BFFAF - Dow Inc.: A Recession Buying Opportunity On Long-Term Fundamentals

Summary

• A number of negative effects impacted Dow Inc.'s latest quarterly results, but it is nevertheless still profitable and holding up relatively well in the face of early signs of a global economic slowdown.
• Dow Inc.'s main long-term advantage as a North American chemicals company, benefiting from a wide natural gas price gap relative to Europe & Asia remains intact.
• This advantage might come into greater focus next year, as European petrochemical facilities will continue to wind down operations and increasingly resort to permanent plant closures.
• Dow could potentially lose the input cost advantage over its European & Asian peers if an EU-Russian rapprochement suddenly takes hold, or if American LNG is employed in excessive volumes.

Investment thesis: The Russia-Western world conflict over Ukraine is perhaps the most consequential development to shape the global petrochemical industry since WW2. Companies operating in regions or countries that provide ample, affordable volumes of natural gas and other inputs are set to gain a significant long-term advantage over companies that have a large footprint in places like Europe and even perhaps in parts of Asia, where some countries may have failed to secure ample long-term gas supplies, even as the global supply/demand situation remains tight.

Dow Inc. ( DOW ) finds itself in a position of clear advantage as a mostly North American petrochemicals company, which should start to show up in its quarterly results going forward. Dow should be able to benefit from higher global prices for its products, as many of its competitors are being knocked out of business by a lack of affordable natural gas, even as its own operations continue to be fed by affordable supplies on the regional North American regional natural gas market. In the absence of events that may derail the current investment thesis, Dow continues to be a good long-term investment option, worth keeping an eye on for good investment entry points in this stock.

Long-term benefits of current global changes are yet to show up in Dow's quarterly results

While Dow's long-term prospects are set to be bolstered by fundamental shifts in the global manufacturing of petrochemicals, based on changing global energy market flows, in the short term the higher dollar effect as well as other factors served to dampen its latest results.

As we can see, there was a significant drop in quarter-over-quarter sales. Dow's quarterly report highlights a 4% decline in sales compared with the same period from last year, due to the strong dollar effect. Income dropped severely for the quarter, compared with both the same quarter from a year ago, as well as the previous quarter of this year. The cost of sales increased by $770 million compared with the same period from a year ago, while evidently, Dow did not manage to also increase revenue correspondingly by passing on those cost increases. That may change going forward, as Europe's petrochemicals industry is being systematically decimated by the continuing energy crisis that it is facing.

Europe & parts of Asia could potentially see a dramatic decline in petrochemical production starting next year, due to a lack of affordable & dependable gas supplies

We keep hearing lately how Europe is alright and will get through this winter just fine. The part that is seldom mentioned is the fact that demand has been cut by 24% Y-O-Y in November, in order to balance the supply/demand equation for this winter. What this means for Europe's industry, especially the heavily natural gas-dependent petrochemicals industry, is that it has to do its part by shrinking itself. Currently, there is a great deal of effort made to pretend that it is mostly temporary and not all that severe, but in reality, the decisions to permanently shut in petrochemical plants will start to arrive with growing frequency starting next year and beyond.

Though the decline in natural gas demand has been dramatic in the EU this year, the official industrial production stats do not betray any signs of problems. For instance, industrial production for September of this year shows a rather robust Y-O-Y expansion of 5.7% for the EU.

Of course, in USD terms that robust expansion is actually a significant contraction, given exchange-rate trends. A weakening euro has been the main vehicle that allowed the EU to continue reporting economic expansion, even as in USD terms the EU as a whole actually saw its economy shrink by about $1 Trillion in USD terms this year, based on the latest IMF estimates .

Aside from Europe, some countries in Asia have also been experiencing difficulties in securing enough natural gas, especially once Europe started outbidding them for LNG. Countries like Pakistan and India found themselves with supplies due to them being poached by their European competitors in the global LNG market. An early glimpse of the likely end result in terms of what it may mean for petrochemicals production both in the EU and in parts of Asia may be offered by Europe's chemicals giant BASF SE ( BASFY ).

It is unclear at this point to what extent BASF's regional production data resembles wider global chemicals industry trends, but we will probably get to see if this trend gets confirmed or not in hindsight at some point in the coming months.

Investment implications

Starting this quarter, we will probably see the start of European industrial production and other economic data begin to resemble the true trajectory of Europe's economy, which will include a severe deterioration in petrochemicals output, measured in volume, rather than in euros. Lower volumes mean tighter global supplies, which should at some point translate into higher prices, including for Dow's own products. There may be a lag effect in terms of seeing those higher prices, given that most global economic forecasts are pointing to a significant downshift in global economic activity next year, but this should be seen as an opportunity to build a favorable long-term position, which is the way I have been approaching this stock.

I took a small position in Dow Inc. stock earlier this year to make sure I can still participate in the long-term fundamental thesis even if a better buying opportunity will not arise, assuming that it is sound. I also set aside cash reserves in order to take advantage in the event that I am correct about a significant broad-based downturn in stock prices going forward, on weak economic performance. Dow Inc. is definitely one of the stocks I am looking to add to my already existing position next year if a better entry opportunity arises.

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