(Macro) The Chemical Sector Overview
Editor’s Note: This is just a high-level overview of the space. We will be covering the names that we are long in individual write-ups over the next 2 weeks.
By: Jon Costello
The chemical sector is in its longest downturn in recent history. For many chemical companies, earnings have been on a downward path since 2021. As demand remains tepid amid abundant supply, the industry faces several headwinds, both cyclical and structural. However, opportunities are there for investors who understand the risks and potential upside.
After reviewing the industry, I have found a few crucial points for investors navigating the sector in search of bargain opportunities.
One is that opportunities are absolutely there for the taking. Anyone who looks at the past earning power of the typical industrial or commodity chemical company and compares it to today’s market cap and enterprise value can appreciate that most of the sector is cheap. Many chemical stocks trade at obscenely low multiples of mid-cycle earnings. Interestingly, this isn’t the case in the energy sector, where most stocks discount a sustained recovery. But even using extremely conservative valuation assumptions, I believe multi-baggers exist in chemicals for investors who can identify opportunities, size their positions appropriately, buy on weakness, and stomach the inevitable volatility that arises in cyclical downturns.
A second crucial point is that cyclical forces will bring about a recovery. No one can precisely time when this will occur, though I believe a recovery is in the making for some chemical sub-sectors.
For example, some particularly cyclical chemical sub-sectors are experiencing low prices that will likely lead to supply curtailments. Eventually, inventories will get worked down, prices will increase, and margins will grow. Meanwhile, in areas that may remain weaker for longer, low-cost producers are available. These are the companies that are most likely to survive the downturn and thrive in the ensuing upcycle. These are the kinds of opportunities investors should try to identify.
Such low prevailing prices raise the question of whether the sector’s low valuations are justified. This is another crucial point worth fleshing out, namely, that olefin producers are cheap for good reason. This is a large segment of the sector by market cap, and it often tops the buying lists of many generalist bargain hunters. Companies such as Dow (DOW), LyondellBasell (LYB), and Westlake (WLK) are at risk of a far more brutal downturn than their non-olefin peers. Their stocks are right to be low and will likely remain so, as their profits are at risk of moving even lower for years. Any recovery is likely to be fleeting.
This isn’t necessarily the case for non-olefin producers, though I suspect that many have been tarred too negatively with the olefin brush. Investors can therefore divide the chemical sector into olefins and “everything else.” The former are to be avoided altogether, and I discuss why below. The latter is where mispricings can be found.