Alembic Global Advisors

Chemical Industry Reports

Global Chemicals and E&C: The capital cost conundrum

09/08/14 -

Global Chemicals and E&C – The capital cost conundrum

  • Capital cost inflation should result in ethylene replacement values rising by 1.8x
  • New US facilities economically viable despite inflation; E&C margins to expand
  • AXLL and MEOH most attractively valued; CBI and JEC with highest EPS leverage

Summary

With over 11.3m tons of greenfield ethylene capacity having been announced in the US, representing around 21% of incremental capacity through 2017, we believe an analysis of project costs particularly in today’s capital cost inflation environment is key.

Our bottom-up analysis that looks at the various components of project costs – commodity prices, EP&C costs, personnel wages and equipment and facility costs – suggests that greenfield ethylene plants may have experienced a 1.8x inflation over the last decade. This would peg current greenfield ethylene replacement value at around 74c/lb. 

The implications of higher capital costs for the chemical sector can be put into three buckets: (1) impact on commodity profitability, (2) impact on cost curves, and finally (3) impact on project NPV. We see higher capital costs boosting the fixed cost part of ethylene production economics by around 1.9c/lb. Keeping in mind the over 20c/lb cost advantage enjoyed by ethane based ethylene producers in the US we believe higher capital costs will not move the needle much in terms of global cost curves. In terms of project profitability using current economics we see greenfield US-ethane based ethylene facilities generating IRR’s of around 20.5% significantly higher than a WACC of around 10.1% suggesting most of these newly announced facilities are economically viable despite a near doubling in capital costs. Despite these capacity additions we see the ethylene story being a supply dearth one with demand outstripping supply over the next five years and expect a peak in the cycle as early as 2016. From a valuation perspective we see shares of Axiall Corporation and Methanex trading at the steepest discount relative to their replacement value.

From an E&C sector perspective higher capital costs, in our view, should translate to significant margin expansion. Our 2015 margin estimates are still over 200 bps below the last cycle peak, which we believe could prove quite conservative given how quickly capital cost inflation can result in E&C’s gaining pricing power. We see the greatest upside earnings leverage in a margin expansion scenario, relative to our estimates, at JEC, CBI, FLR and KBR in that order.

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