According to a recent industry report, chemical production capacity in the U.S. is expected to go up by 30% in the next decade. Chemical companies plan to invest billions of dollars to expand their ethylene capacity on the U.S. Gulf Coast by around 100 million metric tons per year. This is primarily due to depressed natural gas prices in the U.S., which have provided chemical makers including The Dow Chemical Company (NYSE:DOW) with an opportunity to improve their profits through lower feedstock costs. 
We currently have a $47 price estimate for Dow, which is ~16x our 2014 adjusted EPS estimate of $3.00 for the company.
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Why Are Gas Prices Depressed In the U.S.?
The outlook for U.S. natural gas supply has changed significantly over the past few years, primarily due to the evolution of horizontal drilling and hydraulic fracturing techniques that have enabled energy companies to tap the huge shale gas reserves in the U.S. at commercially sustainable rates. The widespread use of these techniques started only during the early 2000s in the Barnett shale play in north-central Texas. However, since then, natural gas production in the U.S. has ramped up much faster than the growth in consumption, which has led to severely depressed natural gas prices in the country by international standards. The below chart shows how natural gas prices in the U.S. have diverged from that in Europe over the past few years.
Why Are Chemical Companies Attracted Towards Lower Gas Prices?
A glut of natural gas supply in the U.S. has also led to more affordable supplies of ethane, a natural gas liquid that is a key raw material used in the chemical industry. Ethane is cracked to form ethylene, the simplest unsaturated hydrocarbon, which is one of the most important feedstock in the plastics value chain. It is used in the manufacture of polyethylene, also called polythene, which is the most widely used plastic in the world.
The above chart shows that producing ethylene from U.S. ethane is currently a lot cheaper than producing the chemical in Asia or Europe, where most of it is derived from the steam cracking of naphtha. Naphtha is derived from crude oil. It constitutes around 15-30% of crude oil by weight. With the shale gas supply boost in the U.S. resulting in a cheap source of ethane, there has been a divergence in operating margins between naphtha and ethane based ethylene production plants. This has provided chemical companies with a huge opportunity to expand their margins by reducing feedstock costs.
How Does Dow Plan To Leverage This Cost Advantage?
Dow Chemical is one of the largest ethylene producers in the world. This provides its differentiated performance plastics manufacturing capacities with a low-cost advantage. The company currently sources around 60% of its ethylene in the U.S. from ethane cracking. It expects to increase this figure to above 70% by 2018. Dow plans to invest more than $4 billion on the U.S. Gulf Coast to achieve this target.
Last year, the company restarted its St. Charles Olefins 2 plant in Louisiana, in a bid to lower its operating costs by reducing the amount of ethylene purchased. Apart from this, Dow is working on a number of projects to leverage this feedstock advantage in the U.S., as listed below.
- Improving ethane feedstock flexibility for ethylene crackers at its Louisiana and Texas operations by 2014 and 2016 respectively.
- Construction of a new, world-scale ethylene production facility in the U.S. Gulf Coast – slated for start-up in 2017.
- Construction of a new, on-purpose propylene production facility at Dow Texas operations – slated for start-up in 2015.
These investments are expected to boost Dow’s ethylene production capacity by ~20% over the next three-four years while increasing its on-purpose propylene production. The company expects to realize incremental EBITDA of at least $2 billion from these investments in 2017. Notes:
- Cheap Gas Fuels Chemical Boom As Dow Invests Billions, dow.com [↩]
- Dow Strategic Update, dow.com [↩]