Chemicals And Hurricane Harvey: A Bad Formula

|
Includes: AIQUY, AKZOY, APD, BASFY, CE, CLZNY, CVX, CVXTY, DWDP, EMN, GT, HUN, LNEGY, LYB, MMM, OLN, OXY, PPG, PSX, PX, RDS.A, RDS.B, SHLM, SVYZY, WLK, XOM, YARIY
by: John Abbink

Summary

Press attention has focused on the storm’s effect on oil refining, but the enormous Houston-area chemical complex has also been largely shut down.

The economic consequences are subtle but not dissimilar: plastics and petrochemicals are economically universal, providing irreplaceable inputs for as much as 25% of U.S. GDP.

Large, integrated companies such as LyondellBasell or DowDuPont have probably been hit hardest initially, but are likely to recover soonest.

Given the inevitable price increases, companies without Houston-area production should actually benefit. Most of them are overseas, but Westlake Chemical is an exception.

The Houston chemical complex probably will not fully recover until well into Q1 next year.

There is much suffering in the Houston area, so singling out the chemical industry’s woes for special attention might seem insensitive. But the Houston chemical complex is economically vital: it accounts for nearly two-thirds of U.S. primary plastics production and around 45% of basic chemical production, supplying not only domestic demand but also many foreign markets. Last year the U.S. carried a $15 billion trade surplus in plastics alone, almost all of it shipped from Texas. The Houston chemical complex generated revenue of $143 billion in 2016, accounting for 27% of total U.S. chemical industry revenue.

We read a great deal about the storm’s effect on oil refining (which is, of course, an allied industry), and here in the Southeast, we are firmly reminded of the storm’s effects whenever we see a gas station’s price sign. But, other than the fires and explosions at the Arkema (OTCPK:ARKAY) plant in Crosby, the effect of storm damage on the chemical industry has received comparatively little press attention. The reason is that its consequences to end consumers are less visible, and likely to materialize over time rather than with a sudden, highly visible price boost.

The bulk of Houston-area chemical output is materials and intermediates. These ramify throughout the economy. I challenge readers to find less than five such products within their immediate vision, from the case of the device on which they are reading this to the paint on their walls, the adhesive holding their furniture together and the carpet, vinyl, or wood varnish beneath their feet. Through this multiplier effect, petrochemicals and plastics have a hand in 25% of U.S. GDP. So trouble in Houston will drag on the whole U.S. economy. At the very least, manufacturers will temporarily have to find new, inevitably higher cost suppliers, and some may be unable to replace missing Houston-sourced inputs such as highly specialized plastics.

It is notoriously difficult to gauge the effect of a major disaster on GDP: much of the capital destroyed will be replaced, which gives the illusion of stimulus, but of course a stock of wealth has been destroyed. Economists are not too discouraging, suggesting cuts to Q3 and Q4 GDP growth of 0.1 or 0.2 percentage points. However, the effect on profits in unpredictable corners of the manufacturing sector is likely to be considerably higher. Analysts will have difficulty estimating the aggregate consequences of under-utilization, delayed deliveries and increased input prices on earnings, but in some cases they will not be small. Estimates almost certainly need to be reined in, although smaller, mostly private manufacturing businesses (the kind that are said to drive job growth) are probably most vulnerable. The effect on chemical companies’ profitability is more direct, but not necessarily much easier to forecast.

Houston Chemical Industry Structure

The Houston complex is tightly inter-connected - one company’s product is a feedstock, additive or process catalyst for another’s - which explains why the damage from Hurricane Harvey is so disruptive. It may take several stages of processing at different companies’ facilities, each employing inputs from still other plants, before a product that is actually sold to a customer outside of the chemical industry is created. The Arkema plant provides an example: it manufactured organic peroxides, used for their various effects in polyethylene, polypropylene, PVC, polystyrene, acrylic resins as well as in acne medications.

When possible, bulk transport within the Houston complex is by pipeline. But the concentration of chemical manufacture on the Gulf Coast is not an historical accident or simply due to proximity to natural gas supplies: marine transport, both in- and out-bound, is crucial. Items that are not consumed in enormous quantities, such as Arkema’s organic peroxides, are generally moved by rail. Until transport infrastructure is available, particularly at the several ports that are closed throughout the area, large-volume raw materials other than those piped in are unavailable and large-volume finished product (such as the 34 million tons of plastics produced there) cannot leave.

At the moment, this is a minor problem: most capacity has been shut down, so there is no need for inputs or to transport finished products. Bringing capacity back online before transport is available, however, is not possible. Without feedstocks, there is nothing for chemical plants to do. However, capacity of primary inputs such as ethane is already coming on stream.

These are largely available by pipeline (for widely-used bulk liquids and gases), but there is limited capacity to store the products they might be turned into: many are hazardous materials for which appropriate storage is in limited supply. If they cannot be shipped out, only so much can be inventoried. Transportation is a priority for every aspect of Houston’s recovery, and the chemical industry will benefit along with the many others that are desperate to bring things into and out of the region.

Then the challenge of bringing plants back online begins. For an undamaged plant, this is a matter of several weeks and is not risk-free. Chemical plants are not really meant to be shut down, and even routine maintenance is disruptive, involving lost production and start-up risks. Miles of pipe work must be flushed of oxygen before volatile chemicals can be pushed through them. Pressurized reaction vessels filled with explosive mixtures must be reheated gingerly. Damaged facilities will, of course, take even longer to resume production. Downstream plants must wait for the producers of their inputs to come on stream - or arrange for delivery from elsewhere - before they can begin re-commissioning. Since shutdowns are to be avoided, unavoidable ones are often taken as an opportunity to do upgrades as well: some owners may choose to do so now, which may further delay recovery. It is unlikely that the Houston chemical complex will return to pre-Harvey production levels before mid-Q1 next year.

Industry Participants in Houston

Most major U.S. European chemical producers are affected. Upstream, the most victims include the chemical divisions of Exxon Mobil (NYSE:XOM), Royal Dutch (NYSE:RDS.A) (NYSE:RDS.B), and a joint venture between Chevron (NYSE:CVX) and Phillips (NYSE:PSX). These supply the industry’s basic building blocks. As SA author Michael Boyd points out, Westlake Chemical (NYSE:WLK), with plants 150 miles east of Houston, was out of the direct path of the storm and is still producing ethylene at its sizable Lake Charles, LA, facility.

A step further downstream, LyondellBasell (NYSE:LYB), DowDuPont (NYSE:DWDP), Ineos (privately-held) and BASF (OTCQX:BASFY) produce ethylene, too, as well as commodity plastics. The former Dow plant in Freeport is the largest chemical plant in the Western Hemisphere; du Pont had plants in six locations along the Texas coast, including one in Freeport. Olin (NYSE:OLN) and the chemical division of Occidental Petroleum (NYSE:OXY) produce considerable amounts of vinyl chloride monomer and PVC in the region.

Supplying them, and others, are all the industrial gas producers: Praxair (NYSE:PX), Air Products (NYSE:APD), Linde (OTCPK:LNEGY) and L'Air Liquide (OTCPK:AIQUY). For the most part, they are protected by take-or-pay contracts, as is Solvay’s (OTCPK:SVYZY) plant located on LyondellBasell’s Pasadena, TX, site. But this is not true for local suppliers of catalysts, plasticizers or specialties such as Arkema supplied, which include Akzo Nobel (OTCQX:AKZOY), Eastman Chemical (NYSE:EMN) and Clariant (OTCPK:CLZNY). Nor is it true for producers of some large-volume inputs, i.e., Celanese’s (NYSE:CE) methanol and vinyl acetate, Solvay’s hydrogen peroxide or the sodium hydroxide and chlorine produced by Olin and Occidental.

Still further downstream are numerous manufacturers of materials with lower volumes than the “big three” polyethylene, polypropylene and PVC. These include Goodyear (NYSE:GT) synthetic rubber, Covestro (OTCPK:CVXTY) urethanes and polycarbonates, 3M (NYSE:MMM) specialty coatings, Huntsman (NYSE:HUN) urethanes, as well as a wide array of specialty plastics from manufacturers both large, such as the former du Pont, and small, such as A. Schulman (NASDAQ:SHLM).

Another Houston area manufacture is ammonia, primarily used to produce nitrogen fertilizers. At about 30%, the area’s share of U.S. ammonia production is less than it is for petrochemicals and plastics. Recently there has been considerable investment, including a large JV between BASF and Yara (OTCPK:YARIY) that was scheduled to come on stream late this year but will now doubtless be delayed. Arkema’s Crosby site also produced ammonia.

Winners, Losers and the Unaffected

The point of this catalog is to make it clear that many of the largest U.S. and European chemical manufacturers have a Houston-area presence, and that they are remarkably inter-dependent. But it is noticeable that Asian and Middle Eastern producers are largely absent. Paint makers have not flocked to Houston, either – only PPG (NYSE:PPG) has a plant there, and it is not especially large. Makers of inorganic acids and potassium fertilizer, titanium dioxide and pigments, cellulosics, pesticides and a wide range of other chemical products for which hydrocarbons are not a primary feedstock have no special reason to locate on the Gulf Coast. They are not integrated into the Houston supply chain and, except for their energy bills, will be largely unaffected by its difficulties.

Obviously, companies that compete with Houston without themselves being significantly affected by Hurricane Harvey are the beneficiaries of others’ misfortune. Worldwide capacity utilization was fairly high before the storm, so lost supply cannot easily be replaced and prices are already spiking. I mentioned Westlake above, but Saudi, Taiwanese, Japanese, Korean and Chinese producers will all enjoy stronger pricing. Few of these companies have a U.S. quote.

The most obvious victim is LyondellBasell: its Houston operations, including its oil refinery as well as chemical production, contributed 48.8% of H1 revenue. It is remarkable that the consensus on its Q3 earnings actually increased slightly over a month ago. This surely cannot be right, and both Q3 and Q4 figures will have to be trimmed, I would suggest by at least 15%.

Dow merged with du Pont just in time to dilute the effect of the storm on DowDuPont: Houston operations have declined from being about half of Dow’s business to about 30% of DowDuPont’s. But both companies, as upstream, heavily integrated manufacturers, should be able to recover production quickly - perhaps as early as mid-October. With the merger so fresh - it only closed on September 1 - consensus estimates do not seem to be available yet, but if numbers come in that are simply the weighted sum of previous EPS estimates, they are surely too high. I would say a cut of 10% or so is probably a good place to start.

The specialty chemicals supplied to plastics and petrochemical producers are not bulky and in most cases their manufacturers can supply product from their own plants outside the region. These companies’ earnings may be only marginally affected if at all. The picture is different for producers of volume inputs such as Celanese and Olin. These operations’ ability to recover depends on their customers’ recovery. Olin’s and Occidental’s VCM/PVC businesses are the main customers of their chloralkali operations: integration which circumvents some of the industry’s inter-dependency will benefit them as it will benefit the majors. Coming at the end of the growing season, the storm’s timing was fortuitous for producers of ammonia, 80% of which is transformed into fertilizer.

The Houston chemical industry, like the Houston oil refining, will recover and thrive. Over the course of nearly a century, it has created too many advantages to abandon the location, even in the face of the Gulf’s notorious, if only occasional, weather. It is close to the primary raw materials, it is well-served by marine and rail transport, the installed capital base is irreplaceable and so is the skilled labor pool. These are the irrefutable arguments for industrial clustering. Houston simply cannot be replaced, as the chemical industry and the U.S. economy will discover over the next several months.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.