Oil Prices Crashing: Will It Hurt These Chemical Plays? - Analyst Blog - Basf (OTC:BASFY)

Oil prices have been on a freefall for some time now, causing agony for a gamut of industries. The meltdown has put several industries either directly or indirectly influenced by oil price movements on thin ice, and the roughly $5 trillion global chemical industry is no exception.

The ‘Fracking' Boom So Far

The shale gas boom in the U.S. has been a huge driving factor for chemical investment on plants and equipment in the country over the last few years. Chemical makers are currently enjoying the fruits of the abundance of low-cost North American feedstock. Affordable natural gas and ethane (derived from shale gas) has so far offered U.S. producers a compelling cost advantage over their global counterparts who use a more expensive, oil-based feedstock such as naptha.

New methods of extraction such as horizontal drilling and hydraulic fracturing (or fracking) have boosted shale production, bringing down prices of ethane (derived from shale gas) and several other key inputs for petrochemical production in the process.

Leveraging the favorable energy costs stemming from abundant natural gas supply, chemical makers including Dow Chemical (DOW), LyondellBasell Industries (LYB), ExxonMobil Chemical – a part of Exxon Mobil Corp. (XOM), DuPont (DD), BASF (BASFY), Shell Chemical – a unit of Royal Dutch Shell (RDS.A), Westlake Chemical (WLK) and Chevron Phillips Chemical – a joint venture of Chevron Corp. (CVX) and Phillips 66 (PSX) – have been ramping up investment on shale gas-linked projects.

The shale revolution, which started in 2010, made the U.S. an attractive investment hotspot and incentivized a number of chemical companies to invest billions of dollars for setting up facilities (crackers) to produce ethylene and propylene in a cost-effective way. Chemical makers such as Dow Chemical and LyondellBasell have been actively involved in building and/or expanding their cost-advantaged production capacity in the U.S.

Dow Chemical, for an example, is currently in an aggressive ethylene expansion mood. The company's world-scale ethylene cracker in Freeport, TX – which represents a major part of its roughly $4 billion U.S. Gulf Coast investments – is on schedule to come on stream in first-half 2017 and is expected to significantly contribute to its profits when in full swing.

LyondellBasell also remains on track with its ethylene expansion projects. The company's multi-plant ethylene expansion program represents a total investment of roughly $1.3 billion across its Channelview, La Porte and Corpus Christi facilities in Texas which benefit from shale gas production. The expansion program, when in full operation, is expected to expand its annual ethylene capacity by an estimated 1.85 billion pounds in North America with potential for further expansion to 2.4 billion pounds.

According to a recent American Chemistry Council (ACC) report, domestic chemical investment related to share gas has reached as high as $135 billion, most of which are from firms outside of the U.S. Already over 215 projects – many backed by Federal government support – have been announced by chemical makers to take advantage of ample natural gas supplies. Such investments have been aimed at boosting capacity and export over the next several years.

But Oil Plunge Spoiling the Party

The recent slump in oil prices has created a layer of uncertainty regarding the sustainability of this shale-derived feedstock cost advantage. West Texas Intermediate crude recently nosedived to below the $60 per barrel threshold for the first time since Jul 2009 on supply gut. In fact, West Texas crude slipped to $53.60 a barrel on Dec 16, the weakest level since May 2009.

Brent crude followed suit and tumbled to $58.50, also the lowest since May 2009. Both Brent crude and West Texas crude have plummeted to fresh five-year lows as oil cartel OPEC remains firm on its decision not to reduce production and keep its output target at 30 million barrels per day. Oil prices have roughly halved over the past six months as increased supply outweighed demand.

The southern march of oil prices have casted a spell of uncertainty over shale gas production and the economic viability of these projects. Plunging oil prices have raised concerns regarding the profitability of North American shale producers given the fact that fracking is way more expensive that traditional oil drilling.

These shale drillers have taken significant amount of debt in the high-yield junk bond market to run their operations. As such, falling oil prices have placed these producers at risk of losing money and put a question on their debt service capability. This might, in turn, trigger a cut in their investments and eventually reduce shale gas production.

Crashing oil prices have also pulled down the share prices of chemical stocks that have significant shale exposure in the U.S. Dow Chemical and LyondellBasell are among the stocks that have seen their stocks prices head south along with crude oil prices.

The Murky Road Ahead

A potential curtail in shale production due to the oil price slump could eventually erode the feedstock cost advantage that is so far enjoyed by the companies operating crackers in the U.S. over the European and Asian chemical makers (running crackers based on oil-derived naptha) who are now better placed to gain from the plunge.

This may lead to elevated costs for chemical makers that are building capacity in the U.S. and compress their margins in the process. Adding to the pain, descending crude oil is also expected to impact chemical prices across the board as they essentially move in tandem with oil prices.

However, it remains to be seen whether the shale bubble will eventually burst and put these chemical stocks in jeopardy. Only time will tell.

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Oil Prices Crashing: Will It Hurt These Chemical Plays? - Analyst Blog

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