Goldman Sachs Basic Materials Conference

May 16, 2017

Slides

Ask Steve Zander, VP and CFO. And as usual, we'll fire away in questions. But Steve, just maybe for the sake of some background to the audience, if there's anyone that is unfamiliar with you in light of your recent Axial purchase, maybe give us a quick overview of the company, maybe set the scale of some of your businesses and then we'll delve into questions. Sure. Well, thank you for your interest in Westlake. But for those of you that weren't watching the developments last year, last year we acquired a public company Axial Corporation, and really fundamentally changed the business around. So prior to the combination, our concentration was really a large player in the North and South American markets in polyethylene, concentration really in the high clarity autoclave, low density polyethylene space. But with the addition of the acquisition of Axiol last year, nearly a $4,000,000,000 acquisition, it really changed the mix of the assets. And so now we're much more concentrated really in the core alkali and PVC space. So really, it is that caustic soda molecule and that PVC molecule that really moved the margin for us these days. We see that business as a really fundamentally strong position in the cycle today and really as a fundamental change in our business. I think importantly, prior to the acquisition, we were actually balanced in our ethylene molecule. We had ethylene all that we needed to make polyethylene and the ethylene that we needed to make all the vinyl business in our business. Today, with the acquisition of Axial, we have about 1,800,000,000.0 to 1,900,000,000.0 pounds short position ethylene, which I think teases up well for the cycle that we see developing really in the coming years with ethylene. And maybe related to that, you do have an option or Axial had one, and now you've got it on the Swapte cracker. Can you talk about what would compel you to exercise that, what the options there are and the timing? It's a great question. The Wookie cracker that we're building in Lake Charles is capacity is a 2,200,000,000 cracker. Lotte today has 90% ownership, and we have 10%. But we do have an option that you mentioned, and that option allows us to exercise that option up to three years post completion. So completion is expected in start up in 2019. It allows us really to take a good long look at the installed cost. That option allows us to go from 10% ownership up to 50% ownership if we so elect. That brings up to if we elect that option, up to 1,100,000,000 pounds of additional ethylene into our system. Remember, we're short about 1,700,000,000 to 1,900,000,000 pounds of ethylene. So if we elect that option, it really goes a long ways to filling out the integrated chain that we think is so important. But of course, as we assess that option, we'll take a look and see what is the total installed cost. So the cost of that option to us is just that TIC, that total installed cost, plus the small single digit cost to carry. So we'll be assessing that as we march forward with Lotte to assess, is that the right way to put ethylene into our system? Are there other options? Steve, we just heard from Jeff talking about the commodity world. Can you just give us some sense of how you see oil prices or oil to gas and how that affects your business, maybe what's changed in the past and as you guys look forward? Yes. It used to be a much bigger driver of our business when we were more heavily concentrated in the olefin space with a much smaller position in the vinyl space. So that oil to gas ratio historically was a much bigger driver. But today, with our position in vinyls, which really isn't exposed to the oil side of the business, when you think of it, we have an exposure to nat gas to create power to make chlorine. But when you really think of that delta between oil and gas, the bigger driver is obviously on our olefins business. So as we think about this, we certainly want a moderate price for oil, but I don't necessarily want a triple digit price for oil. I think really having a price that makes sense to allow us to have the opportunity to capture the value between the Btu equivalent of gas and Btu equivalent of oil gives us a competitive position if we get, as we've seen over the tips of the skis with a triple digit price for oil, we know what happens there. So as we see it today in the roughly $50 barrel of oil environment, we still see a very competitive environment for our business, largely centralized here in the North American market. We do have an important foothold position in Europe with a specialty business called Vinylit, which is a specialty PVC business there, using really a largely naphtha derived form of ethylene to make its PVC. So we as we see it being integrated over time makes good sense. And certainly, that means having the ethylene access that we need. But certainly, given the advantage that we see, even with a $50 oil price, we think well positions us going forward. Steve, on the final side, can you give us a sense for now that you've got the Axial assets in the portfolio, where your current market position sits on a kind of domestic first contract for both PVC and for caustic soda? So in the caustic business, on a global basis, we're the third largest player in the caustic market. So with the way that business is contracted, volume is contracted, but certainly not way prices are set. So way prices are set, they can be set either on a near term spot basis or they can be set on some kind of oftentimes formula basis. So in our particular business in caustic, our formula mechanic is such that the majority of our formula is such that we actually recognize the price increases rather quickly. So while we do have some formulas that allow us some delay in recognition of that price, the majority of our prices are contract structures are set so that we actually recognize the price nominations much more quickly because they have a current month component in the majority of our contract structures. That's not true for everybody in the cost of space. In the PBC space, it's much more transparent. Prices are set on a regular basis by price nominations by producers. Typically, for large volume buyers, there is a delay in the ability to push that price through. Small volume buyers take that price increase relatively immediately, but the larger volume buyers take that typically a month delayed. And that price is relatively transparent on the marketplace. So we would certainly like to get to a point where the price realization for both our caustic and PVC is far more transparent to all. But that will take us a while before I think the industry can migrate away from these formula mechanics that take a while before price realization and really flow through to the bottom line. And when you talk about those formula mechanics, do those same mechanics exist for the caustic that you export? Or is this primarily a domestic focus? Yes. This is primarily a domestic issue that I was addressing. On an export basis, those are typically spot established and so spot based. And so on these export prices, they are reflective of kind of spot mechanics. And so the formula I was referring to is really more of a domestic matter. Great. And then maybe touching on the PVC side. We've seen both you now, as you look at the latte cracker option and certainly many of your competitors in U. S. PVC increasingly look to backward integrate ethylene into that PVC molecule. How do you think about the implications for The U. S. Domestic PVC market? Does that give some more leeway for domestic PVC competition to improve? Or is it a big enough global market that you don't really see much price risk there? Well, I think as we think about what's happened in the vinyl space and PVC space over time, we've seen how the margins for PVC has actually been a compressed margin. Most of the margin in the overall vinyls chain has either been in ethylene or in chlor alkali. I think how the market has really teeing itself up today, we certainly see an opportunity to see more margin expansion in PVC. If you think back over the last few years, we've seen margin expansion very significantly on the ethylene side of the business. And so certainly, with the addition of a lot more ethylene in the marketplace and some risk of margin compression, that slice of the pie, if you will, of ethylene is likely to narrow and the slice of the pie available to PVC and to caustic probably widen. And so certainly, as we see the cycle changing for all three of those components, ethylene, caustic and for PVC, We certainly think that the opportunity set is there to expand margins in both PVC and caustic. Being exposed to ethylene as we are over the next few years, we think, is a significant advantage. It brings us an opportunity to buy ethylene at a variety of attractive prices, either through the integrated mechanics that the low teeny cracker brings to us or the opportunity to buy ethylene either in the marketplace or through a variety of other arrangements that can be negotiated for those who may be quite long ethylene. So we think that, frankly, over time, the integrated model makes sense. But I don't think the lack of full integration is actually a disadvantage in the very near term. And then one of the bigger debates, I think, in the space has been recently what the impact of higher coal or lower coal prices in China does to supply curve for PVC there. A lot of it runs there's been maybe as much as 4,000,000 to 5,000,000 tons of PVC talked about coming upstream at some point in the next year to about three years. Presumably, some of that's economic and some of that is related to a push by the Chinese government to clean up the industry. How do you handicap those numbers? And do you account on any benefits from those plants going off? Well, I'd characterize these plants as being not necessarily shut, but kind of probably running at lower operating rates. Certainly, we've seen over the last few months some increase in operating rates in China. And so while I think there has been some potential upside risk to that added capacity, I think there is a limit to how much incremental capacity could come before we start pushing the boundaries that the Chinese authorities have set in terms of being compliant with their emission standards. Those emission standards, I think they take quite seriously for air and water emissions. I think they are trying to consistently enforce them. And so as a consequence, I think there are some boundaries here in which the producers who are using a coal based feedstock can run operating rates up or down and stay within the boundaries and still be compliant with the environmental emission issues that China has. I think what you've seen, therefore, is more rationally behaving producers in that market in terms of how they price and how they operate their plants. And what we've seen, therefore, is, frankly, a better set of economics. The Northeast Asian producer for PVC is the higher cost producer. And as a consequence, it allows the lower cost producers, such as ourselves here in the North American market, to really be able to capture some of that margin accordingly. And as long as they operate in that more rational mode of operating, I think there is really a good runway here for those of us on the low end of the cost curve. Do we have any questions from the audience? Steve, your consolidation of chlor alkali in The United States looks pretty successful. Would you try to do some consolidation in Europe? That's the first question. Second question, Eastman is trying to sell some ethylene assets. Does your contract with Eastman survive a sale? On the first question, as it relates to Europe and the vinyls business, we've actually started that process by looking at opportunities around the world and took that opportunity in 2014 by acquiring Ventolin. You've seen in the European market a small degree of consolidation that really started several years ago and over the last few years has grown substantially. You've seen INEOS acquire Solvay. You've seen Mexichem buy Vestalet. You've seen Westlake buy NuVintalet, all in space for two or three years. And so you've seen a significant tightening up of numbers of producers in the European market. And a consequence, it's created more rational behaving producers in that market because it was a very fractured market from a producer of both chlorine, caustic and PVC. There's still a lot of producers in that market, but you've seen far more consolidation of the market versus the four major producers of PVC in this market. So I think the opportunity, as we see it, is to invest where we can get a very good return, not so much be a consolidator per se. If that's the consequence, then so be it. But our focus is really looking for an investment that provides a very good return over the cycle. And so that really is our focus. As it relates to an opportunity to be integrated, whether it is ethylene such as the Eastman assets or ethylene in other ways, we certainly look for ways to invest. But again, my thesis always is the same, and that is to be investing in an asset that provides us a return, a return that really provides us good economics. As it relates to any contract arrangements we might have with Eastman, the answer is that's always a function of negotiation of how that works. And so when you think about the arrangements that we have with any counterparty, the answer is it's always a function of negotiations. Charlie? Steve, if you as you've gotten critical mass on both two major polymers, polyethylene and PVC, is the strategy over the next five years or so to also move more downstream into derivative markets, whether it's packaging markets or compounding markets or other aspects of these two molecules to get more margin out of these businesses and more growth out of these businesses? Our focus really in the downstream area has been to provide an integrated chain. And so I think you've seen us invest both upstream and downstream. And so our investments downstream into and say, into the vinyls business, you've seen us invest in large diameter pipe, some siding business through the acquisition of Axial and their Royal business. We think that business provides good stability and has provided good returns. But you also have to be interested in really making sure you're making the right investment on the right product. There are some aspects of that PVC building products business that have better returns than others, and it's a function really of a North American market demand. So as an example, in the construction markets, we've seen actually a better market than some of the fittings markets and some of the siding markets that have better returns over time versus some of the larger diameter pipe businesses, which are a bit more challenged because they're still operating at more challenged operating rates. We are in the compounding business through our acquisition of Axonox. And so that compounding business is a very good business and has very good return threshold. But again, we recognize there is channel conflict, of course, by being downstream as we sell resin downstream, we're also selling resin to some of our competitors as well as our internal customers as well. I'm also mindful that, that channel conflict, that sales channel conflict certainly has to be properly managed. And certainly, we're well aware that as I sell resin to my own building products customer downstream or sell resin to a third party customer downstream that I recognize I am in a channel conflict with them. I have to make sure that, that's always very transparent and transfer pricing being balanced and even handed. Steve, I haven't asked you in a while. I haven't talked in a while about the MLP issues with the government. Can you sort of I haven't I'm sorry, I haven't talked to you in a while. But what's sort of going on with you and Uncle Sam? Well, we finally, at the January, got clearance from and clarification from the IRS that our income streams for the Master Lending partnership are now fully qualified. For a period of time, there was some uncertainty with the post regulation the IRS had that those regulations would have disqualified the income stream from the partnership. We as a result of lots of discussion with the IRS and them spending time to understand the science behind the ethylene, they concluded that, that income stream is qualified and that concern or issue is completely off the table having now been fully qualified. So the partnership is now back, if you will, in business, back to the basis on which we started back in 2014. So the opportunity to grow the partnership, whether it be through organic growth or dropdowns or acquisitions of assets or expanding that margin, those are the four levers of growth that we have, have now been kind of reaffirmed in the marketplace. And it will be our expectation to grow the market presence of the partnership over time. Would you expect, Steve, to accelerate that process? Or is it sort of opportunistic? Well, the way the mastermind of partnerships work in the market is that consistent growth of distributable cash flow to unitholders. And so when you think about that, those four levers that I mentioned are important to make sure that we grow that distribution at that low double digit growth rate. We've been on that trajectory for the last three or four years as we've expanded and debottlenecked our ethylene crackers without having necessary to do a dropdown once these IRS regulations came into effect. Our last dropdown was in 2015 when we added about 3% of the operating company into the partnership. Today, the operating company still has about 87% of its assets that could be dropped into the MLP. And it would be my expectation that over time, all of those assets are owned by the master limited partnership, plus Lotte assets that we earlier spoke of certainly are a great candidate to be acquired by Westlake Opco and then dropped into the partnership. So we still see lots of opportunity to do that. So as we see it going forward, we still want to deliver on the promise we sold the investors when we did the IPO back in 2014, and that is to continue to distribute cash flows to the investor so they can see continued growth. And we're on that trajectory today of that low double digit growth rate. And that is still my expectation on that. And to achieve that, you certainly need to grow the income stream of the partnership, which require either debottlenecks, acquisition of assets or dropdowns. Terrific. Thanks, Richard. Just going through some pedestrian questions. You might have brought this out, Maybe I missed it in the early part. I think there's a $70 price increase for caustic in this current quarter we're in. Can you comment on that? And then I wanted to ask you about or I'll ask you the polyethylene price increases. Where do you see polyethylene prices over the next three to nine months? So let me I'll speak to the caustic price increase first. Certainly, of our competitors has announced a third quarter increase in caustic. I believe it's a $70 increase effective for Q3. Going back to the last quarter, we had we and several of the other industry participants announced price increases. We announced $65 a ton for diaphragm and $85 for membrane. Others in the industry announced $60 for both products. I think if you look at the some of the indices that have been published by folks like IHS, you'll see that they have a $60 price working its way into the index over the last several months. And so certainly, as I think that competitor that announced that $70 a ton increase certainly sees the market as we do and that there is strength in the markets to be able to take a price increase such as that. And certainly, we're assessing the market, and we'll assess whether we want to announce a further increase or not, recognizing that we actually announced a higher price, 65 and $85 versus some others who announced a $60 price increase for 2Q, we're already in the market with actually a higher average realized price. And so as I say, look, we're assessing whether we need to increase prices further at this stage or not. But certainly, I think that competitor recognizes strength in the market as we do. And we think it can just take a price increase. We'll certainly move forward on that as well. As it relates to polyethylene, the second part of your question, as you know, we added a number of had a number of price increases earlier this year. We added a nickel back in February followed by a $03 price increase in March. There is another $03 increase that was put on the table initially for March and later moved to May or April and then May. Certainly, we see a very strong market in PE still today. We're still having all those discussions with our customers as to whether that additional $03 beyond the $08 that is already in the marketplace can be absorbed, but we're certainly seeing still very good demand for polyethylene. So we won't know whether we get some, all or none of that $03 until we get later into May, but we certainly still see a very strong demand level for PE. And one last question about PVC. We you guys talk a lot about China. I'm just curious, what how do you see the how would you characterize demand in The United States or North America for PVC right now relative to last year? I'd say that, well, sequentially to last year, we're seeing good sequential growth in terms of demand for PVC relative to last year. I would say, as we are sitting here now in May, still good demand in PVC. This is the peak of the building season as we go through the summertime. And so as you may recall, we put in $06 of price increase early on in the first quarter. We'll get the full impact of that in the second quarter because of that we had $04 in February and $02 in March. And so certainly, we continue to see strength in demand. And as I say, we'll get the full benefit of that price increase in Q1 more fully felt in Q2. And unfortunately, Steve, we've run out of time. So thanks for your time. Thank you for your interest.