2019 outlook: Materials

Structural changes in the PVC market are creating favorable supply/demand dynamics for some US producers.

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The market for polyvinyl chloride (PVC)—that nearly ubiquitous thermoplastic resin used in everything from rainwear to garden hoses and, of course, easily recognized white pipes—has changed considerably in the past couple of years. I believe most investors have yet to grasp the full implications of these changes and how they might benefit some US producers.

PVC is made by combining petrochemicals acetylene or ethylene with chlorine. Chlorine is made from salt water and electricity in a process that generates caustic soda, a widely used industrial chemical present in paper, detergents, and textiles, among many other products. For the past 15 years or so, the world has added PVC capacity mainly through China-based plants that use coal in a cheap but outdated and highly polluting process to make the necessary acetylene. China built many such plants, leading to significantly oversupplied global PVC and caustic soda markets.

In 2016, the Chinese government began to aggressively enforce environmental regulations in major industries such as steel, mining, power generation, and chemicals. Since this enforcement program began, several of the worst-polluting coal-to-acetylene-based PVC plants in China were closed, which has tightened the global supply/demand balance for PVC and caustic soda. What's more, China will no longer allow any significant additions of new coal-to-acetylene-based PVC production.

Against the backdrop of reduced PVC and caustic soda supply, prices have risen considerably from their cyclical lows in early 2016. In fact, caustic soda prices earlier this year reached higher levels than most analysts had ever seen, causing concern that the cycle had peaked and leading to selling of PVC-related stocks ahead of a projected down cycle.

And here, I believe, lies the opportunity, because my analysis suggests we are not even close to peak pricing. Global PVC and caustic soda demand has grown roughly 2% annually, and tightening supply-demand conditions will require adding new PVC capacity to meet future demand growth. With China's coal-to-acetylene route cut off, the only way to add PVC capacity is based on ethylene, which means building new capacity in the US, because the shale revolution has given the US ample supply of cost-advantaged ethylene feedstocks. And while PVC and global caustic soda pricing has improved significantly, prices still are not high enough for producers to justify building new, fully integrated US ethylene-based PVC plants (see chart below). Therefore, instead of being at peak levels, as many investors think, I believe prices for PVC and caustic soda have to go much higher to justify adding capacity to meet normal demand growth.

In addition, since no major capacity additions have been announced to date, new production capacity will take roughly 5 years to permit and build in the US. Consequently, it is possible that prices will reach new peak levels before we can build enough new capacity to catch up with demand growth. In this scenario of rising prices, I believe the shares of certain US companies that already provide ethylene-based production of PVC and caustic soda should do very well.

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