Dow Chemical Earnings Preview: Impact of Lower Oil Prices On Plastics Margin In Focus

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The Dow Chemical Company (NYSE:DOW) is scheduled to announce its 2015 second quarter earnings on July 23. [1] We believe that the company’s margin-expansion streak that has been going on for the last ten quarters could be broken this time around, because of the sharp decline in benchmark crude oil prices that has narrowed the spread between crude oil-derived naphtha and ethane cracking. However, relatively lower natural gas prices in the U.S. during the second quarter, compared to the previous year, primarily because of ample inventories, could mitigate the impact of lower oil prices on the company’s margins. In addition, the positive impact of productivity cost savings from higher operating leverage could also provide a cushion to the company’s unit profitability. During a recent presentation at the Credit Suisse Basic Materials Conference, Dow officials pointed out that a 100 basis points improvement in the annual operating rate, boosts its EBITDA by more than $200 million. [2]

Dow is a diversified chemical industry giant operating in basic and specialty chemicals, advanced materials, agro-sciences, and plastics business segments. It delivers a broad range of technology-based products and solutions to customers in approximately 160 countries, and in high growth sectors such as electronics, water, energy, and agriculture. Last year, Dow reported annual sales of over $58 billion and adjusted net income of around $3.7 billion. We currently have a $56/share price estimate for Dow, which is approximately 18.7x our 2015 full-year adjusted diluted EPS estimate of $3.00 for the company.

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Lower Oil Prices To Eat Into Plastics Margins

Being in the petrochemical business, Dow relies heavily on hydrocarbon feedstocks for manufacturing its end products like packaging films and elastomers. As a result, dynamics in the oil and gas industry impact its results significantly. For example, the company has gained enormously from lower natural gas prices in the U.S. over the past few quarters, as it resulted in thicker margins on the production of ethylene – a key ingredient in the manufacturing of almost all plastic products. According to our estimates, the company’s Performance Plastics adjusted EBITDA margin has grown by over 670 basis points since 2012. Most of the products sold by the division are derivatives of the simplest unsaturated hydrocarbon, ethylene, which is most commonly derived from steam cracking of either naphtha or ethane. While naphtha is derived from crude oil (naphtha constitutes around 15-30% of crude oil by weight), ethane is a natural gas liquid that is extracted from raw gas streams at natural gas processing plants.

With the shale gas revolution in the U.S., the production of ethane and other NGLs has also grown significantly, which has weighed on their prices. According to a consultancy firm, Envantage, ethane extraction capacity in the U.S. has risen by almost 60% over the past 8 years to over 1.23 million barrels per day (bpd) currently, and is expected to hit 2.2 million bpd by 2020. [3] This has created a lot of incentive for chemical producers in the U.S. to crack ethane for producing ethylene and even led to a slew of new project announcements on the Gulf Coast. (See: Cheap U.S. Natural Gas Is Attracting Huge Investments From Chemical Companies)

However, the recent decline in oil prices has resulted in the flattening of the global ethylene cost curve, as naphtha prices have come down along with crude oil. This is expected to reflect in the pricing of ethylene and its derivative products, which will pressure Dow’s top-line growth and limit its margin expansion as well. In addition, it is also expected to slow down the rate of development of tight hydrocarbon reserves in the U.S., which could further diminish the low-cost advantage enjoyed by the U.S.-based ethane-cracking plants. However, during the most recent earnings conference call, Dow’s CEO, Andrew Liveris, pointed out that the company’s shrinking exposure to commoditized end products, as a result of the ongoing divestment program, and an anticipated pick up in demand growth fueled by lower oil prices, should mitigate the impact of the changed oil price environment on its profits. We currently estimate the potential negative impact of lower crude oil prices on Dow’s Performance Plastics division’s 2015 EBITDA margin to be around 100 basis points and will look for cues in the earnings release to update this forecast. [4]

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Notes:
  1. Upcoming Events, dow.com []
  2. Credit Suisse 2014 Basic materials Conference, dow.com []
  3. The Impending Boom of U.S. Ethane Exports, wallstreetdaily.com []
  4. Dow Chemical 2015 Q1 Earnings Call Webcast, dow.com []