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Upside With Westlake As Manufacturing Sector Gets Slammed
As we see a drop in global manufacturing, the demand for plastics and other chemical products inherently drops. We are on the brink of a global recession (many parts of the world are already in one), which will send demand for these key products even lower.
When you evaluate a petrochemical company, it’s important to understand their “crack spread” or realistically how they make money and what kind of margin they can achieve. The spread is simple:
- The petrochemical facility needs a feedstock to break down and convert into something else
- A cracker (the part of a facility that breaks down the hydrocarbon) takes in a mix of products: ethane, propane, butane, iso-butane, light naphtha, heavy naphtha, or gasoil.
- It “cracks” the hydrocarbon down into other materials that can be converted
- The cracking process requires multiple ingredients- feedstock, natural gas, and electricity to create the next step. The cost of these key pieces is very important because as costs rise at the front end- the company needs the price of the end stock to also rise!
- We have seen natural gas and electricity prices soar, which should increase the price of the final product.
- For example, they produce LDPE (low density polyethylene, which is just a plastic container or squeeze bottle or other molded plastic. They also produce PVC (polyvinyl chloride), which is just the tubes used in the house to run water, electricity, or outline doors/windows.
- During COVID, shortages appeared everywhere, and housing took off sending the price of LDPE and PVC skyrocketing. Even as electricity, natural gas, and feedstocks also soared, the chemical companies were able to pass through the additional price and add a significant premium.
- Now that supply chains have caught up, manufacturing is falling, and housing is collapsing- the cost of feedstocks are still high but there is NO DEMAND for the end product.
- This has caused margins to collapse, and severely impact the ability for the companies to actually generate revenue
We have seen a slew of economic run cuts, which just means that a facility is reducing its operation because it can’t make money. The facilities have to run at a minimum level (usually around 60% utilization) to maintain pressure gradients.
Typically, it’s cheaper to have it run at a minimum to cover fixed costs while the company loses money on their variable costs. The shutdown and restart of these facilities is a massive undertaking (and very costly) which is why they just reduce runs instead of “mothballing” them.
On the other side, we have had new facilities come online over the last year that have been under construction for the last 3-5 years. After spending billions, companies are incentivized to “turn them on” even if the market is oversupplied to cover fixed costs.
This is all leading to a market that is saturated with product as the market is just at the beginning of tipping into a recession. Plastic demand is dropping in response as the housing market is getting hit hard around the world shrinking new starts and a key end market for petrochemical companies.
The below charts are just some examples of how deep the margins have fallen.
PVC Proxy
Integrated LDPE proxy
Integrated LLDPE proxy
When you layer in all the crack spreads against the stock price, you can see a massive move higher in stock price that is NOT supported by margins.
Instead, margins have dropped off significantly while price has remained very elevated. We expect to see a swift reversal especially as the global economy worsens and housing data continues to disappoint to the downside.
Today’s Recommendation:
The best way to play this is by buying puts on Westlake Corp. (NYSE: WLK).
Their earnings and guidance were absolutely terrible, and you can see how the Street has been taking down estimates while the stock price has moved higher.
Westlake is U.S. based with the largest exposure to housing. It has plenty of room to fall in price. Here’s why:
When we look at new home sales compared to previous Fed tightening cycles, there is more pain that will last for an extended period of time. We have a historic spread between homes under construction vs completion- which is a problem for petrochemical companies.
All of the homes under construction have already put in orders and likely taken delivery of the product they need. The slowdown in demand and housing is going to keep those homes on the market and drive down new starts going forward.
Homebuyer demand is collapsing, and it’s reached the lowest level since the start of the 2008 housing crash. We are still in the early innings when it comes to the drop in housing data.
We have expected single family sales dropping like a rock:
The affordability indexes have also gotten hit, which means people won’t be in any hurry to purchase a new home:
When we summarize all the data and look at key metrics for Westlake- things are only getting worse.
We have already covered in great detail the continuing slow down on PMI, global manufacturing and trade, and consumer activity. All of these core pieces are moving in the wrong direction.
China has “saved us” in the past, but they are experiencing a real estate crisis that rivals 2008 (and likely worse) which has absolutely destroyed demand in Asia.
They have also brought on their own petrochemical capacity that is no longer being consumed in a meaningful way within their borders. Not only is the economy slowing BUT now you have to compete against insanely discounted Chinese product.
China activity indicators for Nov came in much weaker than expected on COVID-linked restrictions and protests. Floor space startsremain at 13-year lows and residential demand is back to new cyclical lows.
Overall construction activity was unchanged at cyclical lows and 24% below pre-pandemic trend while bottoming out on a y/y basis (-9.3% y/y vs -14.2% in Aug).
We have industrial production around the world dropping and retail sales- so can we really see a big pick up in plastic demand? Can housing really save us? The last point of strength in manufacturing has been Asia-Ex China, which has moved into contraction in December.
As central banks keep pushing rates higher, world manufacturing is only going to slow further as investments pause and companies struggle to manage balance sheet leverage.
Given the level of debt in the world- central banks can’t afford to slow down their rate hikes to attempt to pull liquidity from the system and manage inflation.
We have also never had a coordinated increase in global rates to this level any time in our history.
We are going to see way more pain across the board impacting plastic and housing demand.
CONCLUSION
Petrochemicals are a great way to bet on the direction of global growth and given the elevated stock price and terrible margins- now is the time to strike.
Westlake is set to see a rapid move lower to about $80 and likely back to $60 over the longer term.
***Action to take: “Buy to open” the WLK July 21, 2023 $95 put option up to $7.75 per contract.
- The symbol is WLK230721P00095000
- Search for options under the stock’s ticker: WLK
- Make sure you choose the right option (expiring on Jul 21, 2023)
- Choose the $95 strike price
- Select “put” options
- Select how many contracts to buy
- Once you have the right contract, click “buy to open”
- Choose “limit order.” This sets the price for the trade
- Use a limit of $7.75
- Click “buy” to transmit the order.
If you place a limit order near $7.75, your order should be filled.
Note on risk: Options plays can be volatile, and all involve plenty of risk. And although these ideas are well-researched, nothing is guaranteed. Don’t bet the mortgage money here. And remember, it’s up to you to decide how much you’d like to put into each play. Please be sure to diversify your risk, and don’t put all of your money into one play.
We believe the July options will give us more than enough time to capture the slowdown happening now and likely to accelerate in Q1’23. It also helps to protect our “theta” or time decay to give us time to let the thesis play out.
I am expecting great returns from this play over the next few months.
On behalf of the entire team here at Power Profits Insider, we wish you and your family a very Merry Christmas and a prosperous New Year!
Regards,
Freedom Financial News
