Oil Refining/Chemicals

Transcription

1 Weak oil prices offer chance to buy chemical stocks on the cheap Neutral/Overweight (Maintain) Sector Update December 16, 214 Daewoo Securities Co., Ltd. [] Yeon-ju Park Young-jee Bae Q14F earnings contraction to be worse than projected due to oil price collapse Oil prices have fallen more sharply than expected, suggesting 4Q oil refining and chemical earnings will be even worse than previously projected. Refiners are likely to be hit with massive inventory valuation losses and negative lag effects (i.e., the input of previously purchased high-priced oil amid falling product prices). Chemical firms are anticipated to suffer extreme negative lag effects as well, as they typically use naphtha 6 to 9 days after purchase. Now the key issue is when, and at what level, oil prices will stop falling. Oil prices likely to recover after 2Q15 Despite the recent plunge in oil prices, US shale oil production has continued to increase. With regard to oil wells for which initial investments have already been completed, it is still economical to continue production so long as prices remain above the direct cost of drilling. E&P companies, meanwhile, are minimizing their losses by curtailing new exploration activities and focusing on production at more profitable fields. With oil prices already down to the US$5/bbl level, however, it makes little sense for US shale oil companies to keep producing at the same rate as before. Indeed, we are seeing clear signs of change on the supply side. In North Dakota, the number of drilling permits issued has dropped 3% MoM in November (-1% MoM adjusting for actual working days). The oil and gas giant ConocoPhillips has announced that it will cut its capex by 2% YoY in 215. We see a strong possibility of oil prices recovering after 2Q15, as US oil output adjustments should get fully underway in 2Q15, and oil demand is expected to seasonally pick up in 2H15. Investment strategy: Lotte Chemical remains our top pick Historically speaking, oil refining and chemical stocks have rarely outperformed the market when oil prices have been in decline. However, we believe oil prices have overshot to the downside and will likely pick up after 2Q15. In our view, falling oil prices provide a good opportunity to buy chemical stocks on the cheap. Weak oil prices should ultimately boost the competitiveness of chemical firms and curb capex by non-naphtha-based competitors, supporting an ethylene up cycle. We believe Lotte Chemical (Buy/TP: W2,) will see the fastest earnings growth once oil prices stabilize given the tight markets of its key products, ethylene and monoethylene glycol (MEG). Crude oil prices to pick up after 2Q15 on US output adjustments and seasonal strength 12 1 WTI Brent (1H15) - Continued US crude output growth - Limited demand growth Persistent excess supply (2H15) - US output adjustments - Demand recovery (seasonal) - OPEC production cuts Oversupply to ease /14 1/14 1/15 4/15 7/15 1/15 1/16 Source: KDB Daewoo Securities Analysts who prepared this report are registered as research analysts in Korea but not in any other jurisdiction, including the t U.S. PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES & DISCLAIMERS IN APPENDIX 1 AT THE END OF REPORT.

2 December 16, QF earnings contraction to be worse than projected due to oil price collapse Oil prices have fallen more sharply than expected, suggesting 4Q oil refining and chemical earnings will be even worse than previously projected. Refiners are likely to be hit with massive inventory valuation losses and negative lag effects. Since refiners hold inventories of 1,-2, bbl on average, a US$1/bbl drop in oil prices is estimated to lead to inventory valuation losses of W1-2bn. Furthermore, refiners should also experience negative lag effects amid falling oil prices, as they calculate their input costs by averaging oil prices for the current and previous months. If the current oil price level persists through year-end, the average Dubai crude price from September to December is likely to be US$32bbl/day. Meanwhile, won weakness against the US dollar, improving refining margins, and falling official selling price (OSP) are positive for operating profit. A US$1/bbl rise in refining margins or OSP is estimated to drive up quarterly operating profit by W5-8bn. And a rise of 1 in the US$/W rate should increase operating profit by W3-5bn. However, won deprecation is also likely to lead to F/X translation losses (arising from US dollar-dominated debt), outweighing any positive effects on earnings. As such, overall, earnings are likely to fall below the market consensus. While chemical firms are anticipated to suffer only modest inventory valuation losses, they are likely to be hurt by extreme negative lag, as they typically use naphtha 6 to 9 days after purchase. Figure 1. Crude oil price declines lead to inventory valuation losses Figure 2. Refining margins have improved, but negative n lag effect remains a drag Dubai crude (L) US$/W (R) 1,18 1,15 1, Korea complex refining margin Korea complex refining margin (lagging) 9 8 1, ,6 1,3 5 1/13 7/13 1/14 7/14 1/15 Source: Petronet, 1, -5 1/13 7/13 1/14 7/14 1/15 Source: Figure 3. Falling OSP positive for refiners earnings Figure 4. ABS spread treads: Negative lag effect hurting chemical companies 5 4 Asian OSP ($) 8 ABS spread ABS spread (-1.5M) Source: Bloomberg, Source: Cischem, 2

3 December 16, Oil prices likely to recover after 2Q15 Now the key issue is when, and at what level, oil prices will stop falling. We projected oil prices to remain at the US$7/bbl in the medium term, as we had expected US oil production to decrease amid falling oil prices given high shale oil production costs. However, US crude oil production has increased by 6, bbl/day MoM in December. The US Energy Information Administration (EIA) estimates that US crude oil production will further increase by 1, bbl/day MoM in January. The oil price downtrend has sharply depressed shale oil producers margins. However, US shale oil production has continued to increase. With regard to oil wells for which initial investments have already been completed, it is still economical to continue production so long as prices remain above the direct cost of drilling. E&P companies, meanwhile, are minimizing their losses by curtailing new exploration activities and focusing on production at more profitable fields. During 28-9 amid the global financial crisis, the WTI price turned downward after peaking in July 28. However, both the number of drilling permits and crude oil output remained on the rise until the WTI price fell below US$57/bbl in November. With oil prices already down to the US$5/bbl level, however, it makes little sense for US shale oil companies to keep producing at the same rate as before. A decline in exploration activities should lead to a slowdown in output growth with some time lag. Figure 5. Crude oil prices should pick up after 2Q15 on US output adjustments and seasonality 12 1 WTI Brent (1H15) - Continued US crude output growth - Limited demand growth Persistent excess supply (2H15) - US output adjustments - Demand recovery (seasonal) - OPEC production cuts Oversupply to ease /14 1/14 1/15 4/15 7/15 1/15 1/16 Source: Figure 6. Drilling and production activities in North Dakota during the 28 global crisis Source: EIA, 3

4 December 16, 214 Indeed, we are seeing clear signs of change on the supply side. In North Dakota, the number of drilling permits issued has dropped 3% MoM in November (-1% MoM adjusting for actual working days). We note that, in 28, the number of drilling permits began to decline about three months after the WTI turned downward. With regard to shale oil, the downtrend in oil prices is depressing drilling activity (due to higher production costs). The oil and gas giant ConocoPhillips has announced that it will cut its capex by 2% YoY in 215. US shale oil field service firms share prices are nose-diving. The EIA revised down its forecast for 215 US crude oil production growth from 9, bbl/day to 7, bbl/day. The agency projects oil output to decrease sharply in 2H with production growth falling by 14, bbl/day in 3Q and 27, bbl/day in 4Q. In light of forecasts for global oil demand growth of 9,-1.2mn bbl/day for 215, a fall in US supply growth should push global supply and demand toward more balanced levels. Historically, crude oil demand has risen in the second half of the year. Thus, we see a strong possibility of oil prices recovering after 2Q15, as US oil output adjustments should get fully underway in 2Q15, and oil demand is expected to seasonally pick up in 2H15. Figure 7. Number of drillid rilling permits issued in North Dakota decreased in November Figure 8. US shale oil service provider shares have plunged (-2Y=1) 4 3 Concho Resources Sanchez Energy Goodrich Petroleum /12 6/13 12/13 6/14 12/14 6/15 Source: EIA, Figure 9. ConocoPhillips, reportedly the most cost-competitive competitive shale oil producer, plans to cut capex by 2% in 215 Source: Datastream, Figure 1. Crude oil demand shows seasonal increase in 2H (mn bbl/day) Q14 2Q14 3Q14 4Q14F 1Q15F 2Q15F 3Q15F 4Q15F Source: Company data, Source: IEA, 4

5 December 16, Strategy: Lotte Chemical remains our top pick Historically speaking, oil refining and chemical stocks have rarely outperformed the market when oil prices have been in decline due to short-term inventory valuation losses. However, we believe oil prices have overshot to the downside and will likely pick up after 2Q15. In our view, falling oil prices provide a good opportunity to buy chemical stocks on the cheap. Weak oil prices should ultimately boost the competitiveness of chemical firms and curb capex by non-naphtha-based competitors, supporting an ethylene up cycle. In the chemical segment, we are most bullish on Lotte Chemical, followed by Kumho Petrochemical and LG Chem. We believe Lotte Chemical will see the fastest earnings growth once oil prices stabilize given the tight markets of its key products, ethylene and MEG. The company s 4Q results are highly likely to come in weaker than anticipated, hurt by declining oil and chemical prices as well as a negative lag effect. If polyethylene (PE) prices plunge during the last two weeks of December, Lotte Chemical Titan (a subsidiary) might incur valuation losses on naphtha inventories. However, once oil prices stabilize, 1Q earnings should improve dramatically on the back of widened spreads for PE and MEG (based on spot prices). As the prices of certain chemical products in tight supply (e.g., MEG) are declining less sharply than naphtha prices, their spreads are widening. At first glance, this improvement might seem temporary. However, it should be noted that, in the past, spreads have not necessarily improved when oil prices have dropped. (For example, when oil prices have plummeted amid economic slumps, MEG margins have contracted.) As such, we attribute the widening of spreads amid falling oil prices to tight supply conditions. Over the medium to long term, if naphtha prices stay low, Asian naphtha crackers could see improved competitiveness. In addition, the ethylene up cycle could last longer than expected, as investments in Chinese coal-to-chemicals and US ethane crackers could contract. Under the current oil and naphtha price levels, the cost competitiveness of Asian naphtha crackers has become stronger than that of Chinese coal-to-chemical facilities, and is quickly catching up with that of US ethane crackers. Figure 11. Ethylene cost curve: Asian NCCs have gained cost competitiveness on falling crude oil prices Figure 12. MEG-naphtha spread has widened amid falling naphtha prices Ethylene production costs Transportation costs Low utilization Asian NCC Drop in oil/naphtha prices By-product value (US$/tonne) 1,5 1,2 9 Naphtha price (L) Spread (R) (US$/tonne) Rise in ethane price China CTO US ECC Cumlativeethylene capacity Notes: ECC = ethane cracking center; CTO = coal-to-olefins; NCC = naphtha cracking center Source: Source: Cischem, 5

6 December 16, 214 Kumho Petrochemical (Buy/TP: W1,) is anticipated to see its earnings improve, aided by: 1) the slow but steady recovery of the synthetic rubber market and 2) energy unit capacity rampups in 216. Natural rubber prices plunged after peaking in 211 due to oversupply, but the pace of decline has slowed since prices fell below US$1,5/tonne. Indeed, below that level, tapping and collection expenses, which account for 6% of production costs, can barely be covered. The pace of decline in butadiene prices has slowed (as has the downtrend in natural rubber prices), causing its spread with naphtha to widen. Butadiene supply is projected to increase at a much slower rate in 215 and beyond, which should lead to improvement in the supply and demand situation over the next couple of years. Synthetic rubber supply growth is also anticipated to slow. LG Chem (Buy/TP: W3,) is expected to experience strong upward momentum (relative to its peers) in 2H15. EV battery sales have been weak in 4Q14, but should increase on the back of new EV model launches next year. Nevertheless, losses will likely persist in 215. Share price momentum is projected to recover in 2H15 when EV battery sales start to expand full swing. We see limited downside risks to oil refining stocks now. However, shares are unlikely to recover quickly until oil prices and refining margins start to show meaningful rebounds in 2H15. Refining margins have improved recently, but any structural recovery will require a rise in capacity utilization on the back of demand growth; in our view, a turnaround is unlikely to take place until 2H15 (or later). We favor SK Innovation (Buy/TP: W11,) in the refining sector, as its earnings should increase on capacity expansion. Figure 13. Natural and synthetic rubber prices Figure 14. Butadiene supply and demand forecasts (US$/tonne) 2,5 2, SBR - butadiene (R) Butadiene (L) (US$/tonne) SBR (L) 8 Natural rubber (L) 7 6 (' tonnes) 1,4 1,2 1, 8 Butane dehydrogenation By-products Demand increase 1, , /14 4/14 7/14 1/ F 15F 16F 17F 18F 19F Source: Platts, Source: Industry data, Figure 15. Chevrolet Volt sales Figure 16. US$/W and JPY1 1/W (units) 4, Chevrolet Volt 1,3 JPY1/W US$/W 3, 1,2 2, 1,1 1, 1, /13 7/13 1/14 7/14 1/15 7/15 Source: Ward s Auto, Source: 6

7 December 16, 214 APPENDIX 1 Important Disclosures & Disclaimers 2-Year Rating and Target Price History Company (Code) Date Rating Target Price Company (Code) Date Rating Target Price Lotte Chemical(1117) 11/1/214 Buy 2, 4/21/213 Buy 2, 1/26/214 Buy 16, 1/22/213 Buy 22, 1/5/214 Buy 19, 12/1/212 Buy 2, 4/28/214 Buy 22, Kumho Petrochemical(1178) 11/2/214 Buy 1, 3/24/214 Buy 24, 1/5/214 Trading Buy 9, 2/5/214 Buy 26, 1/22/214 Trading Buy 1, 1/14/213 Buy 28, 1/14/213 Trading Buy 12, 1/22/213 Hold - 12/1/212 Hold - No Coverage LG Chem(5191) 1/2/214 Buy 3, SK Innovation(9677) 1/28/214 Buy 11, 1/5/214 Buy 33, 1/5/214 Buy 12, 7/2/214 Buy 35, 6/24/214 Buy 14, 3/24/214 Buy 33, 4/8/214 Buy 16, 1/27/214 Buy 35, 2/4/214 Buy 18, 9/4/213 Buy 38, 1/7/214 Buy 2, 4/21/213 Buy 32, 7/28/213 Buy 22, 12/1/212 Buy 38, (W) 3, Lotte Chemical (W) 25, SK Innovation (W) 15, Kumho Petrochemical (W) 4, LG Chem 25, 2, 15, 1, 5, 2, 15, 1, 5, 1, 5, 3, 2, 1, Dec 12 Dec 13 Dec 14 Dec 12 Dec 13 Dec 14 Dec 12 Dec 13 Dec 14 Dec 12 Dec 13 Dec 14 Stock Ratings Industry Ratings Buy : Relative performance of 2% or greater Overweight : Fundamentals are favorable or improving Trading Buy : Relative performance of 1% or greater, but with volatility Neutral : Fundamentals are steady without any material changes Hold : Relative performance of -1% and 1% Underweight : Fundamentals are unfavorable or worsening Sell : Relative performance of -1% Ratings and Target Price History (Share price ( ), Target price ( ), Not covered ( ), Buy ( ), Trading Buy ( ), Hold ( ), Sell ( )) * Our investment rating is a guide to the relative return of the stock versus the market over the next 12 months. * Although it is not part of the official ratings at Daewoo Securities, we may call a trading opportunity in case there is a technical or short-term material development. * The target price was determined by the research analyst through valuation methods discussed in this report, in part based on the analyst s estimate of future earnings. * The achievement of the target price may be impeded by risks related to the subject securities and companies, as well as general market and economic conditions. Disclosures As of the publication date, Daewoo Securities Co., Ltd. issued equity-linked warrants with Lotte Chemical, LG Chem, SK Innovation as an underlying asset, and other than this, Daewoo Securities has no other special interests in the covered companies. As of the publication date, Daewoo Securities Co., Ltd. has acted as a liquidity provider for single stock futures backed by shares of Lotte Chemical, SK Innovation as an underlying asset, and other than this, Daewoo Securities has no other special interests in the covered companies. As of the publication date, Daewoo Securities Co., Ltd. has acted as a liquidity provider for equity-linked warrants backed by shares of LG Chem, SK Innovation as an underlying asset, and other than this, Daewoo Securities has no other special interests in the covered companies. Analyst Certification The research analysts who prepared this report (the Analysts ) are registered with the Korea Financial Investment Association and are subject to Korean securities regulations. They are neither registered as research analysts in any other jurisdiction nor subject to the laws and regulations thereof. Opinions expressed in this publication about the subject securities and companies accurately reflect the personal views of the Analysts primarily responsible for this report. Daewoo Securities Co., Ltd. policy prohibits its Analysts and members of their households from owning securities of any company in the Analyst s area of coverage, and the Analysts do not serve as an officer, director or advisory board member of the subject companies. Except as otherwise specified herein, the Analysts have not received any compensation or any other benefits from the subject companies in the past 12 months and have not been promised the same in connection with this report. No part of the compensation of the Analysts was, is, or will be directly or indirectly related to the specific recommendations or views contained in this report but, like all employees of Daewoo Securities, the Analysts receive compensation that is impacted by overall firm profitability, which includes revenues from, among other business units, the institutional equities, investment banking, proprietary trading and private client division. At the time of publication of this report, the Analysts do not know or have reason to know of any actual, material conflict of interest of the Analyst or Daewoo Securities Co., Ltd. except as otherwise stated herein. Disclaimers 7

8 December 16, 214 This report is published by Daewoo Securities Co., Ltd. ( Daewoo ), a broker-dealer registered in the Republic of Korea and a member of the Korea Exchange. Information and opinions contained herein have been compiled from sources believed to be reliable and in good faith, but such information has not been independently verified and Daewoo makes no guarantee, representation or warranty, express or implied, as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein or of any translation into English from the Korean language. If this report is an English translation of a report prepared in the Korean language, the original Korean language report may have been made available to investors in advance of this report. Daewoo, its affiliates and their directors, officers, employees and agents do not accept any liability for any loss arising from the use hereof. This report is for general information purposes only and it is not and should not be construed as an offer or a solicitation of an offer to effect transactions in any securities or other financial instruments. The intended recipients of this report are sophisticated institutional investors who have substantial knowledge of the local business environment, its common practices, laws and accounting principles and no person whose receipt or use of this report would violate any laws and regulations or subject Daewoo and its affiliates to registration or licensing requirements in any jurisdiction should receive or make any use hereof. Information and opinions contained herein are subject to change without notice and no part of this document may be copied or reproduced in any manner or form or redistributed or published, in whole or in part, without the prior written consent of Daewoo. Daewoo, its affiliates and their directors, officers, employees and agents may have long or short positions in any of the subject securities at any time and may make a purchase or sale, or offer to make a purchase or sale, of any such securities or other financial instruments from time to time in the open market or otherwise, in each case either as principals or agents. Daewoo and its affiliates may have had, or may be expecting to enter into, business relationships with the subject companies to provide investment banking, market-making or other financial services as are permitted under applicable laws and regulations. The price and value of the investments referred to in this report and the income from them may go down as well as up, and investors may realize losses on any investments. Past performance is not a guide to future performance. Future returns are not guaranteed, and a loss of original capital may occur. Distribution United Kingdom: This report is being distributed by Daewoo Securities (Europe) Ltd. in the United Kingdom only to (i) investment professionals falling within Article 19(5) of the Financial Services and Markets Act 2 (Financial Promotion) Order 25 (the Order ), and (ii) high net worth companies and other persons to whom it may lawfully be communicated, falling within Article 49(2)(A) to (E) of the Order (all such persons together being referred to as Relevant Persons ). This report is directed only at Relevant Persons. Any person who is not a Relevant Person should not act or rely on this report or any of its contents. United States: This report is distributed in the U.S. by Daewoo Securities (America) Inc., a member of FINRA/SIPC, and is only intended for major institutional investors as defined in Rule 15a-6(b)(4) under the U.S. Securities Exchange Act of All U.S. persons that receive this document by their acceptance thereof represent and warrant that they are a major institutional investor and have not received this report under any express or implied understanding that they will direct commission income to Daewoo or its affiliates. Any U.S. recipient of this document wishing to effect a transaction in any securities discussed herein should contact and place orders with Daewoo Securities (America) Inc., which accepts responsibility for the contents of this report in the U.S. The securities described in this report may not have been registered under the U.S. Securities Act of 1933, as amended, and, in such case, may not be offered or sold in the U.S. or to U.S. persons absent registration or an applicable exemption from the registration requirements. Hong Kong: This document has been approved for distribution in Hong Kong by Daewoo Securities (Hong Kong) Ltd., which is regulated by the Hong Kong Securities and Futures Commission. The contents of this report have not been reviewed by any regulatory authority in Hong Kong. This report is for distribution only to professional investors within the meaning of Part I of Schedule 1 to the Securities and Futures Ordinance of Hong Kong (Cap. 571, Laws of Hong Kong) and any rules made thereunder and may not be redistributed in whole or in part in Hong Kong to any person. All Other Jurisdictions: Customers in all other countries who wish to effect a transaction in any securities referenced in this report should contact Daewoo or its affiliates only if distribution to or use by such customer of this report would not violate applicable laws and regulations and not subject Daewoo and its affiliates to any registration or licensing requirement within such jurisdiction. KDB Daewoo Securities International Network Daewoo Securities Co. Ltd. (Seoul) Daewoo Securities (Hong Kong) Ltd. Daewoo Securities (America) Inc. Head Office 34-3 Yeouido-dong, Yeongdeungpo-gu Seoul Korea Two International Finance Centre Suites Finance Street, Central Hong Kong, China 32 Park Avenue 31st Floor New York, NY 122 United States Tel: Tel: Tel: Daewoo Securities (Europe) Ltd. Daewoo Securities (Singapore) Pte. Ltd. Tokyo Branch 41st Floor, Tower Old Broad St. London EC2N 1HQ United Kingdom Six Battery Road #11-1 Singapore, th Floor, Yusen Building Marunouchi, Chiyoda-ku Tokyo 1-5 Japan Tel: Tel: Tel: Beijing Representative Office Shanghai Representative Office Ho Chi Minh Representative Office 241A, 24th Floor, East Tower, Twin Towers B-12 Jianguomenwai Avenue Chaoyang District, Beijing 122 China Room 38T31, 38F SWFC 1 Century Avenue Pudong New Area, Shanghai 212 China Suite 213, Saigon Trade Center 37 Ton Duc Thang St, Dist. 1, Ho Chi Minh City, Vietnam Tel: Tel: Tel: Daewoo Investment Advisory (Beijing) Co., Ltd. 241B, 24th Floor, East Tower, Twin Towers B-12 Jianguomenwai Avenue, Chaoyang District, Beijing 122 China Daewoo Securities (Mongolia) LLC #46, Blue Sky Tower, Peace Avenue 17 1 Khoroo, Sukhbaatar District Ulaanbaatar 1424 Mongolia PT. Daewoo Securities Indonesia Tel: Tel: Tel: Equity Tower Building Lt.5 Sudirman Central Business District Jl. Jendral Sudirman Kav , Jakarta Selatan Indonesia