Chemicals MARKET WEIGHT J. McNulty [CS]
With ethane prices falling ~20% to begin the year, we wanted to highlight potential ramifications for chemical and NGL producers. Commodity chemical stocks have raced to begin the year (WLK up 34%, LYB up 20%, DOW up 11% YTD) on the hope that rapidly falling ethane will lead to a surge in profitability for ethylene production. MLP stocks, on the other hand, have been parked in neutral so far this year, taking a breather following a 14.6% rise in 4Q11 and renewed chatter of pass-through entity tax legislation. In speaking with our industry sources, we believe that the recent incremental fall in ethane is being driven by a confluence of temporary factors as opposed to any incremental structural change in the supply of ethane. That said, based on expected supply/ demand dynamics over the next few months (detailed below), we expect this to result in stronger than expected margins and profitability for ethylene producers.
Implications for Chemicals-Near/Med Term Positive for Ethylene Producers: We believe the rapid declines in ethane since 1/3/12 have been driven by a few factors: 1) lower demand from impending turnarounds (as a reminder, we expect up to as much as 13% of US capacity to be down in later winter/spring; 2) slightly above normal inventory levels; and 3) declines in propane prices due to weak heating demand-ethane prices tend to maintain a certain delta with propane. However, we do not see a structural change in ethane supply that would warrant a further downward re-rating of ethane prices in 2012 (incremental fractionation capacity not expected until 2013), and thus based on our conversations with our industry sources we believe ethane is more likely to have a floor in the 60's cents/gallon. Overall, we see rising profits for ethylene producers over the coming months, as a heavy turnaround schedule is expected which should keep ethane from pushing higher, and also serve to firm up pricing for ethylene (along with high crude oil prices globally). Implications for MLPs-The secular NGL growth story remains in tact, in our view, and MLPs levered to NGLs should continue to perform well. The NGL infrastructure build out remains on track with gross processing margins at record highs. Our top picks to play the NGL market include: DPM, EPD, NGLS, OKS and WES.
NGL Supply/Demand & Fundamentals-To note, while ethane comprises ~40% of the NGL barrel by volume, ethane comprises less than 30% by economics. The remainder of the NGL barrel correlates more closely with crude oil prices, which are expected to remain firm. The key driver of the NGL story is the structural shift in the price of natural gas relative to crude oil, which continues to move lower. This decline in relative value further reinforces the fundamental NGL growth story. NGL extraction (supply) should continue to be maximized as gross processing margins remain near record highs. And ethane demand should also be maximized as it remains the most advantaged feedstock for the petrochemical industry.