Chemicals leave a nasty taste for investors

A reminder of the effects of short selling bans around the world

Before we get into our analysis of the chemicals sector, I’ve attached the best piece of independent academic research that was conducted into the effect of the short selling bans in the aftermath of the Lehman default. Amid rumors of additional bans on short selling, this paper finds that bans (i) were detrimental for liquidity, especially for stocks with small market capitalization, high volatility and no listed options; (ii) slowed down price discovery, especially in bear market phases, and (iii) failed to support stock prices, except possibly for U.S. financial stocks. Click here to download Alessandro Beber’s paper - Short-Selling Bans around the World: Evidence from the 2007-09 Crisis.

Even before the recent ruckus, some investors were predicting tough times for the chemical firms. One or two of them recently admitted to difficult trading due to the twin perils of a sluggish global economy and a rising cost base. Given how many different products are required to make each chemical compound, these businesses are hypersensitive to raw material inflation. We can look at sentiment in the overall sector but will also focus on a sub segment whose fortunes are finely balanced. Firms like Wacker Chemie (ETR:WCH) and Oci Co. (SEO:010060) make the silicones for the Solar Energy and Semiconductor industries. As with the firms they feed, investors are split down the middle when it comes to predicting their future fortunes, with short sellers pessimistic, but long only managers optimistic.

Short interest across the global Chemicals sector currently stands at an average of just 1.35% of total shares outstanding. The average is pulled down by large diversified companies in which securities lending activity is commonly low. However, the average change in short interest over the past month has seen an increase of 132% as the sector becomes increasingly short. On the long side of the market, institutional investors who lend have reduced their holdings in the sector by an average of 4.3% over the past month with the exception of some names with exposure to the Solar Energy and Semiconductor sectors including Wacker Chemie and Oci Co. Ltd.

The share price of Wacker Chemie fell the most in two and a half years last week following missed earnings estimates as a result of rising raw material costs. Short interest has surged from 2% to an annual high of 9% of total shares outstanding on loan, with the exception of a spike in May which was a result of dividend arbitrage. In contrast, institutional investors who lend have taken a bullish stance towards this stock, increasing holdings over the year to 13% of total shares. This contrasting trend is also observed in the Solar sector which may demonstrate that investors believe the performance of the solar stocks will directly affect the chemical stocks that supply the industry. The solar stocks face headwinds in the short term as government subsidies are slashed but there is an opinion that renewable energy will become more main-stream in the long term, hence the bullish view taken by long only funds.

Korea has placed a ban on short selling following the high volatility in the markets, but short interest in another chemical supplier to the solar industry, OCI Co. Ltd, predates the ban. Short interest has trebled since May to almost 6% of total shares outstanding on loan. Short sellers did temporarily cover their positions in June reducing short interest from 6% to 4% but quickly returned to shorting the stock as the share price continued to fall. August has sent the share price tumbling a further 30% but there is no evidence of any profit taking. Again, we see a similar trend in securities lending activity to Wacker Chemie. With only 24.3 million shares in issue, institutional investors who lend have been increasing their holdings to an overall 9% of total shares.

Large diversified stocks including Dow Chemical Company (NYSE:DOW) and Basf Se (ETR:BAS) observe short interest to be flat at 0.5% and 1.8% of total shares outstanding. Sentiment on the long side of the market in these stocks contrasts that of the solar related chemical stocks. Institutional investors have decreased their holdings in the two stocks since the start of the year. However, following a 10% decline in holdings in Dow Chemical Co., the recent price decline to six month lows has led to a 7% increase in holdings in August. Basf Se has had a decline of 5% of holdings since June.

Finally, Ecolab Inc. (NYSE:ECL) which provides cleaning and sanitizing products, acquired chemical and cleaning solutions business, Cleantec in December, increasing its exposure in the chemicals markets. In the last six weeks the share price has dropped from annual highs to new annual lows, which was further amplified by increasing costs, tightening margins and falling net income reported in July’s second-quarter earnings report. This prompted a surge in short interest from 2% to 7% of total shares outstanding in the same period, showing that short sellers believe the share price has further to fall. Institutional investors have reduced holdings to annual lows but may be taking advantage of the low share price and have increased holdings by 5% in August.