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LyondellBasell: A Murky Story in the Highly Cyclical and Capital-Intensive Chemical Industry

LyondellBasell's (LYB) origins date back to the 1950s when breakthrough discoveries were made in synthesizing petrochemicals. Today, LyondellBasell is one of the world’s largest diversified chemical suppliers and refiners.

The heart of LyondellBasell's business is converting fossil fuels into plastic resins and other petrochemicals that are sold to manufacturers and eventually turned into food packaging, home furnishings, clothing, tires, automotive components, fertilizers, paints, and much more. Petrochemicals are everywhere in modern society.

In many parts of the world, crude oil is the feedstock of choice in the production of petrochemicals due to oil's accessibility and low cost. As a result, petrochemical prices are generally tied to the price of oil.

However, LyondellBasell has a large presence in the U.S., where cheap and plentiful natural gas is used instead as an input. When natural gas prices are low relative to oil prices (which has been the case for much of the past decade), LyondellBasell and other U.S. producers enjoy a cost advantage over foreign rivals.

In addition to its U.S operations, LyondellBasell has a manufacturing facilities in Europe and Australia, and the firm sells its products in over 100 countries across the globe.

Business Analysis
It's often difficult to make a strong case for the long-term safety of a commodity company's dividend, and LyondellBasell's payout is no exception.

For one, stiff competition and little differentiation in quality from one chemical producer to the next ensures that firms have limited pricing power. Profits are at the mercy of unpredictable global markets for oil and natural gas, which are the raw materials used in the synthesis of petrochemicals.

Furthermore, the chemical industry is highly sensitive to the economy since its products are used in the manufacturing of many discretionary consumer goods (cars, clothing, textiles, etc). So when consumer spending fell during the financial crisis, sales in the industry took a major hit.

To make matters worse, capacity isn't easily scaled up or down. Firms invest years and hundreds of millions of dollars into their plants and are reluctant to take them offline. As a result, chemical producers face high fixed costs, even when business is slow.

Essentially, the chemical industry is extremely difficult to navigate due to its unpredictability and capital-intensive nature.

In fact, these challenges came to a head for LyondellBasell in 2009 when the company declared bankruptcy. The firm's debt load ballooned following a merger and became untenable to service when the recession hit, demand fell, capital markets froze, and input prices sat at unexpectedly high levels.

That said, LyondellBasell is now more than a decade out of bankruptcy, and several characteristics of the firm support the current dividend.

First, LyondellBasell is no longer hampered by the same large debt load that precipitated the company's bankruptcy in 2009. At the time, LyondellBasell had close to $23 billion in debt maturing; today, the firm's debts total just $12 billion, over half of which doesn't come due for at least another five years.

Indeed, LyondellBasell now earns an investment grade Baa1 credit rating from Moody's. An improved balance sheet lessens the pressure to reduce the dividend and preserve cash should business conditions take a turn for the worse.

Second, while demand for petrochemicals is cyclical, the long-term outlook on demand is bright. There are few alternatives to petrochemicals for many applications, and major end-products such as plastics and fertilizers are expected to see solid growth as standards of living improve around the world.

Third, LyondellBasell's global portfolio of manufacturing facilities and sales offices limits the company's reliance on any one region. When one region suffers due to low demand or high costs (e.g. feedstocks, energy, labor), another region may perform well.

Finally, the firm's scale has enabled management to invest in plants that are flexible in which feedstocks (i.e. types of natural gas or oil) can be used in production. In theory, the ability to switch between input types lowers the risk that a sustained price increase in a specific feedstock would materially impact LyondellBasell's bottom line.

Overall, LyondellBasell's story is a murky one. The chemical industry is generally not conducive to paying reliable dividends; however, LyondellBasell possesses some interesting characteristics that could keep its dividend safe.

Key Risks
LyondellBasell is in much better financial shape than when the firm declared bankruptcy in 2009. However, in recent years management has run the business somewhat aggressively, issuing new debt in order to expand production, buyback shares, and grow the dividend, all despite little top or bottom line growth since 2015.

As a result, LyondellBasell's debt metrics are nearing uncomfortable levels. Should input or output prices move unfavorably or demand decline for any sustained period (as the case may be following the recent oil crash and coronavirus outbreak), management could be forced to cut the dividend in order to preserve cash and protect the balance sheet.

In addition, the factors that have helped LyondellBasell perform well over the past decade aren't necessarily enduring advantages. Specifically, LyondellBasell benefits at present from cheap and abundant U.S. shale gas, making it cost effective to produce in the U.S. and export overseas.

However, there's no guarantee that U.S. shale gas will always be cheap relative to oil (to which output prices are tied). Historically, the chemical industry has moved wherever oil and gas prices are the lowest. In the 1990s, for instance, firms shifted production overseas from the U.S. in search of lower oil prices, highlighting just how transitory geographic advantages can be in the industry.

That said, LyondellBasell's globally-diversified portfolio of manufacturing plants does mitigate some of the risk that U.S. plants might lose their cost advantage. It's hard to know, though, just how robust the company's portfolio is until it's tested.

If nothing else, investors should not expect the same pace of dividend growth that the company experienced in the early 2010s, which was fueled by share buybacks, newly-issued debt, and a rising payout ratio.

Concluding Thoughts
While LyondellBasell is in better shape than when the firm declared bankruptcy in 2009, the chemical producer can't escape the challenges of operating in an industry characterized by cyclical demand, stiff competition, volatile input and output prices, and high fixed costs.

There are factors supporting LyondellBasell's long-term outlook, including secular growth in the demand for plastics and other petrochemical-based products, as well as the firm's decent balance sheet and geographic diversification.

However, our preference as conservative income investors would be to avoid most commodity producers like LyondellBasell, preferring instead to invest in businesses in stronger financial positions or who are in better control of their own fate.

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