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The chemical industry's margins are starting to widen from cheaper shale gas produced by hydraulic fracturing, or fracking. Fracking has sent natural gas prices down in the U.S. and has also made chemicals that are based on ethane to fall in price. Chemical engineers can convert ethane to ethylene, a fundamental and widely used chemical feedstock. This industrial chemistry is connecting the economic phenomenon of fracking to the chemical industry. Ethylene is a building-block for a host of chemicals and polymers and is a plant hormone used to induce flowering and fruit ripening.

With this in mind, we can check to see if there are any attractively priced chemical companies, which would benefit from this secular price drop in ethylene.

Fracking Gains

Westlake Chemical (WLK) and LyondellBasell (LYB), the largest producers of ethylene in the United States, reported their highest-ever profits in 2012. Fracking-generated ethane is expected to drive profits through 2014 for many U.S. chemical companies

Apparently, the market got ahead of itself and LyondellBasell Industries' earnings announcement trailed analysts' estimates due to an increase in the loss from the European plastics unit. During the fourth quarter, the company earned a profit before charges to refinance and close a French refinery.

During the fourth quarter, the company earned $623 million or $1.09 per share as compared with a loss of $218 million or 38 cents per share during the previous year. The company's profit without including discontinued operations was $1.13 per share as compared with the $1.14 average of 19 analysts compiled by Bloomberg. During the previous year, the company earned a heavy charge related to repayment of debt and shutdown of its Berre refinery in France and other items. During the year, the company earned $2.83 billion or $4.92 per share as compared with the previous year, when the company earned $2.14 billion or $3.74 per share. The company's earnings from continuing operations were $4.96 per share and the annual revenue declined by 6%; $45.35 billion from $48.18 billion.

The operating loss in Asia and Europe arising from olefins and polyolefins has increased to $94 million as compared with $73 million from a previous year. According to Laurence Alexander, an analyst at Jefferies & Co., the company's result from the olefins business in Europe is below the analyst's estimates but still they recommend the company as a "buy."

Chairman and the Chief Executive Officer James Gallogly said, "Outside of North America, the global olefins industry continues to experience low operating rates and profitability, negatively impacting our European olefins and commodity polyolefin businesses." He also said that the company is increasing its capacity in the U.S. as shale-gas extraction increases the supply of natural gas liquids, which are a feedstock for olefins used to create plastics such as polypropylene and polyethylene.

Hassan Ahmed, an analyst at Alembic Global Advisors, stated that investors expect better results since the U.S. prices for ethane, which is used to create ethylene and related plastics, fell precipitously during the fourth quarter.

Value in Chemical Companies

Chemical companies that will benefit the most are ones with significant U.S. operations that have relatively low gross margins. As cheaper ethylene works its way through the chemical value chain, prices of chemical reactants will become cheap for more and more complex molecules. This will matter less to companies with high margins since the cost of chemicals are a small component of direct costs.

Consider the chemical companies with significant U.S. operations listed below:

Ticker

Company

Gross Margin

P/E

P/S

D/E

DOW

The Dow Chemical

15.84%

46.31

0.68

1.01

ASH

Ashland

26.96%

86.51

0.75

0.86

LYB

LyondellBasell Industries

12.69%

16.01

0.79

0.35

CE

Celanese

18.57%

12.99

1.23

1.79

DD

E. I. du Pont de Nemours

26.45%

18.27

1.25

1.16

EMN

Eastman Chemical

21.75%

24.12

1.39

NA

WLK

Westlake Chemical

17.19%

19.49

1.69

0.38

APD

Air Products & Chemicals

26.62%

18.03

1.86

0.96

IFF

International Flavors & Fragrances

41.66%

28.75

2.16

0.72

FMC

FMC

35.78%

19.81

2.25

0.61

MOS

The Mosaic

27.65%

14.25

2.6

0.08

WPZ

Williams Partners

29.92%

20.33

2.81

0.93

SIAL

Sigma-Aldrich

52.09%

20.99

3.62

0.28

LyondellBasell and Celanese have low gross margins while trading at reasonable valuations. They all sell products that were derived from ethylene either directly or indirectly. However, Celanese has a high debt-to-equity ratio. Investors seeking to benefit from fracking should consider LyondellBasell as a buy candidate.

Please read the article disclaimer.

Source: A Fracking-Driven Chemical Stock