• IHS estimated global chemical demand grew by 4.2% in CY2016, outpace new supply growth of 2.6%. We believe risks of oversupply eases off on the back of strong demand ahead.

• We reiterate our BUY call on PCG (BUY, TP: RM9.50) and initiate coverage on LCT (BUY, TP: RM7.25). We prefer PCG over LCT as the former leverages on its low-cost gas feedstock and integrated supply-chain warranting superior EBITDA margin compared to peers.

• LCT’s structural shift towards shale gas feedstock and capacity expansions bodes well for its earnings. It also places LCT in a stronger position to benefit from its close proximity to strong growth regions and favourable industry dynamics.

Risks of oversupply concern dissipated

We believe risks of oversupply concern has been easing as IHS estimated that global base chemical demand grew by 4.2% yoy in 2016 to 472m metric tonne per annum (MTPA). This has outpaced the new capacity growth of 2.6% yoy to 597m MTPA. The strong demand growth was due to steady global GDP growth of 2.6% (World Bank).

Petrochemicals, naphtha expected to rise in tandem with crude oil

Petrochemical prices rose in 2017 in tandem with higher crude oil price. This is in line with our expectation as we observed a strong correlation of +0.945 between Brent crude and ICIS Petrochemical Index (IPEX) over 1993-2016. However, we note that the increase in naphtha prices have outpaced Brent crude price and other commoditised chemical products. As such, we believe the operating profit margin for most naphtha-based producers could be at risk compared to gas-based counterparts.

Comparing Malaysia’s two major petrochemical producer

Commoditised chemical producers with gas feedstock have competitive advantage over naphtha-based producer. This is mainly due to low feedstock cost advantage vis- à-vis petrochemical prices trending Brent crude. Additionally, PCG’s strength lies in its integrated supply-chain with parent, Petronas Group, resulting in superior EBITDA margin compared to peers. On the other hand, we believe LCT plans to undertake several measures to address cost competitiveness such as: i) capacity expansion via TE3 and PP3 projects; ii) joint investment with parent Lotte Chemical Corp in a US Shale gas project, potentially adding c.20% to earnings on full year contribution from FY20F onwards, and iii) construction of a new naphtha cracker at its Indonesian plant.

Proxy to GDP growth; PCG is our top pick

While higher feedstock cost amidst rising crude oil price could pose earnings risk, we believe the outlook of a healthy global GDP growth could sustain demand and ensure decent product spread. Our top pick within the petrochemical sector is PCG (BUY, TP: RM9.50) given its sustainable business driven by competitive feedstock cost and potential earnings boost from specialty chemical ventures. Despite being a naphtha based producer, we remain positive on LCT (BUY, TP: RM7.25) ahead of its structural improvement in its supply chain and diversification into competitive feedstock which should sustain earnings growth moving forward.

Source: BIMB Securities Research - 25 Apr 2018