Perspectives: What impact higher commodity price has on a chemical company?

Whenever we discuss potential chemical investment, we frequently ask about the possible impacts that may result from higher prices for commodities such as oil, gas and other raw materials. As I am writing this blog, oil prices are around $98/bbl; a decade ago, oil prices were merely in the teens (http://www.eia.doe.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=WTOTUSA&f=W ). Not surprisingly, some companies’ financial performances are impacted by their exposure to oil, gas and petrochemical-derivatives, yet many others have relatively limited and/or low exposure and are therefore better able to weather the storm - the trick is the ability to know the difference!

Few inputs impact the world economy to the same extent that the price of oil does. Oil powers cars, trucks, boats, airplanes, and even power plants, which make up the backbone of the global economy. Needless to say, higher energy prices will have an impact on consumers, as well as a company’s ability to invest in capital equipment and grow the business. Increased commodity chemical prices will place downward pressure on a company’s finance/debt as well as negatively effects consumers’ credit. From the feedstock to the commodity producer to the ultimate consumer, everyone suffers.

However, the magnitude of the impact depends on the company’s pricing power, business model, location in the value-chain, and uniqueness of their products and services. During an economy where commodity prices are rising, chemical companies’ financial performances may depend on their ability to pass along the increasing costs to customers (e.g. price escalators) and ultimately to the end-users. Hence, the management team’s ability to execute the company’s risk management strategy plays a crucial role!

The above chart provides a useful reference guide, illustrating the potential impact that certain commodity prices have on various products. Commodity chemical producers (e.g., SABIC, LyondellBasell), diversified chemical producers (e.g., Dow, Dupont, 3M), specialty chemical producers (e.g., Lubrizol, Milliken, Ferro, Solutia), agricultural/fertilizer producers (e.g., Monsanto, Potash), chemical formulators and service providers (e.g., Ecolab, Nalco), and chemical distributors (e.g., Univar, Brenntag) are influenced differently and to varying degrees of their margin. Some could even benefit from rising commodity prices. To say the least, the chemical industry is complex. Companies typically have a very long value chain, and very rarely can a company be found containing only one product line with just one end market. A savvy investor needs to possess a deep domain expertise in order to gain visibility into the value chain, take a broader view and appreciate the supply/demand dynamics.

One silver lining in this high crude price environment is that many commodity chemical producers are benefiting from relatively cheap natural gas, which is a key raw material for many products manufactured in the United States. Higher natural gas prices, in particular, severely diminish the competitiveness of the industry, as it uses natural gas not only as inputs for fuel and power, but also as a raw material and for feedstocks. Feedstocks for most petrochemicals are typically derived from either oil or natural gas (the U.S. chemical industry is the largest industrial user of natural gas, consuming one-eighth of the total natural gas demand). Oil prices, including heavy liquids (e.g., naphtha and gas oil), are determined in the global market. The price of natural gas (as well as liquid gas such as ethane, propane, and butane) is driven by local/regional supply and demand since it has inherent physical limitations moving over long distances. Many large energy companies are heavily investing in order to find ways to help alleviate this issue, for example, building liquefied natural gas (LNG) terminals. Overall, the price of a feedstock is largely determined by the price of oil and/or natural gas.

Another silver lining is that alternative energies like wind, solar, and geothermal, as well as alternative fuels like biofuels, ethanol, cellulosic ethanol and fuel cells, all see increases in demand when the price of oil increases, since oil is their principal competition – also keep in mind that fossil fuels are the main sources of environmental pollutions. Many chemical companies’ products and technologies will, in fact, benefit from an environment with higher oil or energy prices, since chemical companies produce critical materials for solar panels (e.g., PV thin-film, pastes, encapsulants, coatings, metallization, shingle roofing), components for wind energy system (e.g., carbon fiber, infusions, fiber glass, pre-impregnated materials/prepregs), materials for energy storage devices/systems, various solutions for next generation’s electric vehicles, biofuels, etc. High energy prices also spark other innovations, from industrial biotechnology and bio-plastics to fuel cells.

Arguably, chemistry is the essence of modern life, and as a result, the chemical and chemical-related industries will continue to thrive in any commodity-priced environment, so long they remain flexible.

Even Warren Buffet likes the "business of chemistry" ….another stamp of approval for chemical industry thorough acquisition of Lubrizol

During the last few years, Berkshire Hathaway Inc. has made many investments in chemical and chemistry related businesses such as Nalco, Dow (Rohm and Haas), Great Lakes Chemical (GLK), Kaiser Aluminium & Chemical Corp. Sealed Air Corp, GSK, J&J etc. along with some petrochemical companies like ExxonMobile, ConocoPhillips, PetroChina and so on. Mr. Buffet’s notable commitment to the chemical industry is illustrated thorough Monday's announcement to purchase Lubrizol (LZ) for $135 a share, 28% above Friday's closing price! The consummate value investor, Mr. Buffet is expected to pay $9.7bn (which includes $700m in net debt) for the transaction. Even after paying a $30 premium (i.e. 28%) over the $105 closing price on Friday, Lubrizol transaction is priced at approximately, 7x 2011’s EBITDA and 5.4x 2012’s EBITDA.

Now if you consider today’s availability of cheap money in the capital structure, the WACC is no more than 8.5% (assuming at least 2x interest coverage with a realistic leverage 4.7x - 5x), Mr. Buffet is expected to generate top quartile returns (with a minimum Internal Rate of Return (IRR) percentage in the 20s within 3-5 years!).

We can talk all day long about the public market anomalies, various deal dynamics, and business related topics such as sustainability of margins in the lubricant additives value chain or excessive swings of commodity feed stocks (e.g. energy price, oil and petroleum derivatives). However, a company’s success will continue to depend on the management’s ability to control risk and take advantage of perceived market risks. For example, Lubrizol is a well managed company that poses an excellent profile of a “very good” specialty chemical company, growing its revenue consistently (for example: $3.4B in 2004; $5.4 in 2010), generating very strong cash flows and returns on capital, displaying a strong balance-sheet and flush with cash. We should also realize that Lubrizol has been increasing earnings at a compounded growth rate of 16% (at least for last 10 years; and Lubrizol's earnings growth has accelerated to over 25% per annum during the last 5 years).

Lubrizol continues to maintain its specialty status in a “so called commodity risk” environment by focusing on: its proprietary product (not necessarily patent protected product), mastering its product application for their customers’ system/process, delivering process/system monitoring services and maintaining overall strategic focus etc. (note: Relatively speaking, Lubrizol is neither capital intensive nor over reliant on R&D expenditure). Ultimately, Lubrizol’s strong performance over the years coupled with an excellent new owner should position Lubrizol to be even more successful as it moves forward. What are your thoughts?

Private equity environment continues to improve:

The private equity deal market has been quick to rebound in 2011. According to Thomson Reuters, merger and acquisition deals are already over $36 billion for the year-to-date and the value of deals are up 88% from last year. Analysts not only expect private equity investments to continue but they also expect the size of deals to increase as well, since the credit crisis hindered the purchase of cheap debt. Although the entire private equity market has vastly improved over the past year, the investments leading the way have been in the industrial industries (including chemical & chemical related businesses), health care, and real estate.

If we measure the composition of global transaction volume, capital raising, the dollar value of private equity exits, and total equity investment. Collectively, these four key components illustrate the most fundamental elements of the private equity market, and when they are indexed, one can observe that in the 3rd quarter the global private equity industry continued to rebound from the 2008-2009 recession as total equity investment in private equity transactions increase to a record $40.1 billion ($36.4 billion reported in the 2nd quarter and $17.8 billion reported in the 1st quarter). However, PE activity has not yet returned to pre-recession levels and the industry is evolving for the better as many funds/PE firms are winding down their operations.

The biggest benefit of economic downturn is that private equity firms or companies tend to lose focus or ignore inefficiencies in go-go days. A few new private equity firms continue to emerge and a few existing firms will emerge even stronger, but many will go away. A generalist investment approach for very large funds might have some particular relevancies today (return of cheap money, access to resources due to larger fund fees/scale), while the middle-market (and certainly lower middle market) needs more specialized and focused investment approach because resources are limited and the middle-market contains structural inefficiencies that are absent from larger, more liquid markets. Isn’t this a good opportunity for both private equity investors and business sellers working with specialized professionals?

Synergistic acquisition to promote innovation

In January, BASF and LKCA (a subsidiary of Linde Group), announced that they would jointly market licenses and plants for the capture of CO2 from flue gases, and recently, with assistance from RWE Power, they have created (and successfully tested) a major breakthrough in carbon capture technology. The new innovative technology captures CO2 by means of utilizing new chemical solvents that can reduce energy input by about 20 percent. Furthermore, the new solvents feature superior oxygen stability, which reduces solvent consumption significantly, which consequently improves efficiency.

In the future, climate-capture technology will likely play a key role in generating climate-compatible power from coal, and this new technology process, once scaled up to large power plants, will reduce power plant waste gases and facilitate clean energy generation. In addition, as this technology should capture more than 90% of the CO2 contained in waste gases, a vast supply of recycled CO2 can be created and used for inputs in chemical transformations such as production of fertilizers. New plants demonstrating this technology are scheduled to be in operation by 2015, and the technology should be expected to be utilized commercially in coal-fired power stations by 2020. Ultimately, once this technology expands, there will be a significant reduction in the release of climate-damaging CO2 due to its successful capture and transport for recycling or sequestration.

So, why is this development relevant in the chemicals industry? And why is it relevant within the private equity industry? First, this development illustrates the strong motivations within the chemicals industry to become more environmentally sustainable while simultaneously reducing costs and improving efficiency. Furthermore, this new technology derived directly from the pooling of knowledge and resources from various firms with different areas of expertise; individually, the companies would likely have found development of this technology exceedingly difficult, however, when their resources were combined, breakthroughs were managed in rapid fashion. Similarly, in the private equity industry, companies are strategically acquired so as to enable such synergies to promote swift innovation and long-term value creation, and as this particularly example clearly illustrates, the broader chemicals industry provides a viable forum in which to initiate such developments.

Partner up with the seller: Preserve and Grow Capital!

For the last 2-3 quarters, we have been experiencing the greatest psychological recovery in the recent history of economics and frankly, it’s hard to pinpoint the “Real Why”. While the stock market has improved to the benefit of some, the majority of Americans continue the struggle to meet their daily needs (for as expected, job recovery is slow). Recent market activity has been surreal; however, if you looked into the dreadful realities of bankruptcy proceedings during the last few years, last month’s “Flash Crash” in equities markets should probably have been expected. Moreover, “amend to extend” loans have surfaced, seemingly pushing the inevitable off well into the future.

Unfortunately, the fact remains that access to capital continues to be tight and typical private equity firms have heaped tens of billions of debt onto companies acquired from 2004 to the end of 2007—debt that is likely difficult to service, and certainly not cheap, which ultimately begs the question whether a traditional PE firm can afford such an increase in debt (or so called financial engineering). Therefore, we expect to see lots of opportunities in the middle market, certainly in the lower middle market; however, the real difficulties lie in determining how realistic the valuations of certain companies are. Valuations for bankrupt companies are often well below the ultimate auction rates of assets for many reasons. However, unreliable and yet attractive valuations could potentially open the window to big bargains; although there still exist enormous hazards if the buyer really does not know the business and its operational complexities, the opportunities are there for the picking.

It’s critical that PE firms look carefully into protecting the principle investment (downside) as the basic guarantee, without compromising the upside for all parties involved. This “win-win” approach could be achieved through implementing a creative structure for a deal. If the PE investor understands the business and its assets, it would still make a lot sense to go for straight equity deals. An industry focused, specialty PE firm could potentially move into growth/late-stage investments where growth capital is critical for a company’s success. In these cases, industry specialization will not allow a firm to negotiate better with the market, but will also provide a perspective that enables deeper understanding of market variability, condition, the visibility of a company within the market, and general day to day operations from a business perspective. For example: one could choose a convertible structure to get the coupon for 2-4 years, then convert them into equity at a pre-decided price and include an exit structure (with a built-in clause for claw-back, earn-out, etc., if the company does not perform as promised by management/owner/i-banker; … structuring is always specific to the business and market peculiarity of the deal) under which the PE fund’s stake is bought out by the promoters (or investment banker/ placement agent) or other investors. A structured deal could be a valuable tool when a PE investor is not comfortable with a sell-side investment banker’s projection on revenue and returns. The fact is that there are many ways to get things done so long as all parties take a “partnership approach” and a PE investor has deep understanding of a business and its operating domain!

Dealing with a PE investor who has deep understanding of a domain and its business operations allows a seller to get the well deserved full value of a business, to get the deal done quickly and to sustain a long-term relationship with all parties involved.

Lyondell Basell: Phoenix From the Ashes

If there was a major blight on the outlook on the chemical industry in recent years, it was LyondellBasell Industries US operations filing for Chapter 11 bankruptcy protection in January of 2009. Although the company officially emerged from bankruptcy in May this past year, it was LyondellBasell’s reported second-quarter earnings that left little doubt as to the health of the company and the health of the industry. Time to time, a good company can get stuck with a bad balance-sheet (often imposed by so-called financial engineers), with disastrous consequences; as is often the case, these financial engineers do not fully appreciate the complexities involved in the operational facets of the chemical industry and are incapable of implementing changes that can truly benefit the company stakeholders.

LyondellBasell reported second-quarter net income of $203 million as well as sales of $10.4 billion (+7% QoQ and +40% YoY up), cash increased to $3.8B from and total liquidity is now ~ $5B and the EBITDA was $1.4 billion (Net Debt / LTM EBITDAR of 1.1x). All five reporting segments have done well; however, improved olefin and polyolefin margins coupled with a better cost structure have driven attractive results!

Evidently, LyondellBasell has emerged from Chapter 11 restructuring a much stronger company, particularly operations in the US; operating income in the company’s olefins & polyolefins in the Americas segment was up 123% from the year-ago quarter. Looking forward, LyondellBasell expects similar positive performances as the US ethylene market rebalances following several turnarounds. It will be interesting to observe how operating rates and margins going forward will be influenced once the increased capacity comes online in the Middle East and Asia. LyondellBasell is one of the world's largest independent petrochemical companies that resides in the commodity end (upstream) of the value-chain. However, one can nonetheless appreciate LyondellBasell’s remarkable rebound, which ultimately reflects the good health of the broader chemical industry and could potentially illustrate why now is the opportune time to invest within the industry: specific markets within the industry are rebalancing and opportunities for growth are widespread and plentiful.