PERSPECTIVE: SHALE GAS’S IMPACT ON U.S. CHEMICAL INDUSTRY

I believe that the Shale Revolution presents a once-in-a-lifetime opportunity unique to the United States that will have a profound impact on the chemicals industry.  Nearly 100 projects announced as of Q1-2013, $72 billion in potential chemical industry capital investments, $67 billion in additional output by 2020 (with new & permanent federal, state, and local tax revenue of $14 billion from increased chemical industry output by 2020, according to ACC)!

The Shale Revolution will create 17,000 new high-paying and knowledge-intensive positions in the chemical industry, will result in a $32.8 billion increase in United States chemical production, will cause $16.2 billion in capital investments to build new petrochemical and derivatives capacity, and will lead to $132.4 billion in United States economic output related to increased chemical production and capital investment.  The Energy Information Administration estimates that shale gas production will grow 113% from 2011 to 2040 and that its share of United States natural gas production will grow from 34% to 50%.  The primary end market consumers during this period will be the electric power generation end market and the industrial end market. 

The shale gas benefit to some of the specific chemical manufacturing industries is most pronounced to the following: resins and synthetic material manufacturing grew by 1.7% in 2012, but is projected to grow by 8.1% in 2025, basic organic chemical manufacturing grew by 1.5% in 2012, but is expected to grow by 9.5% by 2025, agricultural chemical manufacturing grew by 1.2% in 2012, but is expected to grow by 7.7% by 2025, and plastics and rubber products manufacturing grew by 1.5% in 2012, but is expected to grow by 4.6% by 2025.

Due to the shale gas boom, in which the ACC expects a 25% increase in ethane supply, 99% of which is used for ethylene purposes and 82% of ethylene is used for plastic resins, the United States will be the lowest-cost ethylene producer.  As such, the ACC anticipates the additional chemical industry output generated by this 25% increase will result in an additional $18.3 billion from bulk petrochemicals and organic intermediates, $13.1 billion in plastics resins, $1.0 billion in synthetic rubber, $0.3 billion in man-made fibers, and $0.2 billion in carbon black.  These outputs are expected to require a new capital investment of $16.2 billion in the forms of debottlenecking, brownfield projects, and greenfield projects.  As a result, there is the potential for a raw material cost advantage of up to 60% for products in the ethane-ethylene value chain.

In addition to the shale gas impact on ethanol supply, production of ammonia will become more domesticized as well, leading to large growth possibilities in the agricultural chemical manufacturing industry.  Further, the increased shale production has led to increased United States capacity for methanol, which could lead to a significant opportunity because presently accounts for half of the world’s consumption.  Hundreds of chemicals are also used in the fracking process, where roughly 2.5 million gallons of water and 1.5 million pounds of sand represent 99.5% of the fracking mixtures, and the remaining 0.5% of the mixtures is made up of chemicals.  Projects directly synthesizing heavier derivatives will also benefit from increased shale gas because they are experiencing greater returns due to being in shorter supply because of cracker conversions to ethane.

The input cost advantage in North America that is being led by an increasing abundance of nat gas and helping both organic chemical producers through NGLs as well as the inorganics through lower energy costs (Middle East being the one exception), the North American chemicals landscape looks to be the most promising world-wide for years to come, justifying the heavy domestic investment that the industry is set to see.  Key questions would remain in our ability to manage typical risks for a complex industry, such as environmental, regulatory, specialized credits and equity investment approach, proper tax treatments, infrastructure and access to realize the Shale gas driven potentials. What are your thoughts?

Perspectives on Clean Technology (Follow-on)

In 2009 I shared some thoughts here on clean technology development. After some positive feedback I thought it would be appropriate share additional perspectives to do a follow-on piece for 2012.

Clean technology is not a phenomenon that is going away, and that is becoming clearer with each passing year. A few pervasive fundamental drivers exist:

• The same motivating factors that were driving clean tech five years ago still exist, and some (emerging market demand and environmental stress) are even getting stronger
• Clean tech is an incredibly diverse industry and the term reaches into a broad array of business segments
• There is systemic inertia which continues to push toward greater efficiency and reduced environmental impact – not just in energy, but across the spectrum
• Need for sustained innovation and the effect of cost arbitrage
  

While folks are concerns about sovereign debt, regulatory changes, and increased competition, 2011 was a record year for clean technology deployments and I believe 2012 will be even a better year as capital flow increases and emerging dynamics continue to make the case for clean technology as a worthwhile industry. From energy, to materials, to natural resources, and even governmental and regulatory action, developing clean technology is a mindset that a host of players are caught up in. And one issue that is frequently misunderstood is the utter scale and pervasiveness of what this area encompasses. To put it simply, clean tech is in play virtually everywhere that matters (e.g. water, smart or renewable materials, clean transportation, electric vehicles, energy storage, etc.)

Energy issues do not seem to ever go away. Today, there is a lot of regulatory action which is setting out with the goal of correct arbitrage and imbalances between technological development and commodity pricing (think of the corn ethanol subsidy/drawdown). It serves as an impetus for new tech growth, and that is what is important here. Appropriate regulatory action is certainly not slowing down development, as clean tech is also a politically popular and viable economic movement.

As I have said before, this is a different animal that what we saw in the 90s with the dot-com era (high initial capital infusion followed by a network of low cost start-ups to develop value). Rather, the clean tech industry is one that driven by “tech innovation AND implementation.” That is to say – the dissemination of innovative technology on a broad scale and the ability to ramp up production and utilization sooner rather than later. It is important to balance that point by saying that technology is the driving concern here, and a capital-intensive asset-driven business is not. Technology developers should be implementing strategies which allow them to advance their developments with lighter asset burdens. Partnerships with manufacturers and high-infrastructure companies while focusing on research and development is a smart play – one which will see faster commercial realization. Once again, a savvy industry focused investor (e.g. specialty venture capital or private equity investment firms) should understand the difference of “asset plays vs. new technology play” and consider review both the immediate capital cost of deployment of a new technology as well as the long-term cash flows and liabilities that can be inherent in such investment consideration.

Nowhere is the implementation need more conspicuous than in sustainable and renewable energy. Traditional energy sources, especially fossil fuels, are creating incentives for their own replacement – both economic and environmental. To scale this sector to the point of wholly replacing traditional energy is far from a realistic proposition in the foreseeable future. What is important at the present moment is to scale deployment of new energy technology while reducing associated costs. The goal is to grow an important supplement to traditional energy, which will mitigate its costs. We are seeing this more every year (think of growth in wind and solar, as examples). Efficiency is another key theme in energy – one that can be addressed by clean tech advancement (but which necessitates the incentives to do so). Regulators can play an important role here.
Certainly one of the biggest areas for clean tech development moving forward is powered transportation. Here we see some of the greatest energy consumption (again, particularly fossil fuels) coupled with high environmental impact. This is particularly true for emerging markets, where we see exploding industrialization and associated demand. The impact of these areas cannot be ignored. Much can be done to improve the industry on a technological basis. Fuels, materials, drivetrains, and motors are all components that are ready for innovation. Again, incentives must be in place.

The central theme of my view on clean technology is that it’s an expansive industry, which will provide consistent economic development opportunities moving ahead and chemical and specialty materials industry players are at the forefront of this movement. An innovation in “business of chemistry” could translate into an innovation for “clean technology industry”, and vice versa. What are you views?

Synergistic acquisition to promote innovation

In January, BASF and LKCA (a subsidiary of Linde Group), announced that they would jointly market licenses and plants for the capture of CO2 from flue gases, and recently, with assistance from RWE Power, they have created (and successfully tested) a major breakthrough in carbon capture technology. The new innovative technology captures CO2 by means of utilizing new chemical solvents that can reduce energy input by about 20 percent. Furthermore, the new solvents feature superior oxygen stability, which reduces solvent consumption significantly, which consequently improves efficiency.

In the future, climate-capture technology will likely play a key role in generating climate-compatible power from coal, and this new technology process, once scaled up to large power plants, will reduce power plant waste gases and facilitate clean energy generation. In addition, as this technology should capture more than 90% of the CO2 contained in waste gases, a vast supply of recycled CO2 can be created and used for inputs in chemical transformations such as production of fertilizers. New plants demonstrating this technology are scheduled to be in operation by 2015, and the technology should be expected to be utilized commercially in coal-fired power stations by 2020. Ultimately, once this technology expands, there will be a significant reduction in the release of climate-damaging CO2 due to its successful capture and transport for recycling or sequestration.

So, why is this development relevant in the chemicals industry? And why is it relevant within the private equity industry? First, this development illustrates the strong motivations within the chemicals industry to become more environmentally sustainable while simultaneously reducing costs and improving efficiency. Furthermore, this new technology derived directly from the pooling of knowledge and resources from various firms with different areas of expertise; individually, the companies would likely have found development of this technology exceedingly difficult, however, when their resources were combined, breakthroughs were managed in rapid fashion. Similarly, in the private equity industry, companies are strategically acquired so as to enable such synergies to promote swift innovation and long-term value creation, and as this particularly example clearly illustrates, the broader chemicals industry provides a viable forum in which to initiate such developments.

Solvay- using its cash hoard for an acquisition?

While its outlook remains challenging, Solvay reported a strong set of results for Q1-2010, especially a volume jump in its Plastics division and good progress in pulp & paper, construction business etc. Solvay has cash to spend after selling its pharmaceuticals business last February and a redeployment of its cash proceeds likely near-term. The question is where?

There are many possibilities for Solvay’s acquisition: Croda International and/or Symrise which are relatively stable; on the other hand, Solvay could buy one of the struggling companies like Arkema, Clariant, Rhodia, and Umicore etc. The real question is: would Solvay act to transform the company (risky) to be a major long-term value player or will it just satisfy the street/market by looking at the short-term (safe) benefit?

Why doesn’t a PE firm do well in Chemical business?

Chemical companies were always considered a very good credit risk, given their cash flows and fixed assets as well as diversification through their cross-border activities. Except for liability lawsuits, very few large chemical companies ever went bankrupt. Even highly leveraged large transactions were successful — from Union Carbide in the 1980s to the Gordon Cain transactions and the more recent acquisitions of Nalco, Celanese (lucky deals) and LyondellBasell, Hexion/Huntsman (not so lucky deals).

The fact is typical private equity firms (even Bulge Bracket firms, let alone middle-market buy-out firms) do not do well with chemical company investment due to their: i) short-term focus [“catch me if you can” mentality] ii) lack of understanding of complex chemical business where financial engineering may not be enough iii) timing the economic cycle often difficult and IPO may not be an easy exit strategy.

I believe, one of the key criteria to be successful in chemical industry is to maintain TRUST and long-term relationship. Traditional private equity often only focus on low price of a chemical business (say 4 to 6x EBITDA range) instead of the long-term value of a business. At the same time, the level of distrust among traditional Wall-Street players are more than ever, causing problem to raise reasonable debt. While many other sector players are paralyzed and remain static, the chemical industry folks are busy in debt raising or financing due to good fundamental and here are a few examples.

Ashland Chemicals (ASH) announced a few weeks ago to issue $600 million of unsecured senior notes due 2017. ASH will use net proceeds from the offering along with free cash flow generated (which we estimate to be $383 million in 2009) to retire the $750 million 9% bridge loan facility that is set to mature and roll over to an exchange note (at a likely even higher interest rate) in November of this year. By taking out the $750 million bridge loan before maturity, ASH can prevent it from potentially being rolled over to an exchange note that we believe would likely bear interest in the 12-14% range. While the ultimate impact of the pending debt offering on ASH’s interest expense is yet to be decided, we believe that it 1) reduces ASH’s financial risk, 2) eliminates the near-term maturities that were weighing on the stock, and 3) could potentially even result in a lower interest expense going forward.

Nalco Chemical Company (NLC), has issue $500 million aggregate principal amount of 8 1/4% senior unsecured notes due 2017 (the "Notes"). The notes will be issued at 97.863% of the principal amount to yield 8 5/8%. Nalco Company intends to use the net proceeds from the offering, along with proceeds from new credit facilities, comprised of a seven-year $750 million term loan credit facility and five-year $250 million revolving credit facility, to repay outstanding debt.

DOW Chemical (Dow) reduced its financial leverage, shrunk its near-term debt obligations and eliminated its extremely expensive perpetual preferred notes with the issuance of $2.25 billion of equity as well as $6 billion of longer-term debt.

Rockwood Specialty (ROC) has successfully completed an amendment to its credit agreement, allowing the company additional financial flexibility through its covenants, and extended maturities of its Term Loan E and Term Loan G, however all this did come at a price. Rockwood has amended its leverage covenant definition and level from Total Debt/ EBITDA of 4.25x to Senior Secured Debt / EBITDA of 4.40x, stepping down to 4.00x by the end of 2010. I believe, the credit agreement was little pricy, $8.7mm in one-time upfront fees (keep in mind that ROC was owned by KKR and it was highly levered during IPO…. Very similar to Nalco). This adjustment leaves the company significant room under the covenant--well beyond what is needed in this economic/earnings environment and gives them room for acquisitions if the opportunities arise. 2009 EBITDA estimate (excluding FX gains and losses) is $530.1mm. Next, Rockwood will extend maturities of $1.22 billion of Term Loan tranches E and G to May 15, 2014 from July 30, 2012.

Is Biodiesel market marked by uncertainty?

The biodiesel market in the U.S. faces important issues; however, biodiesel is a key component of a sustainable future, and the industry will have overcome many challenges. U.S. and global demand for biodiesel has soared in recent years, but growth slowed in 2008 as energy demand and petroleum-based diesel prices fell. U.S. biodiesel production in 2008 rose nearly 40% to 683 million gals, as soaring U.S. exports, mainly to Europe, more than offset a drop in U.S. demand, according to the Energy Information Administration (EIA; Washington). Considering current economy, it’s not a surprise that U.S. domestic demand fell 8% year-over-year in 2008, to 320 million gals. A surge in biodiesel capacity and production was caused by biodiesel mandates under the U.S. Renewable Fuel Standard (RFS), higher fuel prices over the last few years, and a $1/gal biodiesel tax credit, EIA says. The European Union recently imposed tariffs on biodiesel imports from the U.S., which could limit U.S. exports, and EPA has not issued rules for implementing biodiesel blending requirements under RFS, which creates uncertainty for market players. While world capacity and consumption of biodiesel grew on average by more than 50%/year from 2002–07; however, the outlook for the biodiesel market this year remains highly uncertain!

Evonik Starts Up Operations at U.S. Biodiesel Catalyst Plant (May 4, 2009), at its 60,000-m.t./year sodium methylate unit at Mobile, AL. Sodium methylate is a catalyst used to manufacture biodiesel produced from sources such as rapeseed or soybean oil.

On the other hand, a number of Biodiesel/Ethanol producers have filed for Chapter 11 protection; such as:

White Energy Inc. : (Reuters) - Ethanol producer White Energy Inc filed for Chapter 11 protection in a Delaware bankruptcy court on Thursday, citing adverse market conditions, court documents showed. In court filings, the company said that while cost of raw materials to produce ethanol were high, excess supply of ethanol in the market has kept ethanol prices low, resulting in “minimal or non-existent profit margins.” White Energy listed assets and liabilities in the range of $100 million to $500 million in its Chapter 11 filing.

Aventine Renewable Energy (April 08, 2009): Aventine Renewable Energy Holdings Inc. of Downstate Pekin became the latest U.S. ethanol producer obliged to seek Chapter 11 bankruptcy protection Wednesday, as the industry’s once-fat profit margins continue to shrink. Ethanol, an alcohol product made from corn and used as a gasoline additive, got a major boost a few years ago from government regulations designed to encourage use of the product to reduce the nation’s dependence on petroleum. ….

Panda Ethanol (Jan. 28, 2009): Dallas-based Panda Ethanol Inc.’s Hereford Biofuels subsidiary filed for Chapter 11 bankruptcy protection in U.S. Bankruptcy Court for the Northern District of Texas.

According to the company, it intends to sell its major asset—a 105 MMgy ethanol facility currently in the late stages of construction in Hereford, Texas—pursuant to a Section 363 sale process, pending approval by the bankruptcy court. The bankruptcy filing doesn’t include the parent company of the Hereford subsidiary, Panda Ethanol.

Verasun (Nov. 5, 2008): VeraSun files for Chapter 11 bankruptcy protection; The recent retreat in corn prices caught one of the nation’s largest ethanol producers offguard. VeraSun Energy Corp. and its 24 subsidiaries filed voluntary petitions for relief under Chapter 11 of the U.S. Bankruptcy Code in the United States Bankruptcy Court in the District of Delaware on Oct. 31, allowing it to enhance liquidity while the company reorganizes.

According to the company, the filing was “precipitated by a series of events that led to a contraction in VeraSun’s liquidity, impairing its ability to operate its business and invest in new and expanding ethanol facilities.” In a statement, the company said it “suffered significant losses in its third quarter financial statement,” citing that a dramatic spike in corn prices attributed to its corn procurement and hedging arrangements resulted in “unfavorable operating margins.”

Many other biodiesel producer are struggling to survive and the the question is what is next!