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HSBC What Price is Right

HSBC What Price is Right

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Published by willbeacham
HSBC outlook for chemical feedstocks in the Middle East
HSBC outlook for chemical feedstocks in the Middle East

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Published by: willbeacham on Jan 24, 2011
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By Sriharsha Pappu and Tareq AlarifiFeedstock pricing changes likely to be announced in 2011. We expect this decision to beinfluenced by a combination of both economic and policy factors, and we forecast a phasedincrease that does not fundamentally alter the competitive position of the industryThe impact on margins from these feedstock price increases is highest for companies with thebiggest cost advantages (eg SAFCO), while those with lower cost advantages and margins(eg SABIC) are least affected. The increase in HSBC's energy price forecasts however, outweighsthe impact of higher feedstock costsYet despite generally raising our target prices, we are cautious on the sector for 2011 givenrecent strong performance, elevated expectations and high valuations. Our top picks in thesector are Tasnee (OW(V), TPSAR44), Yansab (OW(V), TP SAR65) and SABIC (OW(V), TP SAR130).We downgrade Petrochem (TP SAR25) and Sahara (TP SAR25) to N(V) from OW(V) andIndustries Qatar (TP QAR135) to UW from N
Disclosures and Disclaimer
This report must be read with the disclosures and analystcertifications in the Disclosure appendix, and with the Disclaimer, which formspart of it
What price is right?
Re-evaluating the feedstock price environment
Natural Resources & Energy/Middle East Chemicals - EquityJanuary 2011
1Natural Resources and EnergyMiddle East ChemicalsJanuary 2011
The feedstock pricing question
Pricing revision – topical in 2011
In the wake of constrained gas supply, multiple competing uses and a burgeoning cost advantage, thereare serious questions being raised about the feasibility of continuing with the current gas pricing regimewithin Saudi Arabia. The view gaining traction among industry participants is that some form of modification to the pricing framework is required both as an incentive for companies to provide new gassupply and to ensure a more efficient distribution of limited gas resources. This discussion is particularlyrelevant today as some of the feedstock formulae – particularly for liquids – run only until 2011, whichmeans a new pricing benchmark, at least for liquids, will need to be approved before the end of the year.We believe that a new gas pricing framework will be approved at the same time, and therefore that achange in the feedstock price environment is imminent.
A combination of economics and policy
In our opinion, any change to the feedstock pricing regime will be driven by a combination of economicand policy factors. The economic argument based on incentives for supply growth, efficient allocation of scarce resources and demand rationalisation would call for Saudi gas prices to reflect global levels of USD4-5/mmbtu vs. the current price of USD0.75/mmbtu. However, an increase of this magnitude woulddeliver a significant economic blow to the industry which would run counter to the key policy objectiveof driving downstream chemical investment and generating employment.We believe that policymakers will work to ensure that feedstock price increases take place in a manner soas not to shock the industry or dramatically alter its competitive dynamic. We also believe that policymakers will be just as conservative with their underlying energy price assumptions while assessing thecompetitiveness of the petrochemical industry as they are while setting their annual budgets.We are raising our estimates for Saudi gas and ethane equivalent prices from the current USD0.75/mmbtu toUSD2.0/mmbtu by 2015. We expect that this increase will take place in a phased manner, with prices risingfirst to USD1.25/mmbtu by 2012 and in a staged manner thereafter (see table below). We also assume that theliquids discount will decline by 1ppt each year from the current 28% before being fixed at 25% by 2014.
We expect to see a change in the feedstock pricing regime in 2011.We believe this will be influenced by a combination of botheconomic and policy factors and we are factoring in a phasedincrease in prices that does not fundamentally alter the competitiveposition of the industry. The increase in HSBC's energy priceforecasts however, outweighs the impact of higher feedstock costs.
2Natural Resources and EnergyMiddle East ChemicalsJanuary 2011
In terms of margins, the rule of thumb is that companies with the biggest cost advantages and the highestmargins (eg SAFCO) are impacted more by an increase in feedstock prices than companies with lowercost advantages and margins (eg SABIC). Our oil and gas team has increased its energy price forecastsfor 2011-15 by around 10% which has resulted in an increase in our product pricing estimates. In mostcases, the impact from higher product pricing outweighs the impact of higher feedstock costs.
Sector investment thesis
Peak conditions to return by 2013/14, market likely to remain balanced in 2011
Rising emerging market demand and limited supply growth will create an environment of higher capacityutilisation rates. Based on our supply assumptions and HSBC Economics global economic growthforecasts, we expect to see a return to peak conditions (utilisation rates of over 90%) within thecommodity chemical sector by 2013/14.However, while we are bullish on the sector in the medium term, we believe that in the near term supply growth in2011 could potentially come in above expectations. We expect incremental supply from existing plants to matchdemand growth for the year as improving macroeconomic conditions ease some of the bottlenecks (in terms of feedstock supply) that resulted in a tight market in 2010. This should be particularly true for European crackeroperating rates, which are tied to operating rates at refineries in the region. An improving macro environment inEurope should lead to higher ethylene supply on greater naphtha availability from refineries.Furthermore, higher oil-product demand and higher oil prices could lead to an increase in OPECproduction quotas which would make more associated gas available, particularly in Saudi Arabia, andresult in an incremental increase in operating rates at newer crackers – which we estimate are currentlyrunning on average at 80% – owing to feedstock supply constraints. In both these cases, incrementalsupply would materialise from existing capacity only if demand growth continued to be strong and henceshould not result in a big dip in utilisation rates due to an oversupply situation. However, this incrementalsupply would, in the short term, prevent a sharp rise in utilisation rates. We forecast ethylene utilisationrates to improve by only 70bps in 2011 over 2010 levels.
Cautious on sector performance in 2011
We believe that after two years of exceptional stock market performance from the Middle East chemicalsector with stocks on average up 47% in 2009 and 24% in 2010, it is time to take a more cautious view onthe sector in 2011. Our cautious stance on performance is based on by high valuations and elevatedconsensus expectations. Middle East chemical sector valuations are now above mid-cycle levels, withstocks trading on average on a 15.6x forward PE versus the historical sector median forward multiple of 14x. While fundamentals are healthy, these appear to be already factored into share prices and we think itit is unlikely that in 2011 the sector will generate the same level of returns seen in 2009/10.
HSBC Saudi feedstock pricing assumptions2011e2012e2013e2014e2015eGas price (USD/mmbtu), New 0.751.251.502.002.00
Gas price (USD/mmbtu), Old 0.750.750.750.750.75
% Propane Discount, New 28%27%26%25%25%
% Propane Discount, Old 28%28%28%28%28%
Source: HSBC estimates

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