The chemical industry's margins are starting to widen from cheaper shale gas produced by hydraulic fracturing, or Fracking. Fracking brought natural gas prices down in the U.S. and also fueled an ethane glut. Ethane can be heated under pressure to synthesize ethylene, a fundamental and widely-used chemical feedstock.
With this in mind, we can check to see if there are any attractively priced chemical companies which would benefit from this secular change.
Westlake Chemical (WLK) and LyondellBasell (LYB), the largest producers of ethylene in the United States, are reporting the highest profits ever, with shares going up 66 percent for Westlake and 91 percent for LyondellBasell. These are set to go up as lower production capacity might force prices to go up.
Industrial uses of ethylene include helping flowers to open, manufacturing plastic bags, producing paint removers, and even ripening fruit. Profit margins for the colorless gas are making record increases and are set to go up even further, which can help revive producers in the U.S.
Asian and European producers work mostly with an oil-based raw material called naphtha, which is more expensive to work with compared to Ethane. The cheap alternative has pushed Dow Chemical (DOW) to start working with ethane as well. Fracking-generated ethane is expected to drive profits through 2014 for many U.S.
Value in Chemical Companies
Chemical companies which 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 won't matter much to companies with high margins since the cost of chemicals are just one component of direct costs (such as labor, allocated overhead, etc.).
Consider the chemical companies with significant U.S. operations listed below:
EPS Growth Next 5 Years
The Dow Chemical
Air Products & Chemicals
E. I. du Pont de Nemours
International Flavors & Fragrances
Westlake Chemical, Celanese, and Eastman Chemical all have low gross margins while trading at attractive valuations. They all sell products which were derived from ethylene either directly or indirectly. Investors seeking to benefit from Fracking should consider these stocks as buy candidates.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.