- It is difficult to locate value within the conventional notion of the petroleum industry, especially in the upstream.
- A holistic approach to the much broader petrochemical and petroproduct value chains suggests that most of the economic value in the petrochemical industry is created and realized downstream.
- Vertically integrated value chain players are able to source cheap inputs and produce value-added products with intangible values.
- A simple case study of 10 publicly traded companies which occupy the “sweet spot” of the petroleum value chain corroborates the intuition regarding economic value realization.
- The value chain analysis framework can be applied to any situation in which raw materials are liberated from commodity market forces.
The Petrochemical and Petroproduct Value Chains
In a previous SA article, Right-Headed Investors Should Avoid Upstream MLPs, I bemoaned the apparent lack of value among publicly traded oil and gas companies. My conclusion was that taking equity in most oil producers is essentially identical to speculating in call options on petroleum prices. Personally, getting long a business a sector which needs higher commodity prices lacks appeal. The simple reality is that, especially at lower prices, most upstream producers must sink more money into the ground than they can get back out. Although there are notable exceptions, higher quality upstream assets typically trade at significant premiums to the discounted net present value of their reserves plus working capital. Those companies which appear to be undervalued relative to this metric also tend to be those which are uneconomical during times of depressed commodity prices (i.e., now), especially on a cash flow (i.e., non-GAAP) basis. Moreover, as FY 2015 draws to close, the value of asset write downs in the upstream segment will be staggering as reservoir managers adjust estimates of the SEC standardized measure (or PV-10) to lower petroleum prices. Others have begun to share this disposition and the evidence is piling up.
SA contributor, Chris Aublinger, in his ambitious series “How Much Does It Cost To Produce One Barrel (MCF) Of Oil (Gas)” has repeatedly noted that the cash flow situations for most upstream businesses are very dire, in which investing cash flows far outstrip internally generated operating cash flows. In a more recent piece, Shale Producers Can’t Make Money At An Oil Price Of $60, Chris also carefully models out how, at current prices, even premier independent producers EOG Resources (NYSE:EOG) and Continental Resources (NYSE:CLR) are not earning acceptable rates of return. Furthermore, the Carbon Tracker Initiative, in its 2014 Oil Major CapEx Report, used deep-dive data from Rystad’s UCube upstream database to demonstrate how the majority of oil majors’ planned and potential capital expenditures require oil prices above $75 per barrel for economic sanction (i.e., break-even on net present value plus a minimum required return on investment). Bloomberg analyst Carl Pope recently echoed this thesis in the article, Why You Should Short Public Oil Companies. In Carl’s view, the majors continue to invest in uneconomic projects out of a lack of options — “Easy oil had already been found”.
Along those lines, I have reformulated my investment thesis: what we normally think of as the oil business (i.e., upstream, midstream, and downstream) can just be thought of as a means of producing the raw materials for the entire petrochemical value chain. In fact, according to ExxonMobil’s (NYSE:XOM) 2014 10-K, the super-major’s refining capacity is well in excess of its year end oil-equivalent production. In 2014, ExxonMobil’s upstream segment produced 3.969 MMBOE/day (53.2% liquids) while its refining throughput was 4.476 MMBOE/day — the highest throughput for a single company in the world. Truly, ExxonMobil is as much a chemical company as an exploration and production company, if not more so.
This concept of a value chain was first described by Michael Porter’s best selling Competitive Advantage: Creating and Sustaining Superior Performance. Simply, a value chain is a supply chain through the lens of economic value creation; it is a linked set of value creating activities which transform raw materials to end-use products.
The petrochemical value chain is immense and truly a source of wonderment. To an extent, I’m referring to oil and gas refining, but it’s much broader and deeper than that. At some point in this chain, between where oil is pumped out the ground to where it is used in a myriad of applications, a commodity can be mystically (i.e. chemically and/or perceptually) transformed into something proprietary and with intangible value. Figure 1, below, produced by the U.S. Department of Energy’s National Renewable Energy Laboratory in a publication on value-added organic chemistry encapsulates both the intricacy and complexity of the petroleum value chain. For the first time in my life, I wish I had actually paid attention in organic chemistry class.
Figure 1: Flow-Chart for Products from Petroleum-based Feedstocks
Source: Department of Energy. National Renewable Energy Laboratory. Top Value Added Chemicals from Biomass Volume I-Results of Screening for Potential Candidates from Sugars and Synthesis Gas. doi: August 2004
Take cosmetics for instance, which are usually not much more than petroleum-based hydrocarbons and ground up minerals. In terms of raw materials, cosmetics are cheap. However, when we add in a little bit of chemistry and brand differentiation to the mix, these raw materials command much higher value premiums which are totally dissociated from the prices of the underlying commodities. Think about it: did the prices of make-up, paints, sealants, tires, water bottles, perfumes, synthetic fabrics, and more drop at all when the price of the primary raw materials (i.e., petroleum) plummeted 40-50% over the past eight months? No. While the consumer saves some money on fuel costs, and refineries lowered their cost bases, consumer petroproducts manufacturers are the overwhelming beneficiaries in times of lower petroleum prices .
The first task at hand from an investor’s perspective is to find the sweet spot in this chain and invest accordingly. In general, the more steps between the commodity and the end-consumer, the greater the mark-up. The greater the mark-up, the more potential there is for value creation. Figure 2, below, exemplifies a simplified petrochemical value chain in which raw materials (bound to commodity market forces) are transformed into value-added consumer products whose prices are dissociated from the underlying commodities.
Figure 2: Sample petrochemical value chain
Source: Petroleum Online. Overview: What are Petrochemicals?
Taking that “sweet spot” notion one step further, the more vertically integrated an enterprise is upon that long value-chain, the greater the potential to cut out the middle-men and realize that value creation along those various steps under one roof. Such a conceptual approach to investing in oil and gas might help investors avoid the pitfalls of investing in commodity driven businesses in which producers are forced to compete on cost and scale and in which they have virtually zero influence over the all-important operating lever: price.
However, there is trade-off with traveling too far down the value-chain. Consumers can be a fickle folk and, as a result, end-products often go into and out of fashion. While commodity producers can always rely on there being a buyer at a set price, the same cannot be said for an out-of-vague or low value brand name. To this extent, commodity-driven businesses can offset increased commodity risk with decreased consumer risk.
Figure 3, below, exemplifies how a small sample of companies fit into this larger value chain. Clearly, there is a direct correlation between how deep one travels down the value chain spectrum and management’s focus on either low-cost leadership, product differentiation, or niche focus. Enterprises which fall into this “sweet spot” are those which are able to source cost advantaged commoditized inputs, process those inputs into high value products, and still manage to isolate themselves from cyclical consumer demand. Graphically speaking, the sweet spot lies somewhere near intersection of integration and the downstream value chain. At this junction, we find the most deeply integrated oil companies like ExxonMobil and integrated petrochemical companies like BASF (OTCQX:BASFY), LyondellBassel (NYSE:LYB) and Dow Chemical (NYSE:DOW).
To phrase everything so far as concisely as I can, the sweet spot in the petrochemical/petroproduct value-chain is the point at which a staple (i.e. non-discretionary) product is somehow liberated from the shackles of cyclical commodity market forces.
Now the trick is to figure out a fair price to pay for a cut of the action and hopefully pay significantly less than this amount.
Some Quick Picks out of the Petroproducts Value Chain
Those who have followed along and are in general agreement so far with the hypothesis may be wondering about some candidates for a deeper dive analysis. I have (somewhat arbitrarily) picked out a representative cross-section of 10 publicly traded companies which occupy the “sweet spot” in the petrochemical value chain. A concise financial analysis of these companies should describe the ability of operations to finance investments and the cost of investor capital (i.e., dividends). It should also give a sense of valuation. I cannot conscientiously recommend an investment in any of these stocks without further due diligence, but I can at least try to point investors in a good direction.
Given the issues with the upstream petroleum industry’s economics, a key metric for the entire value chain is the ability to fund investments and dividends with internally generated cash flows. The basic line of reasoning is that if a business adds significant value, it should be able to generate cash in excess of its investing and financing needs over any significantly long time frame. Although reinvestment of profit into organic growth projects is a good sign, the kinds of profits that need to be reinvested in order to maintain a constant level of profitability are functionally expenses in disguise (i.e., paper profits). In this example, I look at investment coverage ratios over a three year time frame. I used a similar approach in a recent article on upstream oil and gas master limited partnerships.
For a “back of the envelope” valuation, few metrics are as reliable as EBITDA to Enterprise Value (EV) and Price-to-Book ratios. EBITDA is a proxy for cash flows which untangles some of the accounting distortions of deprecation, taxes, and capitalized interest. The ratio of EV to EBITDA is appropriate since it measures cash flows to the overall market value basis of an operating entity (not just shareholder’s equity). The Price-to-Book ratio simply measures the market price of equity in relation to its historical cost basis (plus or minus mark-to-market adjustments, impairments, and other accounting distortions). Again, these metrics are intended as a starting point for ideas; they do not suffice as a thoughtful valuation.
Table 1, below, summarize the three year investment coverage ratios for 10 publicly traded companies. Table 2, below, summarizes key valuation ratios.
Table 1: Operating Coverage Ratios (3 Year)
|Ticker||Name||Operating Cash Flow (3 yr, $MM USD)||Investing Cash Flows (3 yr, $MM USD)||Dividends Paid (3 yr, $MM USD)||Operating Coverage|
|DOW||Dow Chemical Co (The)||18,400||7,261||5,549||1.44|
|DD||E. I. du Pont de Nemours and Co||11,645||-1,262||4,951||3.16|
|LYB||LyondellBasell Industries NV||15,670||6,146||4,945||1.41|
|EMN||Eastman Chemical Co||3,833||7,510||542||0.48|
|WLK||Westlake Chemical Corp||2,409||2,242||418||0.91|
Table 2: Key Valuation Metrics
|Ticker||Market Cap ($MM USD)||Enterprise Value ($MM USD)||EV to EBITDA (TTM)||Price to Book (Q)|
Summary of Results
Judging from Table 1, it is fairly common for companies in the downstream petrochemical value chain to have been able to fund non-discretionary cash flows through operations. This is in very marked contrast to the upstream oil and gas industry which struggles to meet this benchmark even during times of higher petroleum prices. This conclusion, which was suggested by the holistic approach to value chain investing, is backed by empirical data — a definite win, by my own account.
Moreover, 5 out of the 10 companies trade at EV multiples of less than 10x trailing twelve months’ EBITDA; cheap by most standards. On the other hand, all companies trade at significant premiums to their historical cost bases in equity. Obviously, it is preferable to buy assets cheaply, but premiums to book value just show that the markets appreciate a firm’s ability to generate substantial returns on capital.
In summary, an apparent lack of inexpensive, high-quality assets in the upstream oil and gas industry lead me to reevaluate key assumptions about the drivers of value in the much broader petrochemical and petroproduct industries. A holistic approach to the petroleum value chain suggests that the bulk of economic value is created further downstream. The “sweet spot” in this value chain lies at the intersection of integrated operations and a focus on creating products which are priced independently of the underlying commodity inputs. Companies which occupy this sweet spot can thrive in most commodity price environments (and can even benefit in times of lower prices). An empirical analysis of key operating and value-based metric corroborates this intuition.
My conclusion regarding the merits of vertical integration is sure to catch flack, especially because this idea is out of vogue. Reality is that the merits or demerits of vertical integration are actually more nuanced. In the 1970s, a wave of vertical integration (and conglomeration) was spurred on by the quest for efficiency through scale. However, the quest for scale for its own sake is believed to have constrained innovation and flexibility. The vogue now tends to be inverse integration. Market values of parts of companies are now more often worth more than the sum of the whole and these companies are therefore incented to break up thereby unlocking market value. The pendulum has now swung to the point at which corporate break ups occur irrespective of the loss or gain of operating efficiencies. There is no blanketing truth on the merits of integration; each case should be evaluated using a first principles approach (à la Elon Musk and Aristotle). According to a study in 1993 by McKinsey & Company, “A strategy as risky as vertical integration can only succeed when it is chosen for the right reasons.”
Generalizing on the value chain analysis framework, we might ask ourselves if this same logic applies in other situations and across diverse industries. With a little bit of thought, I believe that it is fairly apparent that this framework can be applied to almost any situation in which in which commodities are transformed into tangible products with intangible values.
In looking at any business, again, my challenge to investors is for them to first ask, “where is the sweet spot?” In other words, where is the economic value created and where is it realized? In this respect, value chain analysis is a close companion of economic moat analysis which seeks to identity how competitive advantages (i.e., sources of value) are won, kept, and lost. In this respect, the barriers to entry for deeply integrated petrochemical companies are extraordinarily high (this is a good thing). In order for integrated petrochemical companies to succeed, locating and extracting economical sources of raw materials is only the start. Integrated companies must also rationalize the complex supply chain from the raw materials all the way to the consumer — not an easy task.
Now, as I previously alluded, an investor’s take is now to come with a fair price to pay and hopefully identify real-world situations of price-to-value dislocations — more on that is to follow.