Description

Methanex ("MEOH") at the current share price of US$42 is an attractive short with over 30% downside in 6-12 months, unless macro tailwinds reverse or interest rates decrease significantly. MEOH faces significant cyclical headwinds with (a) a weakening Chinese economy, (b) increasing methanol production capacity in face of weakening chemicals demand, and (c) subdued prices for oil-based substitutes. In my view, shorting MEOH offers attractive risk-reward as a hedge against a severe downturn and offers limited upside potential in case of a soft landing of the economy. MEOH has sufficient sell-side coverage and numerous past write-ups on VIC, so I will focus on my core thesis.

Significant China Exposure

Despite being a North American firm, MEOH’s single largest geographical exposure is to China at around 26% of 2022 revenues, down from its peak in 2020 of 31%. Unlike US and European markets, where the bulk of the volumes is contracted, the Chinese market is a spot market where volumes as well as prices can fluctuate widely. Due to the high fixed operating cost base typical for chemical companies, changes in Chinese economic activity levels can drive outsized swings in profitability of MEOH as a group.

The Chinese economy has struggled to recover since abandoning COVID-19 measures late last year, possibly due to reshoring of supply chains or the lingering effects of the cooling Chinese real estate market. Hopes for increased exports to developed markets and a surge in consumer spending post-lockdown have not materialized so far. The Chinese government is rightfully reluctant to repeat the past stimulus playbook of state sanctioned infrastructure spending: the imbalances and distortions of the economy, including the real estate price bubble, are as obvious as they are severe. These phenomena have unintended consequences such as low birth rates that the Chinese government has avowed to reverse.

While China is experiencing elevated levels of youth unemployment and seeing the first signs of deflation, DM central banks are still raising interest rates to tackle inflationary pressures, which is likely to suppress export demand. There have been many discussions on inflation and its future trajectory on this board, my assumption is that only a significant financial market mishap would motivate central banks to ease monetary policy again. In the event of a general market meltdown, MEOH's share price is unlikely to perform well.

Methanol Capacity Expansions

The methanol market is dominated by MEOH, a smattering of other chemical players that often produce methanol for captive use, and a growing number of Iranian producers that emerged over the past decade. China grew quickly into the biggest methanol market over the past 20 years because of (a) its burgeoning demand for all kinds of fossil fuels, (b) rapidly growing chemical industry, and (c) desire to diversify beyond the classic naphtha chains. As E&Ps raced to capture and monetize natural gas, the merchant producers of methanol rose up to the challenge of supplying China, building facilities where gas is abundant to ship the easily transportable methanol to customers around the world.

MEOH was the prime beneficiary of the rise of merchant methanol producers until the early 2000s, but over the past decade, the Iranians under pressure of Western sanctions decided to invest heavily in methanol capacity to supply the Chinese market. By some estimates, Iran has 12 Mtpa of methanol capacity, making it the single largest merchant methanol producer in the world. Although seasonal patterns in domestic gas usage leads to some gas curtailments to methanol producers over the winter, I think generally ample Iranian gas supply and limited access to Western markets has shaped Iran into a forced seller of methanol to China, which puts MEOH into a challenging position.

Oil Price Risk

Being short MEOH shares is similar to being short oil prices, given similar end uses. I was bullish on oil prices in 2020, and I still believe that the world will find itself short of oil molecules in a few years again due to persistent underinvestment since 2015. However, in the near term, I believe the risk is on the downside, particularly if the Saudis have a change of heart over their self-imposed supply cuts.

As global economic activity has been slowing since mid-22, the Saudis have borne the brunt of the supply cuts in order to maintain oil prices in the $80s, now producing around 8.2 MMbpd, down from 10 MMbpd last year. In my view, 9 MMbpd is the lower limit of what the Saudis can bear without degrading their long-term productive capacity. The current situation is unsustainable in the medium-run, and won’t be sustained in the long-run: other oil producing nations are firing out of all cylinders, repairing their own balance sheets (Nigeria), funding their petty wars (Russia), or funding populist programs (Brazil).

It’s easy to forget that in just 2020, the Saudis were “waging war against shale,” ramping production to 11 MMbpd in the midst of the worst pandemic the world has seen in over a century. Consequently, oil producers as a group have shown tremendous capex discipline even when oil went above $100/bbl in 2022. I do regard the Saudis as competent stewards of the oil markets and I think competing producers, which indirectly includes MEOH, should know that they are currently depending on the kindness of strangers.

Risks

A truly soft landing, i.e. an imminent recovery of the global economy from here, is likely to result in higher oil prices very quickly, and methanol prices and producers like MEOH would be indirect beneficiaries. Given that Europe is also flirting at the verge of a recession, and Chinese policymakers are still hesitant to open the stimulus floodgates, this is not my base case for now.

Proliferation of methanol as a fuel of the future may hitch MEOH on the ESG train. However, most methanol is still fossil-fuel derived and it appears relatively unlikely that MEOH as a stodgy industrial gets swept up by the ESG wave, but the risk is there.

Disclaimers

The author and affiliates may or may not have material positions in issuers and securities mentioned in this note and will not be obligated to give notice of any changes in their views or positioning. You agree to hold the author harmless and to waive the right to any legal action against the author in relation to this note. The views expressed here reflect the author’s personal views about the issuers and securities and do not constitute investment advice. The author makes no representation or warranty, express or implied, regarding the accuracy, completeness or adequacy of the information. This note is for information purposes only and should not be construed as either projections or predictions. Before making any investment decision, you should seek independent investment, legal, tax, accounting or other professional advice as appropriate, none of which is offered to you by the author in this note. The author accepts no duty of care to you in relation to investments. Past performance cannot be relied on as a guide to future performance. You should not assume that the performance of any specific investment or investment strategy will be profitable or equal to corresponding past performance levels. Any investment or investment strategy can be impacted by numerous factors, including market and economic conditions, and may result in a loss to investors. As with any investment, there can be no assurance that any investment objectives or strategies will be achieved or that an investor will not lose a portion or all of its investment.

Catalyst

Continued decline in methanol prices and global economy