The recent sell-off in Saudi Arabian petrochemical stocks could be overdone, presenting value investors with a selective buying opportunity in the most cost efficient producers in the world at a time when global chemical prices may have bottomed, according to Sachin Mohindra, portfolio manager of the Invest AD GCC Focus Fund.
The Tadawul Petro index has fallen 7 percent this year as the global economic slowdown prompted a drop in chemical prices, and a slashing of profits at some of Saudi Arabia’s biggest listed companies.
But the huge competitive advantage of some Saudi firms – stemming from the ready supply of cheap natural gas and crude oil on their doorstep – means that they are likely to prosper as low-margin rivals cut back production.
Investors seem to have failed to distinguish between Saudi companies and high-cost North Asian petrochemicals firms, which have seen an aggregate 9 percent stock price fall this year. Meanwhile, the medium-efficiency European and North American sectors have gained 7 percent and 3 percent respectively.
The fundamentals for the sector have been admittedly the worst since the 2008-2009 global economic crises, with slowing economic growth in China putting strong downward pressure on prices.
For products made in Saudi Arabia – such as ethylene, fuel oil and gas oil, HDPE, LDPE and toluene – prices dropped an average 6 percent between the first and second quarters of this year.
With Saudi plants also reducing their utilisation rates and taking write-downs on inventory, second-quarter net profit slumped, with the world’s largest petrochemicals producer, Saudi Basic Industries Corp. (Sabic) reporting a 27 percent on-quarter fall. Saudi International Petrochemical Co. (Sipchem) and Yanbu National Petrochemicals Co (Yansab) both reported a 10 percent drop in net profit.
This trend is not expected to last. The long-term prospects for the Saudi industry are bright, with emerging market growth expected to remain robust in coming years, and very little new supply expected to come online in the next five years.
Saudi companies are the most cost efficient producers of commodity chemicals in the world, currently receiving their naphtha feedstock at a 30 percent discount to international prices, and producing ethylene at a little over $200 per tonne, compared to around $800 in Europe and $900 in North Asia. Their cost competitiveness tends to increase as oil prices rise as half of global capacity is based on naphtha.
If oil prices remain high and chemical prices stay subdued, European and Asian firms are likely to cut back production significantly and may even wind down some operations, allowing Saudi producers to pick up market share.
However, in the short term, product prices are mostly influenced by inventory cycles, particularly in China, and that is much more difficult to predict. Stocking and de-stocking in China tends to reinforce cycles, as buyers try to accumulate in an upward cycle to sell at the peak, although credit availability, interest rates and export policies will have a bearing on the inventory cycle.
Fear of asset price inflation means that Chinese authorities are keen not to repeat the large-scale fiscal stimulus and credit loosening of 2009 to lift an economic growth rate that has been slipping for six straight quarters. But expectations are growing that, with a new leadership about to be installed, Beijing will act – maybe through investment in infrastructure – if the economy continues to slow.
This could provoke a move to stock up on petrochemicals inventory. But in any case, it is hard to see any significant further decline in prices from current levels, and analysts are forecasting a slight increase in net profit at most Saudi producers in 2013.
Ethylene prices have already bounced to around $1150 per tonne from $800 levels in May, though still far below their April peak of $1400.
Many Saudi petrochemical stocks track the ethylene price with a lag. And while it may be too early to predict a rally, current stock prices more than adequately discount the possibility of continuing weakness in petrochemical demand and pricing.
For example, Sabic, which saw a 16 percent share price drop in the three months to the end of August, now trades at 8.1 times forecast 2012 earnings, compared to a global sector average of 13 times. The company’s forecast 2013 EV/EBITDA multiple is about 6.5 times, compared to a historical 10-year median of 10.5 times.
Valuations are not screamingly cheap, but they are at the bottom end of mid-cycle multiples, and probably low enough given the positive medium-term fundamentals of several Saudi producers.