We maintain our BUY on Petronas Chemicals with a higher TP of MYR7.49 (from MYR6.75) based on 18.4x FY15F P/E, a 10% premium vs the average of its petrochemical peers. The rise in petrochemical prices, lack of major turnarounds (leading to higher utilisation rate), and foray into the lucrative specialty chemicals segment will provide the necessary catalyst for the company to drive its earnings growth.

Petrochemicals product prices are on the rise. Olefins and derivatives (O&D) product prices are moving upwards, supported by the increase in feedstock prices as well as stronger ethylene prices due to supply constraints from around the region. Fertilisers and methanol (F&M) product prices are balanced on the back of stable demand and supply dynamics. We include our FY15 petrochemical product prices forecast in Figure 1.

Specialty chemicals foray. Petronas Chemicals has joined forces with BASF (BASF SE, NR), in a specialty chemicals JV. The JV has announced plans for an aroma chemical complex, 2-ethylhexanoic acid (2-EH acid) plant and highly reactive polyisobutene (HR-PIB). These plants are expected to be operational from 2016 onwards. We are positive on this venture as specialty chemicals prices are less volatile compared to conventional petrochemicals, owing to its niche market. Specialty chemicals also command a significantly higher premium compared to conventional petrochemical products.

Maintain BUY with a TP of MYR7.49. We continue to like Petronas Chemicals and maintain our BUY recommendation with a TP of MYR7.49 (from MYR6.75) based on 18.4x (from 15.6x) FY15F P/E, a 10% premium compared to its petrochemical peers average of 16.7x. We believe the premium is justified due to: i) its revenue being 80% exposed to USD while only 60% of its cost is exposed to the greenback, ii) cheap gas feedstock obtained from its parent company, iii) FY15 earnings growth from increased utilization as the group has no more major plants shutdown scheduled, and iv) gaining a foothold in the specialty chemicals segment, which is less volatile and occupies a niche market.

Olefins & derivatives. Year to date, O&D product prices have moved upwards, in tandem with our expectations of higher O&D prices for the year. We see higher prices driven by tight supply of ethylene in the market due to several plant shutdown around the region. We fine tune our price forecast for LDPE/HDPE/LLDPE (7% lower), paraxylene (13% lower), MTBE (4% lower) and benzene (32% lower). We expect PE prices to remain stable in this range for the rest of the year as supply and demand dynamics balances out. We show in figure 1 our 2015 price forecast, YTD average price, peak price, and lowest price for 2015. Note that the high correlation of petrochemical prices and crude oil price was the basis of the derivation of our product price forecast.

Fertilisers & methanol. Prices for fertilisers, urea and ammonia, are consolidating after the highs of 4Q 2014 due to balanced supply and demand. India, which is facing a shortage of fertilisers due to the government shutting down naphtha-based fertilizer producer, is taking up the excess supply from China as the Chinese government had recently lowered export taxes on urea. However, the Chinese government is also planning to scale back subsidies for fertilizer producers which may support urea prices in the near to mid-term.

Prices have remained high. In 2Q15, planned as well as unplanned turnarounds by ethylene plants in South Korea, Japan and Thailand created a tight supply for ethylene. This shortage of ethylene in the market pushes up petrochemicals product prices as ethylene is an important feedstock in the production of higher value petrochemical product prices. Spreads for Petronas Chemicals continue to remain high as they have an advantage of having a fixed feedstock cost obtained from the parent company, Petronas.

Gas price agreement. Recall that Petronas Chemicals will be negotiating its ethane feedstock price agreement with its parent company Petronas in 2016. We understand that negotiation is still undergoing. Considering that Petronas Chemicals is the only off-taker of Petronas’ ethane gas in Peninsula Malaysia, the company mentioned that the new price will be able to maintain its competitiveness compared to naphtha and shale gas feedstock petrochemical producers. We have inputted an increase in ethane feedstock of 5-10% in our forecast from 2016 onwards.

Petlin fire. Recall that a fire incident occurred on the 23rd of June 2015 at one of the silos at Petronas Chemicals’ low density polyethylene (LDPE) plant in Kertih, Terengganu. We understand the plant is now operational and is currently running at more than 80% capacity.

SAMUR. We understand that Petronas Chemicals’ Sabah Ammonia and Urea (SAMUR) project in Sipitang, Sabah is on track for completion and is due for a start up in 1Q 2016. SAMUR will have a production capacity of 1.2m ton per annum (tpa) of urea and 740,000 tpa of ammonia. The upcoming plant will make Petronas Chemicals the second largest urea producer in South East Asia with a total group capacity of 2.6 mtpa. The total investment costs for SAMUR stands at USD1.9bn and we understand that production will only come online at the end of 1Q16. We expect the start-up of SAMUR will increase Petronas Chemicals revenue by 10% while PATAMI is expected to be increased 24%.

Specialty chemicals. Petronas Chemicals’ and its JV partner, BASF SE (BAS GR, NR) is developing a specialty chemicals complex in Gebeng, Kuantan. Currently, there are three complexes being built; aroma chemicals complex, 2-ethylhexanoic acid (2-EH acid), and highly reactive polyisobutene (HR-PIB) plant. We understand that specialty chemicals prices are more resilient to volatility and are relatively stable considering its niche market. Note that, specialty chemicals product prices are priced higher than conventional petrochemical products and is very lucrative. We show in figure 2 the list of products that will be produced at the specialty chemicals plant as well as its commissioning date. We understand that once the plants are fully operational, specialty chemicals will contribute about 15-20% of Petronas Chemicals revenue due to its higher margins as well as stable prices which we expect to occur in 3-5 years. Recall that, Petronas Chemicals hold a 40% stake in the JV while the rest is owned is owned by BASF. The total capex for the specialty chemicals plant stands at USD500m – Petronas Chemicals stake is at USD200m – while the 2-EH acid plant cost a total of USD59m (Petronas Chemicals stake is at USD24m). For the aroma complex, the production for citral and citronellol will be online in 2Q16 while L-menthol will start in 1Q17. 2-EH acid production is due to start in 2016 while HR-PIB will come online in 4Q17.

Dalak pipeline. A current thorn in Petronas Chemicals’ side is the low utilization of its second mega methanol plant in Labuan (PML2) due to methane supply shortage. Recall that its parent company, Petronas, is currently building a new pipeline to overcome the supply bottleneck which will be completed in 1Q16. We understand that the completion of the Dalak pipeline will increase the utilization of PML2 to more than 90%. Currency sensitivity. We revise our assumptions for USD/MYR exchange rate following the appreciation of the USD against MYR. Our house forecasts for FY15 and FY16 are MYR3.62 and MYR3.55 respectively, previously our assumption was MYR3.50 for both FY15 and FY16.

Product prices sensitivity. A risk to our forecast is product prices missing our average for the year. After the petrochemical prices crashed following the crash in oil, due to its high correlation with crude oil price we believe petrochemical prices will increase in tandem with our bullish view on oil. This makes up the basis of our petrochemical price forecast. In table X below, we provide earnings sensitivity to 10 of the biggest product by capacity to Petronas Chemicals and how it will affect the company’s bottom line. Our sensitivity assumes the product prices will miss our forecast by 5% or exceeded our expectations by 5%.

Crude oil price assumption. Recall that petrochemical prices have a high correlation to crude oil price. Note that our crude oil average forecast for 2015 is USD67.3/bbl while for 2016 is USD80/bbl. Revision in our crude oil price assumption will have minimal impact to our product prices forecast as we expect the dynamics of the petrochemicals market to continue to be dominated by tight feedstock supplies. Petronas Chemicals stands at an advantage when compared to its peers as it has a long term fixed feedstock cost agreement with its parent company, which then enables it to have a relative advantage compared to its naphtha based peers.

Maintain BUY with higher TP of MYR7.49. We adjust our earnings downwards by 5% and 3% respectively for 2015 and 2016 as we take into account our lower price forecast for the year, the downward revision in product prices was offset by our change in our USD/MYR assumptions. We increase our TP of Petronas Chemicals to MYR7.49 (from MYR6.75) implying a 18.3% upside, based on a 18.4x FY15F P/E – which is higher than its 17x historical average and at a 10% premium compared to its petrochemical peers average of 16.7x – due to its new specialty chemicals plant. We believe Petronas Chemicals deserve to trade at a premium due to: i) its revenue is 80% exposed to USD while only 60% of its cost is exposed to the greenback, ii) cheap feedstock obtained from its parent company – feedstock cost make up 50-60% of Petronas Chemicals’ cost compared to 70-80% of an average naphtha based producer, iii) FY15 earnings growth from increased utilization as the group has no more major plants shutdown scheduled, and iv) gaining a foothold in the specialty chemicals segment which is less volatile and occupies a niche market. Maintain BUY. As a comparison, our DCF valuation (Figure 5) implies a TP of MYR7.22.

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Petronas Chemicals is a leading integrated petrochemical producer in the South-East Asia region.

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Source: RHB Research - 27 Jul 2015