2 Stocks to Buy as Fracking Leads to Cheap Ethylene

Bill is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Fracking (hydraulic fracturing) has helped drive the price of methane (natural gas) and ethane down. Since ethane can be heated under pressure to synthesize ethylene, fracking leads to cheaper ethylene, too. Ethylene is a fundamental and widely-used chemical feedstock, which means that fracking leads to cheaper carbon-based chemical products.

When all is said and done, it is likely that fracking will lead to cheaper chemical feedstock prices and higher gross margins for chemical companies. With this in mind, compelling investments can be found by searching for attractively priced chemical companies that would benefit from this secular change in the chemical value chain.

Fracking Gains

Westlake Chemical (NYSE: WLK) and LyondellBasell (NYSE: LYB), the largest producers of ethylene in the United States, are reporting highest-ever profits, with shares going up over 60% for Westlake and over 90% for LyondellBasell. Dow Chemical (NYSE: DOW) is planning to start working with ethane as well. Prices are set to go up as constrained ethylene production capacity might put a floor on prices.

Profit margins for the colorless gas are making record increases and are set to go up even further, which ultimately could lead to expanded production capacity, more price competition, and permanently lower carbon-containing chemical feedstocks.

This secular change in carbon-based chemical synthesis will be confined to companies whose operations are geographically close to fracking sites. This proximity will make conversion of ethane to ethylene cheap and efficient. In contrast, Asian and European producers work mostly with an oil-based raw material called naphtha, which is more expensive to work with compared to Ethane.

Gross Margins in Chemical Companies

Chemical companies that will benefit the most are ones with low gross margins and significant U.S. operations. As cheaper ethylene is used as building block to make increasingly complex molecules, price savings will trickle down to end products. Since the cost of chemicals are just one component of direct costs (such as labor, allocated overhead, etc.) this change won’t matter as much to companies with higher margins

Consider the chemical companies with significant U.S. operations listed below:

Ticker

Company

Gross Margin

P/E

P/S

P/B

LYB

LyondellBasell Industries

11.61%

13.46

0.67

2.69

DOW

Dow Chemical

14.70%

19.03

0.61

1.55

WLK

Westlake Chemical

15.86%

17.09

1.34

2.59

DD

E. I. du Pont de Nemours

26.98%

12.17

1.03

3.95

MOS

Mosaic

28.34%

12.55

2.15

1.8

WPZ

Williams Partners

30.25%

17.43

2.84

2.24

On this basis, the low gross margins of LyondellBasell Industries, Dow Chemical, Westlake Chemical would jump the most on decreasing raw materials expenses.

Valuations

The current market prices for Westlake Chemical are fair near $76.00 per share, after a 90.0% jump in price for the year-to-date.  The firm's 1.34 price-to-sales ratio is in line with today's prevailing market multiples. Westlake Chemical shares currently trade at a high 17.09 price-to-earnings ratio, a higher value than the 14.23 average of the S&P 500 index. Shares trade at a 2.59 price-to-book ratio, which is near the 2.07 S&P 500 average.  The firm's reasonable 0.39 debt-to-equity ratio demonstrates that it's not overleveraged.

At roughly $54, shares of LyondellBasell Industries  offer investors the best way to play cheaper ethylene. This stock trades at a 0.67 price-to-sales multiple, much lower than the S&P 500 average. This stock’s 13.46 price-to-earnings ratio and a 2.69 price-to-book ratio are in line with S&P 500 averages. The firm's reasonable 0.38 debt-to-equity ratio demonstrates that the company is not overleveraged.

In contrast, Williams Partners stock is a more expensive play on ethylene, at a price of roughly $54. Investors can buy more revenues per dollar from the S&P 500 since this index has a price-to-sales ratio of 1.32, while this stock has a much higher 2.84 ratio. Williams Partners shares currently trade at a high 17.43 price-to-earnings ratio and a 2.24 price-to-book ratio, higher than the respective 14.23 and 2.07 averages of the S&P 500.

The current market price for Dow Chemical is fair near $30 per share. The shares of this large cap conglomerate trade at a  0.61 price-to-sales ratio, a  19.03 price-to-earnings ratio and a  1.55 price-to-book ratio. Given the size and complexity of Dow Chemical, I am skeptical that cheap ethylene will dramatically change its average results across multiple segments.

I am skeptical of E. I. du Pont de Nemours (NYSE: DD) for the same reason: it is too big and diversified to be dramatically impacted by cheap ethylene. However, it trades at low multiples, which should attract investors anyway. At $44.90 the stock trades at a 3.95 price-to-book multiple of this stock is higher than the 2.07 S&P 500 price-to-book ratio, but its  1.03 price-to-sales ratio and its 12.17 price-to-earnings ratio are lower than the averages of the S&P 500 index.

E. I. du Pont de Nemours  is also an attractive dividend stock with a 3.83% yield. Future dividend payments are likely because the company pays out 0.45 of earnings as dividends, so earnings could drop considerably before dividends must be cut.

We can compare all the above valuations to those of Mosaic (NYSE: MOS), a stock whose phosphate and potash products do not rely on ethylene or ethylene-derived synthetic intermediates. At $53 per share, Mosaic trades at a 2.15 price-to-sales ratio, a 12.55 price-to-earnings ratio, and a 1.8 price-to-book ratio. By comparison, LyondellBasell Industries and E. I. du Pont de Nemours are fairly priced.

Conclusion

Investors should consider investing in LyondellBasell Industries and E. I. du Pont de Nemours. LyondellBasell Industries has more exposure to cheap ethylene while E. I. du Pont de Nemours trades at cheaper valuations.


BillEdson11 has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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