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Why Chemical Makers Love Cheap Natural Gas

America’s shale revolution and abundance of natural gas isn’t affecting only E&P companies. A whole host of winners and losers are starting to form along the value chain.

However, while producers such as Chesapeake Energy (NYSE:CHK) suffer in the wake of historically low prices, companies that use natural gas as a feedstock are thriving. Margins at U.S. chemical companies are at their highest in years due to the glut of natural gas. New factories are being planned, and current ones are running at full capacity.

With natural gas prices poised to stay low for quite a while, the chemical sector represents an interesting growth play on the fuel’s current status.

 Plentiful Sources & Low Prices Through 2012

U.S. chemical companies are certainly smiling in the face of lower natural gas prices. Aside from the fuel, the shale boom has also produced an abundance of natural-gas liquids (NGL) derived from these wells.

Produced alongside natural gas, ethane is a vial feedstock for the sector. The NGL is sent through a refining process and “cracked” in similar fashion to crude oil to produce one of most basic of commodity chemicals, ethylene. Ethylene is key component in plastic, paint, glue and other products. After rising throughout 2011, prices for ethane have plummeted 39% so far in 2012.

With natural gas prices dropping nearly 50% over the last three years, American chemical stocks are enjoying a large cost advantage over their European rivals. While prices for natural gas may have drifted lower, a variety of factors have pushed oil prices higher.

That’s important because most European and Asian chemical manufacturers use oil-derived naphtha to make ethylene. That disparity in feedstock makes a huge difference in price margins. With ethane prices currently around 70 cents a gallon, it costs U.S. producers about $730 to make a ton of ethylene, while manufacturers that use naphtha to make polyethylene are paying nearly $1,250 a ton.

On the flipside, both demand and prices for ethylene is growing exponentially. As the emerging world continues to modernize, utilization rates for the commodity chemical are forecasted to grow to 90% by 2013, up from 84% in 2009.

Spot prices for ethylene are also poised to rise as higher production costs in Europe and Asia are passed on to end users. By using natural gas as feedstock for their “crackers,” U.S. producers are able to take advantage of high global ethylene prices at significant profit margins. Adding insult to foreign rivals’ injury, U.S. chemical manufacturers can take advantage of cheap natural-gas-fired electricity to run their refining operations.

These juicy margins have spurred a frenzy to build new chemical plants across the country.

Giant Dow Chemical (NYSE:DOW) plans to spend nearly $4 billion over the next five years to take advantage of low natural gas prices. Every 10-cent drop in the cost of ethane boosts Dow’s earnings by nearly $200 million.

Analysts estimate that the current glut of ethane could last until 2017. That means there’s plenty of room for multiple crackers to be built in the U.S. and still be profitable. Helping to feed that glut is a new wave of ethane-dedicated pipelines from companies such as Enterprise Products Partners (NYSE:EPD). Pipeline and processing capacity is estimated to rise by more than double actual ethane demand. This will help keep prices in the basement for some time.

Playing the Sector’s Fortunes

Given the spread between ethane and ethylene, the U.S. chemical sector is a great way to play the abundance of natural gas. While major producers such as Dow and LyondellBasell (NYSE:LYB) will see great benefits from the spread, mid-cap Westlake Chemical (NYSE:WLK) could be a better bet. The vinyl and plastics maker offers a more leveraged play on the pricing difference.

Analysts at Goldman Sachs (NYSE:GS) estimate that for every penny drop in ethane prices, Westlake’s earnings per share jumps by 9 cents. Overall, the investment bank expects Westlake to earn $7 a share this year, or nearly 32% more than analysts’ average estimates.

That’s certainly possible. Last year’s rise in ethane prices caused Westlake to miss fourth-quarter profit estimates by 69%. This was the first time the company had missed analysts’ expectations in more than seven quarters. However, with ethane feedstock prices continuing to drift lower, Westlake is in a prime position to profit from the drop. The margin leverage works both ways. The earnings miss sent shares of the chemical maker downward, so they’re now are fairly valued at a forward P-E of11.36.

While natural-gas producers continue to struggle with historically low prices, the U.S. chemical sector is seeing big results. For investors, shares of Westlake offer a great direct way to play the ethane/ethylene spread and overall low natural gas prices.

Article printed from InvestorPlace Media, https://investorplace.com/2012/03/why-chemical-makers-love-cheap-natural-gas/.

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