Barron's Streetwise - Plastic Has Gone Golden

Episode Date: August 6, 2021

Profits in polymers are piling up. But so are tossed-out bottles. LyondellBasell's CEO talks about demand, shortages, and recycling. Learn more about your ad choices. Visit megaphone.fm/adchoices

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So demand will be stronger for longer, and therefore our earnings should be very strong well into 22. Hello and welcome to the Barron Streetwise podcast. I'm Jack Howe. The voice you just heard, that's Bob Patel. He's the CEO of Lionel Basel, one of the world's largest producers of plastics. Profits in the plastic business have soared, so will favorable conditions last? Bob says yes. We'll examine his case in a moment. One analyst sees more than 40% upside for the stock. We'll also talk about the state of plastic waste and recycling. There is, shall we say, room for improvement.

Kind of a lot of room. I'm in the market for a pipe, and not the kind you smoke out of. I want to build a crossing for a little stream and a bridge seems too fancy for the job. So I'm going to make what's called a culvert by laying a big pipe along the creek bed and covering it with soil and stone. The pipe will have to be strong enough to drive over. One option is galvanized steel. That's steel that's been coated with zinc to resist rusting. A pipe like that would probably last for more than a decade. Another option is something

called HDPE. It's much lighter than steel, but if it's installed right, it's strong enough to drive a big rig truck over. I mean, I don't have one of those, but it's good to know. That pipe will never rust. It'll take hundreds of years to break down. So, what is this miracle material? HDPE stands for high-density polyethylene, and it's the world's most widely used plastic. Shampoo bottles, milk jugs, grocery bags, they're all made from the stuff. Also, sheds, boats, and noses. That's right, noses.

As in plastic surgery. The plastics revolution began in the 1950s with the pioneering polyethylene research of a German chemist named Carl Ziegler, who won a Nobel Prize for his work in 1963. Just four years later, Dustin Hoffman, as Ben in The Graduate, would receive famous career advice from Mr. Maguire. I just want to say one word to you.

Just one word. Yes, sir. Are you listening? Yes, I am. Plastics. Exactly. How do you mean? There's a great future in plastics. Now, Mr. McGuire comes off like an overbearing bore in that scene, but if you ask me, Ben should have asked a few more follow-up questions. Mr. McGuire was spot on. Plastics did have a great future. When that movie came out, global plastic production each year weighed about as much as 65 Empire State Buildings.

Now it weighs more than 1,000 Empire State Buildings, or three per day. And remember, plastic can take hundreds of years to break down, which I guess is good if we're talking about culvert pipes and maybe weird if we're talking about noses, but definitely bad if we're talking about milk jugs. Most of the plastic that has ever been created is still around in the form of waste. A lot of it is also still in use. Relatively little of it, less than 10%, has been recycled. And that's a problem. We'll come back to it in a bit. For now, let's focus, like Mr. McGuire, on business. HDPE has many properties that are prized by engineers and one that accountants love. It's cheap, or at least it's supposed to be.

Over the past year, however, prices have roughly doubled. Demand for plastic is strong. Suppliers are struggling to keep up. Back when the pandemic hit in March-April time frame, all of us remembered back to the financial crisis in 08. And we remembered when demand drops suddenly, you don't want to have a lot of inventory. So we thought demand is going to drop suddenly. Let's slow down production so we don't overproduce. That's Bob Patel, CEO of Lionel Basel. And he's talking about something a lot of CEOs have described to me over the past year, And he's talking about something a lot of CEOs have described to me over the past year, economic whiplash.

Demand collapsed and then came roaring back. Well, actually, what happened was the recovery was very, very rapid. In the case of consumable plastics, demand never went down. It actually went up. So as people went to the grocery store to buy more food instead of going out, that increased plastics demand. PPE that the medical workers were wearing, like the face masks and the disposable gowns, those are made from polypropylene.

Demand actually never went down. It increased. And ever since April, May, we've been trying to catch up. Lionel Bissell is the world's third largest independent chemical company by revenue and the product of past dealmaking. Germany's BASF and Royal Dutch Shell had a joint venture for polyethylene. And in 2000, they also joined forces in that material's generally more rigid cousin, polypropylene. They called this polyamorous union of polymers Bacel,

because that's what you get if you mush the name BASF together with shell. In 2007, Bacel merged with Liondell Chemical in Houston, Texas. That was right around the peak of the housing bubble. That was right around the peak of the housing bubble. The economy soon collapsed, and Lionel Bissell filed for bankruptcy protection in 2009 and emerged the following year with a fresh start. There are, let's just say, gaps in my knowledge of manufacturing polyethylene and polypropylene, but I do know this. You can start with crude oil or you can start with natural gas liquids. And if you have facilities that allow you to crack either one, as the process is called, it's a competitive advantage because sometimes one feedstock is a lot cheaper than the other. In general, fracking in the U.S. has unlocked vast supplies of both oil and natural

gas, and gas in particular here is mighty cheap compared with overseas markets. Lyondell has cracking facilities that can use either oil or gas, and it benefits from its access to cheap gas. Bob took over as CEO in early 2015 around the start of a surge in industry-wide construction of new cracking facilities that threatened to leave the market oversupplied. There was this wave of shale gas-based investment that started back in 2015 and 2016. Typically from the time we approved the project until the time production is realized is about three to five years. So in 2019, many of those new projects, that capacity was coming online. And so we were feeling a bit of the pressure from the additional supply

and margins were declining in 2019. Around that time in early 2019, Goldman Sachs upgraded Lyondale stock to buy. It wrote in a report to investors that ethylene conditions had been slumping for years and that the bottom was in sight. Lyondale stock, it noted, had performed poorly, but the company's earnings had held up well, and that was a buying opportunity. As we now know, that thesis was temporarily sidelined by the pandemic, but not for long. Lionel stock rebounded, and this past May, Goldman lowered its rating on a handful of chemical companies, including Lionel, on what it felt looked like peaking petrochemical conditions. Lionel's second quarter results reported at the end of July showed record earnings. Reported earnings actually beat Wall Street estimates by 13%.

And it wasn't because estimates had been lowered to beatable levels, as sometimes happens on Wall Street, earnings estimates for Lyondell have been rising all year. But the stock fell 1% in response to the earnings report. And it certainly wasn't because it was priced for high expectations. Lyondell trades at five times this year's projected earnings. That's less than one quarter as expensive as the S&P 500. That's less than one quarter as expensive as the S&P 500. A stock price that low suggests investors expect earnings to tumble from here. One reason the plastics industry is so undersupplied right now is that a deep freeze in Texas earlier this year knocked out petrochemical production, and the industry hasn't caught up. Also, a surge in e-commerce means that shipping

containers have been filled with finished goods, and few containers left for commodity items like plastic pellets. Those constraints won't last forever, so what do Wall Street forecasts say? They show earnings per share for Lionel rising from $5 and change last year to over $18 this year, and then declining to just under $15 next year. But even at that level, shares would look extraordinarily cheap at six and a half times earnings. I asked Bob about the outlook for demand. He can tell you, as you might imagine, a million uses for plastics. If you've ever scratched a McDonald's drink cup and you see like a waxy sort of substance, that's also low-density polyethylene.

Don't run out to McDonald's to scratch a cup and see what he means. That can wait. Bob describes the typical growth rate for polyethylene and polypropylene as GDP+, meaning as fast as the world economy, plus a little bit more to account for rising adoption of plastics. Call it 3.5 to 4%. But last year he says demand rose by 7%, and this year it's rising at 5.5 to 6%. I asked what he expects from here, not only for plastics,

but also for Lionel's other products like fuels. I think there's strong demand in front of us. First, you can evidence in the U.S. when reopening really started to happen, as people moved around more, they consumed more goods and services. And so I think that reopening, they consumed more goods and services. And so I think that reopening, as it continues to take hold in the U.S., will drive stronger demand for packaging, for fuels, and other products that are more consumable. If you look globally, we still have reopening ahead of us in Europe, in many parts of Asia. And as that happens, global demand is going to continue to be strong.

Rising COVID cases have delayed reopenings in some areas, and that's bad news. But it could also mean that there's more reopening upside to come. That's one reason Bob is optimistic on future demand. A second reason, as you heard earlier, is shortages. People want cars, for example, and they can't get them. Bob sees that as pent-up demand that will flow through in coming quarters. And his plastics are used to make bumpers, dashboards, seat cushioning, fuel tanks, and a lot more in cars, plus parts for appliances and filling for furniture and many other goods that are in short supply. There's a third source of future demand Bob points to, restocking.

Today, many of these supply chains are depleted on inventory. Our customers, for example, if we're a day or two late on shipments, they're calling us saying they're going to run out of the raw material we supply. So, you know, the restocking will provide a one-time benefit in terms of demand. And I think this all plays out over the next 18 months. Demand will be stronger for longer and therefore our earnings should be very strong well into 22. A lot of us have treated ourselves to new purchases during the pandemic. I bought a wood chipper and a hydraulic log splitter to deal with years worth of fallen

trees. And then I got busy and I remembered I don't make my living as a lumberjack, so I paid people to use those things for me. It was not my best capital allocation work, but my firewood stacks and chip trails are looking orderly. Now, Lyondell bought a stake in a massive ethane cracker and polyethylene facility in Louisiana from a South African company called Sasol. Bob says it would have cost six to seven billion dollars to build that capacity from scratch today, and that he only paid $2 billion. So I guess he did better than I did on my splitter. Bob says plastics enable a thriving society.

So when he found a good value, he assumed the pandemic effects would pass. J.P. Morgan, which is bullish on Lionel Bissell, and which recently called its shares bargain basement, predicts the company will produce free cash equal to more than 17% of its stock market value both this year and next. The stock already comes with a 4.6% dividend yield. I asked Bob what he plans to do with all that money. percent dividend yield, I asked Bob what he plans to do with all that money. He says pay down debt. Beyond that, he says he'll consider dealmaking and stock buybacks.

JP Morgan's price target for Liondell shares suggests more than 40 percent upside from here. We'll see. Back to plastic waste. Why do we recycle so little? Here's Deanne Toto. She's the editor of Recycling Today magazine. Part of it is laziness. Part of it is complexity. Part of it is in one community, these items are accepted in a neighboring community.

There might be some variation. Most people are likely going to screw up and put the wrong thing in the bin, and then that can have disastrous effects. It doesn't take much contamination to make something no longer usable. I think it's probably time for a recycling quiz. Listening in is our audio producer, Jackson. Hi, Jackson. Hi, Jack. So you were telling me that you know what those recycling number codes mean in the little triangle design on plastic goods.

I think I know some of them. Okay. So since you're an expert. Not an expert. I'll say a number. You tell me what plastic the item is made from. You ready? I'm ready.

Number one. Number one is number one. Polyethylene. I'm sorry. I can't accept that. It says polyethylene terephthalate. I have terephthalate news for you. It's incomplete. All right. What's the next one? Number two is number two. All right.

Milk jugs. Also polyethylene. High density polyethylene. Ooh. I'm going to give that one to you. Came through with a high density at the end. Number five. I'm going to give that one to you. It came through with a high density at the end. Number five.

Polypropylene. This guy is good. Number eight. I don't think there's a number eight. I think it stops at seven. Number eight is where I recycle material between my magazine column and my podcast. Sustainability is very important to me. One thing standing in the way of recycling is economics.

We're used to thinking of used merchandise as costing less than new merchandise, but that's not necessarily the case with recycled plastic. Making virgin plastics from pure feedstocks is a large-scale efficient process. Reclaiming plastic from material recovery facilities, or MRFs, requires teams of people to pick out the garbage, then magnets to separate the metals, and blowers to separate the plastics, and the process isn't perfect. The recycled plastic you end up with might be lower quality than new plastic, at a higher price. One way to make it attractive is with branding. Companies can tout their use of recycled plastic to consumers and try to charge more for their products. If the carrot of branding doesn't work, there's always the regulatory stick.

The law, which is the first of its kind in the nation, says beverage bottle makers must use 15% recycled plastics by the year 2022. California last year became the first state in the U.S. to mandate a minimum level of recycled resin in plastic bottles. It starts at 15% next year, then steps up to 25% in 2025, and then 50% in 2030. Companies that miss those targets will have to pay fines, and there are provisions to tweak the numbers if the recycling market between now and then goes kablooey. Coca-Cola, which is regularly named on lists of top corporate plastic polluters, has introduced an all-recycled bottle in the U.S. Skeptics point out that Coke and Pepsi announced partially recycled bottles more than 30 years ago, but didn't stick with them. Things might be different

now, though, if more states go California-style. My state, New York, banned plastic grocery bags, effective right around the start of the pandemic. Critics said back then, the environmentalists have gone too far, and we're going to get COVID from our reusable shopping bags, but that hasn't happened. In my home, we don't really notice a difference. My wife does the big shopping trips with a stack of reusable bags she keeps in the car. I tend to go once in a while for a handful of things with no bag. Sometimes when I get home, I have to decide whether to make two trips into the house or bravely stack and balance multiple items in one trip. The other day I stacked cans of clam

chowder, split pea soup, and Italian wedding soup in one hand while holding a pack of single-serve butterscotch puddings in the other. But please don't call me a hero. The point is cutting back on plastic waste seems pretty achievable and Lyondell mentions plastic bans and restrictions in its annual report as a business risk. Maybe that's part of what's been holding down the stock price. Environmentalists used to stand outside companies' headquarters with picket signs, and these days they effectively kick down the front door by banding together to buy shares, make demands, even take board seats. I asked Bob at Liondell how he discusses the matter of plastic waste when it comes up with investors.

When I talk to people about this topic, I ask that we kind of separate the benefits of plastics from the detriment of plastic waste. And, you know, the benefits of plastics are very clear. of plastic waste. And, you know, the benefits of plastics are very clear. Keeping food fresh, plastic pipes that deliver water, light weighting of vehicles. Just think, energy efficiency wouldn't be possible, fuel efficiency wouldn't be possible without plastics. In some ways, plastics are a very, very sustainable material. What's not sustainable is plastic waste. very, very sustainable material. What's not sustainable is plastic waste. We must educate consumers on how to dispose of the waste once they're done with the use of the packaging. We then have to install the infrastructure to collect the waste in a way that it can be recycled and reused.

Liondell and other companies have formed a group called the Alliance to End Plastic Waste. There's talk of a circular economy with higher recycling rates, using robots instead of people to sort waste, designing products to be more recyclable from the start. Liondell this year launched a family of products called Circulent. Some are made through a traditional mechanical recycled process, but others are made from a more advanced molecular process that the company says produces recycled plastic that's as good as virgin plastic. Processes like that have fans and critics.

Some say they're the key to higher recycling rates. Others say they haven't yet proven successful. Here's Deanne from Recycling Today. I am encouraged. We're seeing a lot of investment on the part of chemical companies into recycling, whether it be mechanical or chemical. We don't see a lot of chemical recycling facilities operating at scale yet. I think there could be potential there, but only time will tell. By the way, for consumers who aren't ready to give up their disposable grocery bags, I asked Bob that age-old question. Plastic or paper? You'll never guess which he prefers.

By the way, I'm an avid reader of Barron's. Have been for probably 30 years. Without fail, unless I'm traveling, Saturday morning I have my tea and I look at Barron's have been for probably 30 years. Without fail, unless I'm traveling, Saturday morning, I have my tea and I look at Barron's. Sorry, that was the wrong clip. Honest mistake. Let's try again. Paper or plastic? So you have to use a paper bag three times to make a plastic shopping bag have the same footprint. And you and I both know that paper bag doesn't get used more than once. No, it gets soggy after the first time. Put the milk in there, it gets soggy, and it's done. And we'll leave you with Deanne's number one recycling request.

It's a pretty basic one. At least make sure your PET water bottles make it into the recycling bin. If you did just that and your HDPE bottles too. So I feel like we're seeing less of those in the home these days. It's totally different with kids these days. When I was a kid, you went out, you played up and down the street. If you got thirsty, you went to someone's house, you drank out of a garden hose. I think kids should go back to the garden hose. I think it would make it.

Jackson Cantrell is our producer. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. I made a big dumb mistake in the Duke Energy episode a few weeks back. I calculated the stock returns

from the wrong start date. Duke has underperformed the market since its new chief took over in 2013. We've made the change for future downloads. Sorry about that. Thank you for listening, and see you next week.