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?

Update: M&A Landscape Q1 2012

2011 was an interesting period for M&A. The first half of the year saw the bulk of activity, with total global deal volume of about $1.27 trillion, benefitting from a better credit outlook and accelerating economic recovery. The second half of 2011 slowed down for just $875 billion according to Bloomberg, with an overall y-o-y deal volume growth of about 9%. European debt worries and macroeconomic issues, like the natural disaster in Japan, were contributing impediments. Despite these hurdles, however, 2011 was a fairly strong year for M&A.

Where does this leave us for 2012? There is a lot to consider, but the overall outlook is for another robust year. The biggest challenge currently, and one that U.S. firms are monitoring closely, is the European debt crisis, which poses some systemic concerns for the coming year. European problems could become American problems if Europe falls into a recession. U.S. exports are not currently growing, and a European downturn could exacerbate this if demand for U.S. products drops. Higher oil prices are another factor which is holding the U.S. back from stronger GDP growth. Q4 2011 alone saw crude oil prices jump nearly 25% over the previous quarter. Turbulence in producing countries like Libya and increasing demand in China and other emerging markets are the culprits.

The American housing market is still in a slump. Mortgage rates are extremely low but potential buyers are wary of further drops in home value. There are still a lot of inexpensive homes on the market which means less new construction. One piece of good news here is that foreclosure saw a sharp decline last year. Unemployment is another headline issue for the U.S. economy. While joblessness seems to be improving at a modest rate, underemployment is actually increasing according to Gallup, showing that more people have given up looking for work or have taken substandard positions. Faltering job growth has been a persistent remnant of the fading recession. We are still experiencing unemployment over 8% after 10 consecutive quarters of GDP growth.

But don’t be put off by these difficulties. There is plenty to be enthusiastic about, and 2012 looks to be busy for M&A. To begin with, there is upwards of $500 billion in dry powder that is expiring soon, so financial sponsors should be chasing targets very aggressively. Lending markets are looking more attractive, as well, particularly for larger firms with lower risk profiles. Cash is available. 2011 also saw better U.S. real GDP growth rates with each passing quarter. Q4 ended with the fastest growth rate since early 2010. And consumer spending (one the chief drivers of our economy) jumped to 4.4% growth over 2.7% in Q3. This is the fastest pace in over five years. Manufacturing is picking up speed and U.S. economic recovery is accelerating. Prospects in the middle market are particularly promising, and this is where the action is. The lower middle market is most active. 79.5% of middle market deals in 2011 were under $100 million. Most of these deals are being done in cash. Total enterprise value to trailing 12 month EBITDA ratios are also on the rise in the middle market: averaging 7.6 in 2009, 8.6 in 2010, and 9.2 last year. Higher valuations are coming in the wake of higher corporate cash reserves, suppressed interest rates, and more M&A activity. The middle market is particularly active in the private equity segment, as well. In the first half of 2011, 75% of deals in PE were valued under $250 million. Deals under $500 million made up nearly 80% of deal flow for the year. Much of the deal-making here is in acquisitive growth (making up as much as 50% of PE acquisition in 2011). Business products and services was the most active industry segment for private equity, while the energy sector saw a drawdown, particularly in Q4.

Please feel free to review “M&A Outlook 2012”:
http://www.slideshare.net/ennovance/ma-outlook-2012

Even Warren Buffet likes the "business of chemistry" ….another stamp of approval for chemical industry thorough acquisition of Lubrizol

During the last few years, Berkshire Hathaway Inc. has made many investments in chemical and chemistry related businesses such as Nalco, Dow (Rohm and Haas), Great Lakes Chemical (GLK), Kaiser Aluminium & Chemical Corp. Sealed Air Corp, GSK, J&J etc. along with some petrochemical companies like ExxonMobile, ConocoPhillips, PetroChina and so on. Mr. Buffet’s notable commitment to the chemical industry is illustrated thorough Monday's announcement to purchase Lubrizol (LZ) for $135 a share, 28% above Friday's closing price! The consummate value investor, Mr. Buffet is expected to pay $9.7bn (which includes $700m in net debt) for the transaction. Even after paying a $30 premium (i.e. 28%) over the $105 closing price on Friday, Lubrizol transaction is priced at approximately, 7x 2011’s EBITDA and 5.4x 2012’s EBITDA.

Now if you consider today’s availability of cheap money in the capital structure, the WACC is no more than 8.5% (assuming at least 2x interest coverage with a realistic leverage 4.7x - 5x), Mr. Buffet is expected to generate top quartile returns (with a minimum Internal Rate of Return (IRR) percentage in the 20s within 3-5 years!).

We can talk all day long about the public market anomalies, various deal dynamics, and business related topics such as sustainability of margins in the lubricant additives value chain or excessive swings of commodity feed stocks (e.g. energy price, oil and petroleum derivatives). However, a company’s success will continue to depend on the management’s ability to control risk and take advantage of perceived market risks. For example, Lubrizol is a well managed company that poses an excellent profile of a “very good” specialty chemical company, growing its revenue consistently (for example: $3.4B in 2004; $5.4 in 2010), generating very strong cash flows and returns on capital, displaying a strong balance-sheet and flush with cash. We should also realize that Lubrizol has been increasing earnings at a compounded growth rate of 16% (at least for last 10 years; and Lubrizol's earnings growth has accelerated to over 25% per annum during the last 5 years).

Lubrizol continues to maintain its specialty status in a “so called commodity risk” environment by focusing on: its proprietary product (not necessarily patent protected product), mastering its product application for their customers’ system/process, delivering process/system monitoring services and maintaining overall strategic focus etc. (note: Relatively speaking, Lubrizol is neither capital intensive nor over reliant on R&D expenditure). Ultimately, Lubrizol’s strong performance over the years coupled with an excellent new owner should position Lubrizol to be even more successful as it moves forward. What are your thoughts?