Refining/Chemical/Batteries OVERWEIGHT March 18, 2020

Industry Note Refining/Chemical/Batteries OVERWEIGHT March 18, 2020

Transition to clean energy accelerates

Kang Dong-jin +822-3787-2228 Major issues and conclusions [email protected] - Oil producers’ game of chicken intensifies as we approach the end of the hydrocarbon era. - Refiners are unfit to raise shareholder returns even if market conditions partially recover, due to financial and investment burdens. - Plummeting naphtha prices help recover the cost competitiveness of NCCs; ABS and PVC to fare well because of their relatively lower supply burden.

Industry and stock outlook - Despite oil price weakness, the crude market’s uncertainty will accelerate the transition to clean energy.

- Companies involved in the move to clean energy remain attractive investments

- Top picks: LG Chem, Hanwha Solutions, Samsung SDI, Doosan Fuel Cell.

Will the peak of annual crude demand recover to the level of 2019? OPEC downwardly adjusted its forecast for crude oil demand growth in 2020 by 0.9 MBPD in its March edition of Monthly Oil Market Report. The forecast for crude oil demand in 2020 is expected to be 99.7MBPD. However, the WHO recently declared a pandemic, and as the number of confirmed coronavirus cases rapidly increase in the US and Europe, there is a high possibility that crude oil demand will be downwardly adjusted.

In our view, the risks are the changes after the pandemic comes to an end.The coming paradigm shift can be abbreviated as “T.H.E.D.” (tele-X, having (e.g., own something), egoistic consumption, decentralization) and will accelerate further in the wake of the pandemic. Accordingly, we see a great change in demand related to mobility in the future. The world is now testing teleconferencing and working-from-home practices, which is expected to facilitate shifts in mobility demand. Mobility demand in the future could be backed up by expanding IT investments. Korea’s Center for Disease Control recently announced that the novel coronavirus will have a long-term impact, and we have to prepare for a new daily lifestyle accordingly. 60% of crude oil demand is related with mobility: over 40% of the demand is for land transportation and the remainder is for marine and air transportation. This paradigm shift will take time for annual demand for crude oil to recover to 2019’s level, and we cannot overlook the possibility that it may never return to 2019’s level. This change has arrived more than five years earlier than originally expected.

We believe the trigger behind the resumed game of chicken in Saudi Arabia started with the belief that the peak demand of crude oil could arrive earlier than expected due to COVID-19. We think the current situation is a game of chicken for the survival of oil-producing countries on the brink of the end of the hydrocarbon era,

Refining: transition to clean energy and improved shareholder value? In the future, it will be difficult for oil prices to rise above USD50/bbl to surpass shale gas companies' BEP level.We believe that US shale companies with high production and BEP levels will suffer the most from the conflict between Russia and Saudi Arabia. OPEC and Russia, including Saudi Arabia, will try to fill the void by boosting production. This factor limits long-term oil price increases.

Low oil prices are positive for refiners as low oil prices can stimulate demand, and inventory valuation losses can be recovered if oil prices rise in the future. Additionally, that the OSP dropped due to the recent rally for a bigger market share is also a positive factor. Accordingly, shares may bottom out faster than others in the short term. However, the question remains as to whether earnings recovery leads to improved shareholder value. Refiners are currently in dire financial straits. Originally, in 2020, the effect of IMO 2020 was expected to significantly improve earnings performance, and investments have moved accordingly. However, margin improvements have been negligible, and the coronavirus pandemic combined with the plunge in oil prices significantly weighed on performance. In addition, due to the high debt-to-equity ratio as the result of continued investments in energy conversion (chemical sector, battery business), even if earnings were to improve, it is likely to be used to repay debts and secure funds for investments rather than improving shareholder value. Therefore, a stock multiple increase is expected to be limited until tangible results are seen from future businesses, or earnings improve more than expected.

Fig 1. 60% of global crude demand comes from mobility

Source: OPEC, Hyundai Motor Securities

Fig 2. Saudi Arabia’s OSP falls below 2015’s level

Source: BNEF, Hyundai Motor Securities

Fig 3. Complex refining margin trends Fig 4. Gasoline/naphtha margin trends

(USD/bbl) Complex refining margin (lagging) Complex refining margin (USD/bbl) Gasoline/Crude oil Naphtha/Crude oil 25 30

20 25 20 15 15 10 10 5 5 0 0

-5 -5 -10 -10 14.01 14.07 15.01 15.07 16.01 16.07 17.01 17.07 18.01 18.07 19.01 19.07 20.01 15.1 15.7 16.1 16.7 17.1 17.7 18.1 18.7 19.1 19.7 20.1 Source: Petronet, Hyundai Motor Securities Source: Petronet, Hyundai Motor Securities

Fig 5. B-C margin trend Fig 6. Kerosene/diesel margin trends

(USD/bbl) Kerosene/Crude oil Diesel/Crude oil (USD/bbl) 10 25 5 20 0

-5 15 -10 -15 10 -20 5 -25 -30 0 15.1 15.7 16.1 16.7 17.1 17.7 18.1 18.7 19.1 19.7 20.1 16.01 16.07 17.01 17.07 18.01 18.07 19.01 19.07 20.01 Source: Petronet, Hyundai Motor Securities Source: Petronet, Hyundai Motor Securities

Chemicals: advantageously positioned vs. ECCs but oversupply burden heavy; competition from Saudi Arabia The NCC spread is improving due to falling oil prices. In particular, the price of naphtha plummeted in an accident at one of Lotte Chemical’s (011170.KS, Marketperform) plants. Due to sharp oil price declines, the cost competitiveness of Asian NCCs is recovering faster than North American and Saudi Arabian ECCs. Of course, the coronavirus pandemic casts a shadow of uncertainty over demand, but as oil price increases are limited, Korean NCCs will improve their cost competitiveness compared with US ECCs. Oil prices have plummeted, but US ethane prices remain mostly unchanged.

However, it would be hard to revisit the situation in 2015-2016 because of heavy capacity expansions. Therefore, the performance of LG Chem and Hanwha Solutions, whose major produces such as ABS and PVC are not burdened by oversupply, should see earnings improve in 2Q20. For Lotte Chemical, US ECCs’ margin squeeze may offset the negative impact of the plant accident.

What will be the next step if Saudi Arabia succeeds in protecting market share by keeping oil prices low? We believe that it is taking the hegemony of the chemical segment. The chemical business is the only business that can ensure relatively stable demand in the future. As Saudi Arabia has the right to decide on the feedstock price, it is likely that it will try to secure competitiveness in the chemical business. Aramco plans to acquire 70% of SABIC in 1H20, which will accelerate Aramco's downstream growth in the chemical business. In addition, Saudi Arabia plans to invest USD110bn in the Al Jafurah Gas Project, and will use the ethane produced from the project as a feedstock for chemical plant feedstock. As such, Korea’s independent NCCs face high risks, especially those with a portfolio of general-purpose products.

Fig 7. Naphtha spread recovering vs. ethane

(USD/tonne) Naphtha (USD/tonne) Ethane (USD/tonne) Naphtha/ethane (R)

1,400 14 Gas price falls in NA, spread Oil prices surge, widens ethane price in NA rises 1,200 12

1,000 10 800 8 600 6 400

200 4 Oil prices collapse, spread narrows 0 2 13 14 15 16 17 18 19 20 Source: Bloomberg, Hyundai Motor Securities

Fig 8. HDPE spread Fig 9. PP spread

Source: Cischem, Hyundai Motor Securities Source: Cischem, Hyundai Motor Securities

Fig 10. PVC spread Fig 11. ABS spread

Source: Cischem, Hyundai Motor Securities Source: Cischem, Hyundai Motor Securities

Fig 12. BD spread Fig 13. EG spread

Source: Cischem, Hyundai Motor Securities Source: Cischem, Hyundai Motor Securities

Investment in energy conversion to pick up after the pandemic ends After the coronavirus pandemic comes to an end, we expect to see each government expanding infrastructure investments related to energy conversion. Looking back, it is true that the rapid spread of the coronavirus has affected demand in the current bear market, but what has caused uncertainty in the financial sector has been the precipitous decline in oil prices. The energy sector only represents 2.7% of the S&P lately, but the derivatives and bonds linked to crude oil can affect the financial market.

Energy conversion through renewable energy investments can lead to energy self-sufficiency, freeing the economy from these external factors. Germany, which has low energy self-sufficiency, saw escalating uncertainties over Nordstream 2 importing gas from Russia due to objections from the US. This is a case where a high dependence on overseas energy has increased uncertainty in terms of politics and security. The unforeseen external factors affecting the economy gives each country reasons to move forward to reduce their dependence on hydrocarbons concentrated in some regions and move toward energy independence. From this perspective, we believe Korea will continue to invest in the hydrogen industry.

Last week after OPEC+ failed to strike a deal regarding the reduction of production, the EU launched the Clean Hydrogen Alliance. This will be the key agenda for the EU to promote carbon neutrality by 2050. The EU will raise funds in the same way that the Battery Alliance did in 2017. In addition, heavy duty vehicles and aircraft have been set as new goals.

The UK is also accelerating efforts to produce green hydrogen. BP and Shell have set the goal of promoting 100% hydrogen heating in the UK by 2025 and building 100 hydrogen-charging stations. A total of KRW13tn will be invested. Water heaters in homes can use hydrogen as a supplement fuel. Additionally, approximately GBP28mn is earmarked for five projects to develop and produce green hydrogen and blue hydrogen. The Dolphyn project produces green hydrogen using seawater in a floating wind power generator. It will build a pilot production facility with a capacity of 2MW by 2023. After the testing period, the capacity will expand up to 10GW by 2026.

Fig 14. Countries moving toward hydrogen economy have relatively low energy self-efficiency

(%) China US Germany South Korea Japan 120

100

0 98.1 00.1 02.1 04.1 06.1 08.1 10.1 12.1 14.1 16.1 Source : IEA, Hyundai Motor Securities

Fig 15. Dolphyn project

Source : KEEI, Hyundai Motor Securities

Fig 16. EU Clean Hydrogen Alliance Fig 17. Solar-powered hydrogen plants

Source : fch.europa.eu, Hyundai Motor Securities Source: Nikkei, Hyundai Motor Securities

European EV sales may fall but market presence continues to strengthen As the coronavirus pandemic envelops Europe, there are concerns that there may be disruptions in EV production and demand. If conditions in Europe persist over the long term, it is probable that EV sales will be sluggish from 2Q20. In this case, there may be concerns about the battery production. Several Volkswagen factories and European auto parts markers stopped production because of COVID-19. However, it is important to note that EVs’ share of sales in Europe has been increasing recently. Even if demand falls, it should be viewed as a temporary impact caused by the coronavirus. Rather, despite sluggish car sales overall, EV sales are bound to increase. Even with lower oil prices, it is not easy to sell ICEVs because of penalties levied on OEMs. As such, we believe the transition to clean energy will accelerate further.

Fig 18. EV, PHEV YoY sales growth in Germany and France

Jan 2020 Feb 2020 250% 217.2%

200% 160.1% 149.4% 150% 138.4%

100%

50%

0% Germany France Source: EV sales, Hyundai Motor Securities

Top picks: LG Chem, Hanwha Solutions, Doosan Fuel Cell, Samsung SDI We believe energy conversion related industries (renewable energy and secondary batteries) merit our attention when the uncertainties stemming from COVID-19 and collapsing oil prices come to an end. The companies in these industries with structural growth momentum are likely to outperform in the stock market too. Our top picks are LG Chem (051910.KS, BUY), Hanwha Solutions (009830.KS, BUY), Doosan Fuel Cell (336260.KS, BUY), and Samsung SDI (006400.KS, BUY).

Investment rating and target price history Two-year price chart Difference (%) Date Rating TP Average High/Low 19/10/08 BUY 390,000 -22.9 -22.1 (KRW ‘000) 19/10/23 BUY 390,000 -23.0 -22.1 600 19/10/28 BUY 390,000 -21.2 -17.2 500 19/12/09 BUY 390,000 -21.3 -17.2 20/01/02 BUY 390,000 -21.2 -17.2 400 20/01/07 BUY 390,000 -21.1 -16.7 20/01/13 BUY 390,000 -20.3 -9.2 300 20/01/23 BUY 390,000 -19.7 -9.2 200 20/02/04 BUY 470,000 -14.8 -10.7 20/02/18 BUY 470,000 -15.2 -10.7 100 LG Chemical 20/03/03 BUY 470,000 -15.5 -10.7 Target price 20/03/10 BUY 470,000 -16.8 -10.7 0 18.03 18.06 18.09 18.12 19.03 19.06 19.09 19.12 20.03 20/03/16 BUY 470,000 -17.3 -10.7 20/03/17 BUY 470,000 - -

Investment rating and target price history Two-year price chart Difference (%) Date Rating TP Average High/Low 19/05/09 BUY 31,000 -32.3 -29.5 (KRW ‘000) 50 19/05/31 BUY 31,000 -31.1 -26.6 19/06/28 BUY 31,000 -32.0 -25.0 45 19/08/08 BUY 26,000 -32.4 -27.9 40 19/09/24 BUY 26,000 -32.3 -27.9 35 19/10/08 BUY 24,000 -28.3 -22.7 30 19/11/14 BUY 24,000 -26.5 -21.9 25 19/12/16 BUY 24,000 -25.4 -20.0 20 20/01/07 BUY 24,000 -25.0 -17.1 15 20/01/13 BUY 24,000 -24.2 -16.5 10 Hanwha Solution 20/02/21 BUY 29,000 -36.9 -34.1 5 Target price 20/03/10 BUY 29,000 -39.9 -34.1 0 18.03 18.06 18.09 18.12 19.03 19.06 19.09 19.12 20.03 20/03/16 BUY 29,000 -40.9 -34.1 20/03/17 BUY 29,000 - -

Investment rating and target price history Two-year price chart Difference (%) Date Rating TP Average High/Low 19/04/22 BUY 290,000 -20.2 -18.4 (KRW ‘000) 400 19/05/02 BUY 290,000 -23.4 -17.6 19/05/31 BUY 290,000 -20.8 -16.4 350

19/07/31 BUY 310,000 -23.0 -17.6 300 19/10/15 BUY 310,000 -23.9 -17.6 250 19/10/30 BUY 310,000 -24.3 -17.6 19/12/17 BUY 310,000 -24.5 -17.6 200 20/01/13 BUY 310,000 -23.7 -7.7 150

20/01/23 BUY 310,000 -23.1 -7.4 100 20/01/31 BUY 380,000 -14.9 -9.7 Samsung SDI 50 20/02/18 BUY 380,000 -15.2 -9.6 Target price 20/03/03 BUY 380,000 -15.7 -9.6 0 18.03 18.06 18.09 18.12 19.03 19.06 19.09 19.12 20.03 20/03/10 BUY 380,000 -17.5 -9.6 20/03/17 BUY 380,000 - -

Investment rating and target price history Two-year price chart Difference (%) Date Rating TP Average High/Low (KRW ‘000) 20/03/10 BUY 10,000 -41.5 -33.2 12 20/03/17 BUY 10,000 - -

2 Doosan Fuel Cell Target price

0 18.03 18.06 18.09 18.12 19.03 19.06 19.09 19.12 20.03

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Investment rating Hyundai Motor Securities offers three sector investment ratings based on six-month forward fundamentals and share price outlook. • OVERWEIGHT: Sector-wide fundamentals and share prices are expected to turn up. • NEUTRAL: No meaningful fundamental improvement is expected. • UNDERWEIGHT: Sector-wide fundamentals and share prices are expected to turn down.

Hyundai Motor Securities offers three company investment ratings based on the relative return expected in the following six months, based on the closing price on the date of rating declaration. • BUY: Excess return of +15%p or more • MARKETPERFORM (M.PERFORM): Excess return of between -15%p and +15%p • SELL: Excess return of -15%p or less

Stock ratings distribution (January 1, 2019-December 31, 2019) Rating Count % of rating category BUY 135 85.99 MARKETPERFORM 22 14.01 SELL 0 0.0

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