BFFAF - BASF: Nothing Left For Investors Except To Pray For Some Favorable European Weather

• I bought BASF stock this year, based on the logic that it is a fundamentally strong company, negatively affected by potentially temporary factors, namely the EU's energy crisis.
• It was only a small bet, less than 1% of my overall portfolio, which I cut in half recently, as prospects of the EU's energy crisis situation improving diminished.
• With every day that the Russia-Ukraine war continues, chances of rapprochement are declining.  EU energy security does not add up without Russian supplies.
• BASF is likely to be asked to curtail its activities this winter, and many winters thereafter.  Even when it will be able to resume production, natural gas prices will be prohibitively expensive.
• Europe's entire petrochemical industry is in danger of collapsing.  Russia is likely to divert natural gas to its own growing petrochemicals industry, making Europe's shortages permanent, as alternatives will be hard to come by.

Investment thesis: BASF ( OTCQX:BASFY ) stock seemed like an enticing investment opportunity, albeit with a significant geopolitical risk factor, as it has been trading at roughly one-third of the price level compared with highs achieved about half a decade ago.

A generous dividend yield of close to 8% is also an enticing factor that many investors identified as an argument in favor of investing in this stock. I was not immune to the long-term value argument, thus I decided to take up a small position as well. It was less than 1% of my overall portfolio, keeping in mind the geopolitical risks involved, which I further reduced by half just recently, in recognition of the prospects of the EU's energy crisis improving in the foreseeable future are deteriorating with every day that passes.

In the absence of a sudden shift towards de-escalation in the direction of the current war that has become a proxy conflict fought on the battlefield as well as in the economic sphere, the EU is set to enter a period of energy insecurity for the foreseeable future, with a tendency towards long-term deterioration being the most likely scenario. BASF may be financially healthy enough to survive this, but there are now very real prospects of it having to spend money on moving operations out of the EU or shutting operations down altogether, which will be a real blow to revenues and profits.

While the prospect of a massive improvement in its stock price is still there in case the current conflict will take on a very unexpected path and the Russia-EU relationship will experience a sudden normalization, the odds of it happening are increasingly low. The odds of permanent deterioration of the trade relationship between the two are increasingly high and despite claims to the contrary, the EU does not have decent prospects of fully normalizing its energy situation through securing alternative supplies. BASF is more likely to see a further decline in its business prospects and thus its stock price than it is to see any improvement from here.

BASF's financial results holding up despite a very challenging energy price situation in Europe.

For almost a year now Europe has been grappling with an energy price crisis. It started with a prolonged shortfall in renewable energy production , including wind & hydropower. That in turn led to higher demand for natural gas. Russia refused to send any additional gas, above and beyond what was already contracted. For a company like BASF, this meant a significant production cost increase.

As we can see, the increase in input costs at its facilities in Europe amounts to hundreds of millions of euros, every month.

Despite these price pressures, net income for the first half of the year barely declined compared with the same period last year.

Part of the reason why earnings have been holding up is that sales have been pushed higher, due to favorable market conditions for its petrochemical products.

As far as its balance sheet is concerned, there has been some deterioration in terms of its net debt.

The increase in its financial debt amounting to a 37% jump in just half a year is perhaps the most worrying aspect of its overall financial performance this year. Overall, BASF held up alright in the face of adverse conditions, which makes for a bullish argument for this stock, especially if one sees the European energy crisis as a merely transitional crisis.

The European energy crisis situation is not likely to improve in the coming years or decades. BASF will be asked to shut down production on multiple occasions going forward. It will most likely have to shut plants in Europe.

While we increasingly hear of severe measures being taken in the EU in order to conserve energy, there still seems to be a widespread belief that this is all very temporary in nature. The reality is that with every day that passes, with no end in sight to the proxy war over Ukraine, the likelihood of EU-Russian energy ties being repaired in the future diminishes. Some alternate supplies have been identified, such as LNG, however, the price pressures that the current situation is putting on major exporters such as the United States & Australia, make Europe's over-reliance on such sources of natural gas very risky. There have been politically-motivated calls in both nations to curtail LNG exports for fear of having their domestic markets converging in price with European or Asian markets. Other sources, such as from the Caspian, ME, or Africa also carry geopolitical risk since these places are all prone to conflict.

Norway has been Europe's second-largest energy provider over the past years, and it continues to be a reliable partnership.

Norway's oil & gas production already peaked almost two decades ago. It's natural gas production which continued to expand could peak any time, perhaps as soon as this year.

Europe's domestic oil & gas production outside of Norway is nowhere near what is needed to be able to say farewell to one's largest oil & gas providers, in the middle of a sustained commodities bull market. It needs massive inflows of energy from elsewhere and the global market is tight, and it is likely to remain so for the foreseeable future. Within this context, it is impossible for the EU to completely shun Russian energy. It may seem possible at times, but other times it will suffer from outright energy shortages. There will be no long-term improvement. If anything, things may get worse, as the Norwegian oil & gas peak production scenario might suggest.

The relationship with Russia is unlikely to be repaired. It may be hard now, but for Russia, the pivot away from Europe is in fact a long-term net positive. It can shift its oil exports to Asia, where demand continues to expand. It can also increase pipeline and LNG gas exports to Asia's growing market. More importantly, it can develop and expand its own petrochemical industry, even as the EU petrochemicals industry is likely to gradually shrink and eventually collapse. It can use this opportunity to shift away from exporting natural gas and towards exporting more value-added products such as fertilizer. Russia already had a program in place meant to expand its petrochemical industry before the conflict. All it has to do is complete the plan. The more it expands in this regard, the less interested it will be to return to selling natural gas to the EU.

In conclusion, Europe's energy situation will most likely swing between good times, when it will be able to secure enough energy, at very high prices compared to the global average price, and bad times, where trying to outbid everyone else will not suffice in securing enough supplies to meet demand. It will fail to do so even at those elevated prices for consumers and industry.

Investment implications.

The immediate focus in Europe at the moment is getting through the coming winter, without experiencing outright energy shortages. For that, a mild winter is necessary. Plenty of wind, some rain, and sunshine can all help to stimulate renewable energy output. If all this happens, it will relieve pressure on Europe to cut natural gas demand, meaning that BASF will not be asked to shut in production at its facilities. Such an outcome might lead to a boost in its stock price, which personally I would see as an opportunity to completely unload BASF stock from my portfolio. If, however, the coming winter will see unfavorable weather from Europe's energy supply/demand perspective, BASF stock is likely to take a further dive, as its operations in Europe will cease for perhaps prolonged periods of time.

The reason I do not see long-term potential in remaining invested in this stock is that at this point Europe's prospects of improving on its current dire situation in regards to its energy security is diminishing with every day that the confrontation with Russia continues. The reality is that without Russian energy, Europe cannot achieve energy security, within the current global context. Half of BASF's locations are in Europe and the entire EU petrochemicals industry is under threat of annihilation given the current situation. The way I see it, the best that one can hope for at this point is to unload BASF stock at a favorable price level, and for that to happen, favorable weather has to be on the side of investors in this stock in the coming months. I cut my position in half recently, as its stock recovered a little. Even so, I took a loss. I hope as everyone should that weather conditions in Europe will be favorable enough to generate enough short-term upside in the stock price to at the very least sell the rest of my position at breakeven or perhaps even a bit higher. The odds of achieving much more in this particular case are getting lower by the day, the way things are going.

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