HSBC What Price is Right

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HSBC outlook for chemical feedstocks in the Middle East

Transcript of HSBC What Price is Right

Natural Resources & Energy/Middle East Chemicals - Equity January 2011

What price is right?Re-evaluating the feedstock price environmentFeedstock pricing changes likely to be announced in 2011. We expect this decision to be influenced by a combination of both economic and policy factors, and we forecast a phased increase that does not fundamentally alter the competitive position of the industry The impact on margins from these feedstock price increases is highest for companies with the biggest cost advantages (eg SAFCO), while those with lower cost advantages and margins (eg SABIC) are least affected. The increase in HSBC's energy price forecasts however, outweighs the impact of higher feedstock costs Yet despite generally raising our target prices, we are cautious on the sector for 2011 given recent strong performance, elevated expectations and high valuations. Our top picks in the sector are Tasnee (OW(V), TPSAR44), Yansab (OW(V), TP SAR65) and SABIC (OW(V), TP SAR130). We downgrade Petrochem (TP SAR25) and Sahara (TP SAR25) to N(V) from OW(V) and Industries Qatar (TP QAR135) to UW from N

By Sriharsha Pappu and Tareq Alarifi

Disclosures and Disclaimer This report must be read with the disclosures and analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

Natural Resources and Energy Middle East Chemicals January 2011


SummaryWe expect to see a change in the feedstock pricing regime in 2011. We believe this will be influenced by a combination of both economic and policy factors and we are factoring in a phased increase in prices that does not fundamentally alter the competitive position of the industry. The increase in HSBC's energy price forecasts however, outweighs the impact of higher feedstock costs.

The feedstock pricing questionPricing revision topical in 2011In the wake of constrained gas supply, multiple competing uses and a burgeoning cost advantage, there are serious questions being raised about the feasibility of continuing with the current gas pricing regime within Saudi Arabia. The view gaining traction among industry participants is that some form of modification to the pricing framework is required both as an incentive for companies to provide new gas supply and to ensure a more efficient distribution of limited gas resources. This discussion is particularly relevant today as some of the feedstock formulae particularly for liquids run only until 2011, which means a new pricing benchmark, at least for liquids, will need to be approved before the end of the year. We believe that a new gas pricing framework will be approved at the same time, and therefore that a change in the feedstock price environment is imminent.

A combination of economics and policyIn our opinion, any change to the feedstock pricing regime will be driven by a combination of economic and policy factors. The economic argument based on incentives for supply growth, efficient allocation of scarce resources and demand rationalisation would call for Saudi gas prices to reflect global levels of USD4-5/mmbtu vs. the current price of USD0.75/mmbtu. However, an increase of this magnitude would deliver a significant economic blow to the industry which would run counter to the key policy objective of driving downstream chemical investment and generating employment. We believe that policymakers will work to ensure that feedstock price increases take place in a manner so as not to shock the industry or dramatically alter its competitive dynamic. We also believe that policy makers will be just as conservative with their underlying energy price assumptions while assessing the competitiveness of the petrochemical industry as they are while setting their annual budgets. We are raising our estimates for Saudi gas and ethane equivalent prices from the current USD0.75/mmbtu to USD2.0/mmbtu by 2015. We expect that this increase will take place in a phased manner, with prices rising first to USD1.25/mmbtu by 2012 and in a staged manner thereafter (see table below). We also assume that the liquids discount will decline by 1ppt each year from the current 28% before being fixed at 25% by 2014.


Natural Resources and Energy Middle East Chemicals January 2011


In terms of margins, the rule of thumb is that companies with the biggest cost advantages and the highest margins (eg SAFCO) are impacted more by an increase in feedstock prices than companies with lower cost advantages and margins (eg SABIC). Our oil and gas team has increased its energy price forecasts for 2011-15 by around 10% which has resulted in an increase in our product pricing estimates. In most cases, the impact from higher product pricing outweighs the impact of higher feedstock costs.

Sector investment thesisPeak conditions to return by 2013/14, market likely to remain balanced in 2011Rising emerging market demand and limited supply growth will create an environment of higher capacity utilisation rates. Based on our supply assumptions and HSBC Economics global economic growth forecasts, we expect to see a return to peak conditions (utilisation rates of over 90%) within the commodity chemical sector by 2013/14. However, while we are bullish on the sector in the medium term, we believe that in the near term supply growth in 2011 could potentially come in above expectations. We expect incremental supply from existing plants to match demand growth for the year as improving macroeconomic conditions ease some of the bottlenecks (in terms of feedstock supply) that resulted in a tight market in 2010. This should be particularly true for European cracker operating rates, which are tied to operating rates at refineries in the region. An improving macro environment in Europe should lead to higher ethylene supply on greater naphtha availability from refineries. Furthermore, higher oil-product demand and higher oil prices could lead to an increase in OPEC production quotas which would make more associated gas available, particularly in Saudi Arabia, and result in an incremental increase in operating rates at newer crackers which we estimate are currently running on average at 80% owing to feedstock supply constraints. In both these cases, incremental supply would materialise from existing capacity only if demand growth continued to be strong and hence should not result in a big dip in utilisation rates due to an oversupply situation. However, this incremental supply would, in the short term, prevent a sharp rise in utilisation rates. We forecast ethylene utilisation rates to improve by only 70bps in 2011 over 2010 levels.

Cautious on sector performance in 2011We believe that after two years of exceptional stock market performance from the Middle East chemical sector with stocks on average up 47% in 2009 and 24% in 2010, it is time to take a more cautious view on the sector in 2011. Our cautious stance on performance is based on by high valuations and elevated consensus expectations. Middle East chemical sector valuations are now above mid-cycle levels, with stocks trading on average on a 15.6x forward PE versus the historical sector median forward multiple of 14x. While fundamentals are healthy, these appear to be already factored into share prices and we think it it is unlikely that in 2011 the sector will generate the same level of returns seen in 2009/10.

HSBC Saudi feedstock pricing assumptions 2011e Gas price (USD/mmbtu), New Gas price (USD/mmbtu), Old % Propane Discount, New % Propane Discount, OldSource: HSBC estimates

2012e 1.25 0.75 27% 28%

2013e 1.50 0.75 26% 28%

2014e 2.00 0.75 25% 28%

2015e 2.00 0.75 25% 28%

0.75 0.75 28% 28%


Natural Resources and Energy Middle East Chemicals January 2011


Consensus expectations for chemical company earnings in 2011 also fully reflect the recovery in fundamentals in our opinion. Sector outperformance will require reported earnings to beat estimates significantly, which we believe they will struggle to do given that current 2011 EPS consensus estimates for the Middle East chemicals sector are on average 45% higher than they were a year ago.We prefer stocks with structural pricing drivers Tasnee and Yansab

Our favoured plays within the Middle East petrochemical sector for 2011 are Tasnee, Yansab and SABIC. Tasnee and Yansab have strong price momentum within important product chains (TiO2 for Tasnee and MEG for Yansab) which is being driven by structural factors. SABIC has significant operating leverage to improving fundamentals at its acquired GE Plastics business. The business at its peak had EBITDA of USD1bn, and we expect a return to close to peak profitability by the end of 2011from levels of cUSD200m in EBITDA in 2010e. SABIC also has volume leverage from the expected commercial start up of Kayan towards H2 2011. Kayan is by far the single largest plant SABIC has ever built and should drive revenue and profit growth y-o-y for SABIC in 2011. For Tasnee, we believe that the TiO2 market will remain undersupplied well into 2012 given the lead times for adding new capacity. We therefore predict 12-18 months of strong pricing power within the TiO2 segment. This segment constitutes 35% of Tasnees earnings and will be a key contributor to the companys earnings in 2011. For more details, see our 1 November 2010 report on Tasnee, Painting a stronger picture. Yansab is a key beneficiary of the record levels of cotton prices cotton and polyester are both used in the textile industry and large price differences between the two often provide a catalyst for substitution. The current price delta between cotton and polyester fibre stands at USD1,780/tonne over 5.2x the average of the differential between 2000 and 2009 which should spur greater polyester demand. This substitution demand drives pricing