Demand-Driven Cycle Begins


Freight rate and volume signals recovering demand; chemical upcycle begins

Previously we commented about the refining/chemical sector entering a demand-driven cycle rather than supply-driven cycle. What investors want to know is by what indicators can we be certain that demand is improving. To answer that question, we suggest looking at the recent recovery of freight rates and volume, both at sea and in the air. In our view, freight rates and volume are the most accurate indicators of real demand. We believe the recovery of such indicators and fiscal expansion in many countries will fuel demand for chemical products and widen spreads.

1Q17 to be inflection point of oil prices; better prepare for upside risks rather than downside risks

February will reveal how much OPEC and non-OPEC countries have cut oil production. Oil prices are likely to respond sensitively to this data, and accordingly, we believe many countries are moving to execute production cut plans. Furthermore, looking at the continued upward revisions for crude oil demand estimates, we expect oil prices to move gradually upward.

NCC and non-ethylene products to be continuously in tight supply, no need to worry about ECCs

Recently, the spreads of non-ethylene products such as BD and BTX have been widening. This is because capacity expansion has been heavily concentrated on ethane crackers. With ECC capacity mostly built to produce ethylene, ECCs reacts more sensitively toward PE and MEG. As such, the increased ethylene capacity is unlikely to have a notable impact on the market.


1Q17 to be inflection point for 1H17 oil prices

Moment of verification approaching

Oil prices continued to strengthen as non-OPEC countries joined the movement to cut production following OPEC’s production cut decision, by 1.2mn bbl/d, at end-November last year. In 2016, WTI price averaged USD43.3/bbl and ended at USD53.7/bbl.

Overall oil market conditions are not far from our forecast, but oil prices are more bullish than we originally thought. In our view, this mirrors the expectation that oil supply will tighten rapidly as non-OPEC nations led by Russia unexpectedly cut production by 0.58mn bbl/d.

We believe 1Q17 will mark an inflection point for oil prices in 1H17, as each country’s production cuts will become available in figures at around mid-February. Depending on the results, we may have to adjust our oil price forecast for 2017.

The market thinks OPEC’s production cut agreement will not be 100% executed. Previously, the execution rate of such a deal was only about 60%. However, this time, we believe OPEC’s production cuts will be deeper than expected. Above all, oil price declines are a great fiscal burden for the GCC states and Venezuela as their currencies are pegged to the USD. If oil prices fall due to increased production, their currencies will strengthen while oil prices fall, which will add to their fiscal burdens.

Furthermore, an additional oil price fall is a burden for Saudi Arabia as Aramco is preparing for an IPO in 2018. Saudi Arabia is responsible for cutting production by 0.49mn bbl/d this time, which represents 40.8% of the total production reduction plan. This means the production cut execution will be higher than before even if Saudi Arabia alone becomes an active participant of the deal.

Major oil-producing countries such as Russia and Iraq are planning to cut production following Saudi Arabia, and a production cut monitoring meeting is on January 13, with participants including Kuwait, Algeria, Oman, Venezuela, and Russia. The fact that Russia has joined the monitoring meeting is positive, and potential introduction of measures to control compliance from the meeting should help drive oil prices higher.

Revise up 2017 oil price forecast based on robust crude oil demand

We adjust up our 2017 oil price forecast (for WTI) from USD53.8/bbl to USD54.3/bbl. Most of all demand for crude oil is solid. The EIA has been raising its crude oil demand forecasts for 2016 and 2017 in its short-term energy outlook. In particular, its projection for 2017 grew to 1.3mn bbl/d in December 2016 from 1.3mn bbl/d in October. The major reason is the ongoing recovery of the industrial economy, reflecting recent strong PMIs in the US, China, and India. India’s PMI has temporarily deteriorated due to currency reform, but its mid- to long-term outlook remains positive.


If OPEC and non-OPEC countries’ production cuts are verified in figures, we will be driven to raise our oil price forecasts further. We see the possibility of the production cut plan not being fully executed, but with only a 50% execution rate (out of a 1.8mn bbl/d reduction plan), the oil supply-demand balance should stabilize given the oversupply of 0.4mn bbl/d projected for 2017 by the EIA. Depending on the actual scale of the production cut, the oil price forecasts could move further upward. In terms of oil price movements, it would be a prudent move to be better prepared for upside risks rather than downside risks.


Economic indicators recovering

Freight volume and rates suggest recovering demand

Previously we commented about the refining/chemical sector entering a demand-driven cycle rather than a supply-driven cycle. For the past two years, the chemical sector was in an unusual cycle that was driven largely by cheap oil. Going forward, however, we expect the demand-driven cycle to unfold.

It is hard to measure demand for basic chemical products such as PE, because they, with the exception of butadiene, are used in a diverse range of applications. As such, it is difficult to say chemical demand is strong because of the demand for any specific applications. Chemical product demand is closely related to “real-world demand.” Therefore, the question we ask is ‘is real-world demand alive?’ PMI is a major indicator of such demand but we need specific indicators.

Our research of the transportation/storage sector for the past five years enables us to verify that the transportation sector directly reflects real demand. The two most important indicators are freight rates and volume. And we see these indicators improving recently. Container throughput at major Asian ports is recovering. Container freight rates are also on the mend.

Flight cargo volume is also seeing a meaningful turnaround. Recently, the US ISM manufacturing index hit a two-year high, raising expectations for a recovery in the real economy. At the same time, the cargo volume at the Incheon International Airport also showed a meaningful improvement. Given the favorable movements of these economic indicators and freight volume indicators, we believe that expectations for a recovery in real demand are well founded.

Refining margin likely to recover

Low inventory burden, solid demand, low US utilization

Since 2H16, refiner shares have been relatively sluggish due to concerns over refining margins. However, refining margins should improve from 1Q17. In addition, since oil prices are likely to climb gradually, we believe earnings momentum for refiners will strengthen further thanks to a lagging effect and inventory valuation gains.

First, inventory burden has eased considerably. Petroleum product inventories in the key regions have fallen since 1H16. Although the inventory level is still high, it came down to the past three-year range in 2H16 vs. 1H16 when the inventory was at its highest in three years. In particular, the distillate fuel oil inventory saw its first YoY decline in two years.

Above all else, demand for petroleum products in the US is solid, evidenced by record-high gasoline demand. In addition, the US refinery utilization ratio is still low when compared with the figure for 2015, even though it is recovering at a moderate pace after the maintenance season.

In our view, the utilization ratios at US refineries are unlikely to exceed the 2016 level, which was lower than usual. US refinery utilization ratios were at their highest during 2H15-1H16 since the global financial crisis. At the time, cheap oil prices shored up refining margins and some refineries delayed maintenance to run at full throttle.

According to the press, the US refineries are having a hard time doing regular maintenance because many refineries simultaneously delayed maintenance. There are reports that the regular maintenance of US refineries will increase by 38% YoY in 2017, which is the fastest since 2010. We believe this will ease the oversupply situation of petroleum products.

Petroleum product inventories in major hubs in Asia and Europe also saw a gradual decline in 2H16 compared to 1H16. In particular, as US gasoline exports continue to grow rapidly, gasoline inventory burdens are on the decline because solid demand can absorb them. We believe that a decline in petroleum product inventories will help improve refining margins.


Chinese petroleum product demand to recover, leading to better supply-demand balance

Slowing demand for petroleum products, especially diesel, is the main reason behind the weak refining margin in China. In that regard, it is positive that petroleum product demand in China is showing signs of improvement.

We find it particularly encouraging that the decline in diesel demand has slowed and is likely to pick up. We interpret this as a sign of inventory exhaustion through exports. Additionally, demand for gasoline is improving recently.

China’s ‘teapot’ refineries, largely responsible for the oversupply situation in the region in 2016, are likely to see their presence dwindle in 2017. In 2015, the NDRC authorized Chinese independent oil refiners, called teapot, to import crude oil in exchange for reducing old refining facilities with capacities of below 40,000 bbl/d. However, restructuring was not easy, and teapot refiners’ utilization ratios continued to rise, which negatively affected refining margins.

Recently, the NDRC has restricted the 2017 oil import quota of Chinese teapot refiners and has not issued an export quota. Beijing announced that it would continue its investigation into possible tax evasion by teapot refiners and strengthen its monitoring activities. As a result, the utilization ratios of Chinese teapot refineries are likely to shrink further.

The Chinese Ministry of Commerce has also decided to cut the export quota of all Chinese oil refineries by 40.8% YoY. It will reduce Chinese export volume, and contribute to the gradual improvement of refining margins.

From 2017, China will strengthen gasoline and diesel quality standards to mitigate air pollution problems. Diesel products have to meet the “V” standard in 11 provinces in the eastern part of China. Products that do not meet these standards will face a sales ban. Already China’s major cities have adopted this V standard, but it is not mandatory in most inland cities. Additionally, as the standards for ship fuel oil become stricter, Chinese state-owned Sinopec and PetroChina have made investments to upgrade their facilities, and in 2H16, these public refiners’ utilizations were kept low due to due to regular maintenance.

Small-size teapot refiners are not yet ready to meet the strict petroleum product standards. As such, teapot refiners will have a hard time raising their utilization ratios in the future.

Growing refining margins and oil prices, revise up 4Q16 earnings forecasts; 2017 refining margin to improve over 2016

In 4Q16, the average compound refining margin stood at USD6.9, up USD1.8 QoQ and down USD2.5 YoY. However, the combined refining margin adjusted for the lagging effect widened to USD9.5 thanks to a gradual rise in oil prices, growing markedly by USD5.1 QoQ and USD3.7 YoY, which was the quarterly record since 1Q11. We believe this is the biggest earnings driver for refiners in 4Q16. Additionally, strong inventory valuation gains stemming from a steep rise in the Dubai oil price, from USD45.1/bbl in 3Q16 to USD53.8/bbl at end-4Q, also likely had a positive impact on earnings.

The average refining margin for 2017 is expected to increase by USD1.1/bbl to USD7.5/bbl in 2017 from USD6.4/bbl seen in 2016. We believe supply-demand conditions will improve, considering the recent tight supply, stabilizing inventory, and stricter regulations on Chinese exports. Against this backdrop, we revised up our earnings forecasts for the refinery sector. Considering that refining shares move closely in relation to refining margins, refining shares should be able to pare their short-term losses gradually.

NCC fundamentals to remain strong long term

It’s not just about PE

Conditions remain favorable for the NCC market. The PE spread remains solid; the spreads of non-ethylene products such as BD, propylene, and BTX have sharply improved since 4Q16; and the synthetic fiber chains such as MEG are also enjoying wider spreads. This is the result of tight supply caused by limited NCC capacity expansion since 2012. With the NCC capacity expansion plans fairly limited after 2017, the supply of non-ethylene products should remain tight.

Butadiene strength may continue for two more years

In the case of butadiene, annual capacity additions have been steadily declining since 2014. From 2011 to 2015 when the butadiene spread entered a downcycle, butadiene capacity rose by 990K tpa. However, from 2017 to 2019, butadiene capacity is expected to grow by just 190K tpa, which is at a historical low. This is the result of limited NCC capacity expansion due to the increased burden of expanding ECC capacity. We believe the tight supply situation will continue until 2019 at least.

The demand for synthetic rubber, which accounts for 50% of total butadiene demand, is stable and the utilization rate is likely to rise further. Strong demand for ABS, which represents 25% of total butadiene demand, is also contributing to robust butadiene demand. This is attributable to the upbeat IT and home appliances markets and increased use of ABS in the automotive industry.

Butadiene price already being reflected into SBR price

We believe tire makers to be raising prices due to rising raw material prices. This means that the price of butadiene, the raw material, will be reflected into SBR price, which will then affect the tire chain. The SBR-butadiene spread has narrowed in the short term but we expect it to be reflected into SBR prices. Considering the tight butadiene supply, concerns over SBR oversupply are groundless, in our view. We also expect restocking demand to increase.

Low MEG inventory and rising methanol price

MEG focuses on lower inventory levels and higher methanol prices
Polyester utilization rate has been increasing steadily, from 70% at the beginning of the year to 85% currently. With the surge of the methanol price in China, we believe the MEG spread has widened significantly. That the MEG inventory is at its historical low is another factor that widens the MEG spread. Since MEG self-sufficiency in China is still around 60% and coal price hikes keep CTMEG’s utilization anchored at just 40%, we expect the MEG spread to continue strengthening in 2017.

Stabilizing propylene supply and strengthening LPG/methanol prices

Although propylene capacity increased by more than 8mn tpa in 2016, it was only after 2H16 that the propylene spread started to improve. We expect the portion of PDH, CTO and MTO facilities, which produce propylene, to increase further in the mid/long term. Because of this, the propylene price is likely to become more sensitive to methanol and LPG prices. Propylene supply burden could ease from 2017, and the price of LPG, the raw material for PDH facilities, could rise. As such, the overall propylene spread should remain firm.

ECCs more sensitive to PE movement; sharp decline of PE spread unlikely

US-based ethane crackers’ influences on the PE market should start to visualize from 2H17. This year, the newly added capacity at US ethane crackers is estimated to be about 3.5mn tpa, and the worldwide ethylene capacity should increase by 7mn tpa. However, as most ECC facilities are expected to come on line at the end of 2017, the PE market is likely to remain bullish for the near future.

The global ethylene capacity increased by just 2.6mn tpa on an annual average from 2011 to 2014, which has resulted in the currently tight ethylene supply situation. Thus, although the highest utilization rate of ethylene since the global financial crisis is expected to decline slightly, it will remain high compared with the past average. There is no scheduled capacity expansion plan for ethylene after 2020. As such, the current capacity expansion is not likely to add to the supply burden in the long term.

In addition, given the recent increase of the US ethane price to USD200/tonne, ECCs’ cost competitiveness for PE is gradually waning. With most facilities’ production concentrated on PE and MEG, the poor ethylene market conditions should be more burdensome for ECCs than NCCs. PE spread, which is at its record high, may decline somewhat, affected by ECCs. However, we do not think ECCs’ influences will be strong enough to squeeze the PE spread either.

According to the ICIS, the ethylene market is likely to remain bullish due to higher-than-anticipated demand for ethylene and growing ethane price.
Ethane price hike to add to price pressure on ECCs

As ethane exports pick up steam, there are mounting concerns that the ethane price in the US will rise. Reliance Industries ordered Samsung Heavy Industries (OTC: OTC:SMSHF) to build six very large ethane carriers (VLECs) and according to the press, ethane exports from the US are expected to increase dramatically after all six VLECs are delivered. Considering the increase in export volume and ECC demand that is likely to grow visibly from 2H17, there is a high probability that ethane price will move upward. In particular, as gas prices remain strong in the US on strong demand, the price pressure on ECCs should to continue to strengthen, given that a premium is necessary to ensure a stable ethane supply

Shares to price in strengthening fundamentals

S-Oil’s 4Q16 results were in line with the consensus.

Earnings should remain upbeat thanks to rising oil prices and improving refining margins.

We believe company fundamentals will improve further as S-Oil launches its residue upgrading complex (RUC) and olefin downstream complex (RUC) projects. In our view, these positive issues are not priced into the shares.

For 4Q16, S-Oil reported sales of KRW4.6tn (+15.4% YoY) and operating profit of KRW444bn (+282.1% QoQ, turned to profit YoY) which was in line with the consensus. The results, however, missed our expectations as the company’s “super” project aiming at yield improvements worked to stretch the maintenance period of RFCC, which slowed the production of propylene and gasoline.

Refining margins remain strong. We see refining margins in the Far East steadily recovering thanks to limited petroleum exports from China and China’s recovering petroleum demand.

We expect the OPEC production cut to bolster oil prices gradually. In particular, the revelation of the OPEC countries’ production cut through an OPEC report in February should fuel oil price momentum further.

The PX margin has declined somewhat. Although Reliance and Petro Rabigh are scheduled to up their PX capacity by 2.2mn tpa and 1.3mn tpa, respectively, it would not necessarily lead to oversupply. Considering China’s still low PX self-sufficiency, the PX margin should recover at a moderate pace.

When the RUC/ODC project is completed in 2018, the production volume of chemicals such as PP and PO will rise, contributing to earnings from chemicals. In addition, an improved yield for light distillate should help diversify S-Oil’s product portfolio, meaning stronger fundamentals. We estimate the completion of the project will have the effect of boosting EBITDA by KRW800bn annually.

We project the end-of-period DPS at KRW4,500. On the back of its stable financials, S-Oil plans to maintain its favorable investor-return policy even in 2017 when it is burdened by heavy capex commitments. In all, S-Oil continues to be an attractive dividend play.

Trading around 1.3x P/B, the stock is undervalued considering its handsome ROE of nearly 20%.

We believe shares will move to price in the improving company fundamentals driven by the RUC/DUC project.




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.

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