    80%

                        1,397

    21%

                               367

     

     

     

     

    Clinton, IL

            476

    100%

                           476

    86%

                               409

     

     

     

     

    Corpus Christi

            771

    80%

                           617

    23%

                               177

     

     

     

     

    La Porte

            789

    95%

                           750

    77%

                               608

     

     

     

     

    Morris, IL

            549

    100%

                           549

    94%

                               516

     

     

     

     

    Total Capacity (M Tons)

          4,331

     

                        3,788

     

                            2,077

     

     

     

     

     

     

     

     

     

     

     

     

     

     

    Current Margin Advantage ($/ton) - Since end of June

     

     

     

                               400

     

     

     

     

    EBITDA ($MM), 90% Capacity Factor

     

     

     

     

                               748

     

     

     

     

     

     

     

     

     

     

     

     

    LALLF Price Assuming 6x Trough Multiples

    Additional Margin from Current Ethane Fractionation Margin Collapse ($/Ton)

     

     

                               192

    Current EBITDA Multiple

     

    EBITDA ($MM), 90% Capacity Factor

     

     

     

     

                               360

     

     

     

     

    Total Potential EBITDA Impact ($MM)

     

     

     

     

                            1,107

     

     

     

     

     

     

     

     

     

     

     

     

     

     

    Projected 2011 EBITDA Estimate

     

     

     

     

                            3,500

    4.3 x

     

              30.93

     

     

     

     

     

     

     

     

     

     

     

    Market Valuation

     

     

     

     

     

     

     

     

     

    Stock Price

     

     

     

     

                            20.10

     

     

     

     

    Fully Diluted Shares

     

     

     

     

                               564

     

     

     

     

    Equity Value

     

     

     

     

                          11,336

     

     

     

     

    Net Debt

     

     

     

     

                            3,557

     

     

     

     

    Enterprise Value

     

     

     

     

                          14,893

     

     

     

     

     

    Big Risks

    1)  Oil prices collapse - this margin will erode and the companies will be challenged to find much margin
    2)  Natural gas industry stops drilling - The companies will have to slow down drilling, but I think the companies will direct most of their capital towards these higher return NGL plays
    3)  Hurricanes - Can shut down plants (Lake Charles) which might help chemical margins around the world, but not help our companies.  WLK is really a single asset company, so there are inherent risks with that as well

    Catalyst

    Listing on the NYSE coupled with significant sellside research coverage
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