Plastics. That was the career advice given to Dustin Hoffman in the classic movie The Graduate, and it might well be good advice for college graduates today.
A little over a year ago, chemical and oil refining specialist LyondellBasell Industries (LYB +0.69%) made the decision to pursue greater ethylene production believing new plants and expansion would increase pre-tax profits by as much as $1 billion by 2016. The chemical, along with propylene, is used to make plastics for packaging, auto parts, carpets, and hundreds of other products and uses.
Operating profit in Lyondell's U.S. olefins unit, which makes ethylene and propylene, rose 23% in the third quarter, due to the low price of natural gas liquids from which they're derived. The company's stock is up 86% over the past year -- not bad for a company that emerged from bankruptcy two years ago.
Whitewashing the market
No doubt that kind of performance attracted the interest of chemical giant Dow Chemical (DOW +0.00%), which decided to restart its idled olefins plant in Louisiana on Christmas Day (after a four-year hiatus) as input costs from U.S. shale formations make the process more competitive now. Ethane, a component of natural gas used to make ethylene, fell to its lowest price in almost five years.
Dow was previously riding the rising price of titanium dioxide to new heights as global demand for autos and home appliances jumped, particularly in the emerging economies of China and India. The price of the additive -- which is used in everything from sunscreen and toothpaste to food coloring and vehicle coatings -- soared, but got an extra boost when Japan's earthquake and subsequent tsunami disrupted supplies at Sakai Chemical. With little new capacity coming online any time soon, it turned into one of those perfect storms, creating a huge supply imbalance.
Dow, DuPont (DD +0.00%), and Kronos Worldwide (KRO +2.52%) enjoyed record profits from sky-high pricing, while those that relied upon TiO2, like coatings makers Sherwin-Williams (SHW 0.74%) and Valspar (VAL +0.00%), to tint paints felt the effect on earnings. That changed in 2012, however, as pricing fatigue set in and postponements in buying titanium sponge (the first stage titanium goes through in processing) became the norm. Hence, Dow's interest again in olefins. But Dow, Kronos, and Huntsman (HUN +1.46%) all felt the pressure on margins because of it.
Boomtown
The natural gas industry is weighed down due to a surfeit of inventory. New drilling techniques like horizontal drilling, along with hydraulic fracturing processes across shale rock formations, have created a glut of natural gas that is keeping prices at record-low levels. The Henry Hub spot price, while well above the absolute lows of less than $2 per million Btus hit early last year, is still depressed at $3.25 per MMBtu, but the chemicals industry in general should be the beneficiary of this situation.
Dow, Lyondell, and Westlake Chemical (WLK 0.67%) use the liquids produced by drillers for processing their products, but Dow might have the lead on all of them over the next year.
It's partnered with Saudi Aramco to create the largest petrochemical facility in the world, which will include a world-scale cracker that will be able to crack a wide range of feedstocks targeted for emerging markets around the world, including China, the Middle East, Eastern Europe, and Africa. The $20 billion project is expected to bring in $10 billion in revenue when it goes online in 2016; the partnership will eventually launch an IPO, giving Dow and its partner equal standing with the company.
From acorns, mighty oaks
While its performance plastics and materials segments gain the most attention because of their sizes, its agricultural sciences division is also expected to continue growing in the year ahead. The segment produces products for use in agriculture, industrial and commercial pest management, and food service. Though one of the smallest divisions, it contributed 11% to total revenues over the last 12 months as sales jumped 9% from the year-ago period.
One of the primary reasons for the growth has been its focus on the corn seed markets in North and South America, where it is steadily gaining market share from Monsanto (MON +0.00%) and DuPont (DD +0.00%). The two continents represent two-thirds of the $16 billion global corn seed market, and Dow's SmartStax hybrids in North America and Herculex technology in Latin America helped drive higher volumes over the past few quarters.
While it's likely that the entire specialty chemicals industry will see its boat rise with the tide coming in, Dow, because of it preeminent position across multiple divisions, could have the inside track to grow. Yet, it's also true that it presents a premium valuation to rivals like Lyondell and DuPont, and with its enterprise value trading at 33 times the free cash flow it generates, it's not exactly a bargain basement stock.
Its shares have jumped almost 25% from the lows they hit late last year and are closing in on new 52-week highs. I'd probably like to see the stock pull back a little before I'd dive in, but overall I believe there's no reason to be down on Dow Chemical.
