Equity Analysis /

Engro Polymer & Chemicals Ltd: High oil prices can trigger a down-cycle in spreads

  • We revise downwards our estimates of EPCL to a Neutral stance with a December 2022 TP of PKR59/sh

  • High oil prices can shrink PVC-Ethylene spreads with high feedstock prices and lower demand

  • Market price implies PVC-Ethylene spread of US$450/ton for CY23 and onwards

Intermarket Securities
16 March 2022
  • PVC-Ethylene spreads have corrected 40% from its recent peak level since Nov’21. Amid the Russia-Ukraine crisis and the prospect of oil prices remaining above US$100/bbl for long, we flag the risk of further compression in spreads. Historically, PVC demand and spreads compressed sharply when oil prices were above US$100/bbl.

  • EPCL’s stock price suggests implied PVC-Ethylene spreads of c.US$450/ton for CY23f onwards, already pricing in a decline of 40% from present levels, in our view. This and some dissimilar aspects to the previous down-cycle period may provide a floor to spreads, in our view.

  • Therefore, we remain Neutral on EPCL with a December 2022 TP of PKR59/sh (down from PKR68/sh earlier) amid uncertain outlook over PVC-Ethylene spreads due to soaring energy prices with an assumption of US$650/450 per ton for CY22/23f.

Remain Neutral with a new TP of PKR59/sh

We maintain our Neutral stance for Engro Polymer & Chemicals Ltd (EPCL) with a December 2022 TP of PKR59/sh. Our assumptions of PVC-Ethylene spreads for CY22/23/LT at US$600/450/450 per ton vs. present levels of over US$700/ton, where we flag the risk of compression in global spreads as elevated crude oil prices threaten to depress demand in the coming years. Since the onset of Russia-Ukraine conflict, Brent crude oil prices have rallied above US$100/bbl; if the conflict escalates (the West imposes further sanctions on Russian oil exports), then oil prices will remain above US$100/bbl. Before the crisis, weak supply outlook had already pushed crude oil prices toward US$100/bbl. The last time oil prices were sustainably above this level (2011-14), several petrochemicals including PVC and PTA saw weak-demand/oversupply and spreads compressed to barely profitable levels in the ensuing years (2012-15). Presently, lockdowns in China, on top of troubles in the property market (Evergrande) also threaten to hurt demand in the APAC region, in our view.

High oil prices can weaken global demand for PVC…

As per historical trends, we could see a drastic contraction in spreads as oil soars above US$100/bbl which will lead to rise in Ethylene prices (a close derivative). There are very few global suppliers in the world – mostly in the Middle East and Far East – which kept Ethylene prices high during the period 2011-15; this also makes PVC market vulnerable to supply disruptions, in our view. Furthermore, commodity inflation driven by high energy price will likely bring slowdown in construction activity thus bringing PVC prices down.

…but some downside cushions are present

However, present scenario has some factors which may prevent a sharp slide in spreads, in our view, unlike the previous down-cycle. PVC spreads are presently almost double the threshold for breakeven levels (or healthy zone) which provides a buffer against spread contraction amid surging oil prices. Before the previous down-cycle, spreads were in the range of US$400-600/ton, which did not provide enough downside protection. Prior to the Russia-Ukraine, there were severe supply concerns and strong demand; these should take time to adjust lower, in our view. Spreads have corrected c.40% from their peak of US$1,290/ton in November 2021 to c.US$760/ton at present. If China counters the Covid outbreak and lockdowns with fresh stimulus measures, it can lead to a rebound in PVC demand (pent-up) and spreads in the near future.

Implied spreads near long-term average

An immediate negative impact of the prospect of weaker PVC-Ethylene spreads could be lower payouts from EPCL; payout ratio may shrink from an average of 60% in CY20-21 to about 30% (as before the most recent up cycle period). However, since the parent Engro Corp requires cash for a potential expansion in another Petrochemical project, it may provide a floor level to payouts from EPCL, in our view, given spreads remain in the healthy zone. The present stock price of EPCL implies a PVC-Ethylene spread of US$450/ton which is 40% below present levels but relatively close to the 10-year average of about US$430/ton. Even the recent peak stock price did not match the peak level of PVC-Ethylene spreads; therefore we think the correction in the stock price amid weakening spreads should be limited. Hence we remain Neutral on EPCL.