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Good morning and welcome to the Olin Corporation Third Quarter 2019 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions]. After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Logan Bonacorsi, Olin's Director of Investor Relations. Please go ahead Miss.
Good morning everyone and thank you for joining us today. Before we begin let me remind you that this presentation, along with the associated slides and the question-and-answer session following our prepared remarks, will include statements regarding estimates of future performance. Please note that these are forward-looking statements and that actual results could differ materially from those projected. Some of the factors that could cause results to differ from our projections are described without limitations in the Risk Factors section of our most recent Form 10-K and in yesterday's third quarter earnings press release. A copy of today's transcript and slides will be available on our website in the Investors section under Past Events. The earnings press release and other financial data and information are available under Press Releases.
With me this morning are John Fischer, Olin's Chairman, President and Chief Executive Officer; Pat Dawson, Executive Vice President and President of Epoxy & International; Jim Varilek, Executive Vice President and Chief Operating Officer; and Todd Slater, Vice President and Chief Financial Officer. We will begin with our prepared remarks, and thereafter, we will be happy to take your questions. I will now turn the call over to John Fischer. John?
Thank you Logan and good morning everyone. Today I will begin my remarks by discussing the key points from the third quarter followed by our updated outlook for the remainder of 2019, a detailed overview of each of Olin's business segments, our long-term view on market dynamics for chlor-alkali and epoxy and conclude with the Winchester segment. With that let's turn to Slide 3.
During the third quarter of 2019 Olin reported adjusted EBITDA of approximately $293 million. While this represents a year-over-year decline, results for the quarter improved 43% sequentially despite a challenging economic backdrop. Third quarter results benefited from lower planned maintenance turnaround costs, strong operating performance, the resolution of the onetime events that affected the epoxy business during the second quarter, as well as seasonally higher volumes across our business segments. However several challenges during that period worked to offset these positives.
Beginning in the middle of the third quarter we saw a significant slowdown in demand from a broad spectrum of chemical customers. We experienced lower than expected demand from urethane, agricultural, refrigerant, alumina, pulp and paper, automotive, electrical laminate, and industrial coatings customers. In addition to lower volumes lower customer demand negatively affected prices for several products. We experienced lower pricing for caustic soda, ethylene dichloride, hydrochloric acid, chlorinated organics, and epoxy resins.
Moving now to our updated outlook for the full year 2019 which is on Slide 4, we expect full year 2019 adjusted EBITDA to be between $930 million and $980 million. This compares to full year 2018 adjusted EBITDA of $1.265 billion. The year-over-year decline in adjusted EBITDA can be primarily attributed to three factors and approximately $325 million impact from lower caustic soda pricing, lower epoxy resin pricing partially offset by lower maintenance turnaround costs.
Looking ahead we expect the weak underlying demand fundamentals in our chemical businesses to persist at least through the remainder of this year. As a result we anticipate our fourth quarter adjusted EBITDA to decline when compared to the third quarter of 2019. The fourth quarter may represent the lowest earnings quarter of the year. The key assumptions behind this forecast are lower caustic soda, ethylene dichloride, hydrochloric acid, chlorinated organics, and epoxy resin pricing, lower volume levels in chlor alkaline and epoxy, lower operating rates in the chemical business due to seasonally weaker demand coupled with seasonal inventory destocking and fourth quarter turnarounds.
Now we'd like to take a more detailed look at each of our business segments starting with chlor alkali products and vinyls which is on Slide 5. The chlor alkali products and vinyls business experienced lower demand from a broad spectrum of customers including urethane, agricultural, refrigerant, alumina, and pulp and paste customers. As an example a major chlorine customer did not buy any chlorine over a four week period beginning in September. Slower demand negatively impacted both volumes and pricing. Third quarter 2019 adjusted EBITDA for the chlor alkali products and vinyl segment was $234.9 million representing a 29% year-over-year decline. This decline was driven by lower caustic soda pricing. Caustic soda pricing in Olin System has declined more than 20% or approximately $90 million when compared to the third quarter of 2018. Chlorinated organics and hydrochloric acid pricing also declined year-over-year.
Volume levels for caustic soda, chlorine, chlorinated organics, and hydrochloric acid all declined year-over-year. Offsetting some of this year-over-year pricing and volume pressure were lower raw material and operating costs. Looking at the fourth quarter of 2019 and given the current demand environment we expect results for the chlor alkali products and vinyl segment to be lower sequentially and to likely represent the lowest earnings quarter of 2019.
Now let's take a closer look at caustic soda pricing which is on Slide 6. Caustic soda pricing in Olin system declined in the third quarter. The price decline was particularly pronounced in the export market where caustic soda pricing indices were down $55 per ton in the third quarter and $25 per ton additionally in October. Domestic pricing while lower in the third quarter and in October was more resilient due to support from a relatively stronger U.S. economy and the cost to serve that market. Looking ahead we expect the current weakness in caustic soda demand to continue in the fourth quarter and potentially into 2020.
Let us now move to the performance of our epoxy segment which is on Slide 7. During the third quarter of 2019 Olin's epoxy business generated adjusted EBITDA of $51.1 million, a 9% decline from the level achieved in the third quarter of 2018. While these results fell short of our expectations, the first three quarters of 2019 represent Olin's strongest nine month period for this segment since the acquisition of Dow's Chlorine Products businesses in 2015. The gradually improving trend in epoxy results highlight the strength of the business as chlorine integration and the potential longer-term earnings power.
Looking ahead to the fourth quarter of 2019 we expect epoxy segment results to be lower than the fourth quarter 2018 results. Sequentially we anticipate seasonally lower volume levels, stable raw material costs, and unfavorable pricing trends to affect quarterly results. We now believe 2019 epoxy segment adjusted EBITDA will be lower than last year's levels due to lower margins partially offset by lower maintenance turnaround costs.
Looking now at a global epoxy resin prices which are shown in the exhibit on Slide 8. During the third quarter liquid epoxy resin pricing continued to move lower in all regions. The average global epoxy resin pricing has declined approximately 15% during the first nine months of 2019. The price declines have primarily been driven by demand weakness from global automotive, electrical laminate, and industrial coating customers. A bright spot in the epoxy business has been sales in the wind energy sector which are forecast to increase approximately 15% in 2019 compared to 2018.
Before moving to the Winchester segment I would like to emphasize the long-term outlook for our chemicals businesses which is on Slide 9. Demand for Olin's key products such as caustic soda, chlorine, chlorinated organics, ethylene dichloride, and epoxy resins have been weaker in 2019 than 2018. Production levels for alumina and pulp and paper, two key end use markets for caustic soda have declined. Demand for epoxy resin in Europe Olin's largest epoxy market has been flat and hydrochloric acid demand in North America has declined due to weaker demand from oil and gas producers. In spite of these near-term dynamics we continue to believe market fundamentals for chlor alkali, vinyl, and epoxy products will be supported by favorable long-term supply and demand fundamentals. We continue to believe that there will be demand growth for the chlor alkali sector on both sides of the ECU. Both chlorine and chlorine derivatives as well as caustic soda.
Capacity growth will lag demand. To date there have been minimal global capacity additions and announcements of additions to meet projected demand growth. The U.S. will continue to enjoy a sustained energy and feedstock advantage over the rest of the world. Current industry economics do not support world scale chlor alkali investments. Ultimately over the long-term supply and demand balances will tighten resulting in upward pricing momentum for Olin's caustic soda, chlorine, and chlorine derivative products. Similarly in the epoxy business we see global demand growth and minimal capacity additions.
Now let's move and talk about our Winchester segment which is on Slide 10. Winchester experienced its first quarterly year-over-year increase since 2016 ending the third quarter of 2019 with adjusted EBITDA of $19.1 million. The 26% improvement was a result of higher commercial, military, and law enforcement volumes and favorable commodity and operating costs. Lower year-over-year product pricing partially offset the improvements. We are forecasting a sequential decline in adjusted EBITDA during the fourth quarter consistent with the businesses normal seasonality. Continue to expect Winchester's results for the full year 2019 to be comparable to or slightly better than the full year levels achieved in 2018.
Now turning to the Lake City contract on Slide 11. Late in the third quarter it was announced that Olin's Winchester segment secured the contract to operate the government owned Lake City U.S. Army ammunition facility in Independence Missouri. This award is transformational for the Winchester business. After a one year transition period Winchester will assume operational control of the facility on October 1, 2020. The contract has an initial term of seven years and we expect this multiyear contract will drive a significant increase in annual profitability for the segment starting in late 2020. We estimate increased annual revenue of between $450 million and $550 million and a corresponding improvement in annual adjusted EBITDA of $40 million to $50 million. The full year effect of the Lake City contract will begin in 2021.
I would like to highlight several other near-term enhancements that will improve cash flows as we transition from 2020 to 2021 and these are shown on Slide 12. In 2021 we expect incremental cash generation of approximately $225 million from items within Olin's control or that are contractually committed. The refinancing of the high cost bonds which were issued as part of the Dow acquisition in 2015 will become callable in late 2020 and are expected to reduce interest expense by $50 million to $70 million annually. The winding down of the multiyear information technology project to integrate the acquired Dow chlorine products businesses will save approximately $100 million of capital and expense spending. The vinyl chloride monomer contract is transitioning from the total manufacturing arrangement that has been in place since the acquisition to a direct customer sale agreement beginning on January 1, 2021. And finally the full year effect of the new Lake City Army Ammunition contract. These cash flow enhancements of approximately $225 million provide significant incremental cash flows to Olin independent of industry conditions. And with that I'd like to turn the call over to Todd Slater, Olin's CFO. Todd.
Thanks John and good morning everyone. The accelerated share repurchase program that was announced on August 5th was completed in early October. 5.7 million shares of Olin's common stock were repurchased for $100 million. Also during the third quarter Olin completed a $750 million bond offering and a new $2 billion bank credit facility. We are able to -- we were able to establish a low risk pathway to refinance high cost bonds assumed during the 2015 Dow acquisition and when they become callable in late 2020 while increasing our financial flexibility.
Now let's turn to our updated 2019 cash flow forecast which is on Slide 13. Assuming the midpoint of our full year adjusted EBITDA guidance we expect to generate approximately $230 million of free cash flow in 2019. From the midpoint of our adjusted EBITDA forecast which is on the far left of the waterfall chart, we deduct $30 million in estimated cash tax payments. The cash taxes paid in 2019 are almost all attributable to earnings in foreign jurisdictions.
Column three reflects the midpoint of our current forecast for capital spending of $375 million which includes annual maintenance capital spending of between $225 million and $275 million and the investment associated with our multi-year information technology integration project of approximately $70 million. As we've previously discussed in 2017 we began a multi-year project to implement new enterprise resource planning, manufacturing, and engineering systems across the Heritage [ph] Olin and the acquired Dow Chlorine Products businesses. The project also includes the required information technology infrastructure.
Now turning to the fourth column, we are expecting a $25 million increase in working capital in 2019 as we use cash from the refinancing to reduce the sale of receivables under our factoring arrangement. In the next column onetime items include information technology integration costs and cash restructuring costs of approximately $90 million. This includes approximately $50 million for the IT integration project that I just spoke about and approximately $25 million of duplicate IT costs being incurred during the transition. These costs are partially offset by $20 million of pre-tax proceeds from the sale of an investment in non-consolidated affiliate in the first quarter. The next column represents cash interest expense. As of September 30th we had approximately 5% of our debt at variable interest rates. In the far right column we are forecasting $250 million -- $230 million of free cash flow.
Now I'd like to move on to Olin's priorities for free cash flow which are on Slide 14. Since the acquisition in 2015 Olin has utilized its cash flow repaying approximately $500 million of debt, repurchasing $190 million of Olin common stock, or 6% of shares outstanding and continuing our consistent quarterly dividend. Looking ahead our 2020 priorities for free cash flow will be expanding our cash position on the balance sheet in advance of the approximately $490 million ethylene payment at the end of 2020. As a reminder this investment will provide Olin additional cost based ethylene for 20 years and support the VCM contract. After 2020 we expect to use our free cash flow to reduce debt levels, reward shareholders, and invest in our pipeline of low cost organic growth projects. These growth opportunities exist in smaller increments across the chlorine on globe and our production platform and can be implemented as market conditions warrant.
Finally, on Wednesday, October 23rd Olin's Board of Directors declared a dividend of $0.20 on each share of Olin common stock. The dividend is payable on December 10, 2019 to shareholders of record at the close of business on November 12, 2019. This is the 372 core consecutive quarterly dividend to be paid by the company. Operator, we are now ready to take questions.
[Operator Instructions]. First question comes from Don Carson of Susquehanna. Don, please proceed.
Yes, thank you. Got a question on the chlor alkali cycle. This cycle seems a little different in that normally industrial demand is more sustainable than vinyls demand especially into residential construction. You seem to have the opposite this time around. Is that why you think that we're going to have lower caustic pricing in 2020 versus 2019 and then I have a follow up on Winchester?
What I would say is what I think is that we think is different about the chlor alkali cycle. As we said at this moment is there's been a significant increase in the amount of chlorine exported as derivatives over the past 12 years. If you look today between 35% and 40% of the chlorine that's produced in North America is actually exported. So when we look at a slowdown in industrial production in the United States it has typically been accompanied by a slowdown in housing and construction in the U.S. But what we really for this cycle to take full effect we really need there to be a global slowdown in construction so that the chlorine demand actually goes down in North America. So we would see a lower level of exports. I think if you looked at caustic demand in North America it would it would significantly exceed chlorine demand right now, just in North America.
And then my follow up on Winchester, we've seen a significant change in industry distribution patterns or about to see where the largest retailer Walmart is going to restrict its sales of certain types of ammunition. What impact you think this has on overall demand if any and could this actually be positive for you given that presumably these smaller distributors who may -- who will take over from Walmart don't get the same terms as a Walmart does?
I would say at the moment it's probably too soon to tell because Walmart is still in the market. Their targeted exit on the products they're exiting is December 1st. And I imagine that they're not helping the market right now because they're trying to move all that product. Longer -- in the immediate aftermath I would not be surprised if there's some short run disruptions on the retail supply side just because Walmart has such a large presence and nobody else comes close. I think your comment on pricing probably has some validity but we'll need to see how that plays out.
Thank you.
Our next question comes from Kevin McCarthy of Vertical Research Partners. Kevin, please proceed.
Yes, good morning. Would you comment on where you think demand for chlor alkali is tracking in 2019 and based on your prior experience with previous downturns what would you expect the trajectory to look like demand wise as we move through 2020?
Kevin, this is Jim. I would say on a year-over-year basis we have seen some weaker operating rates and so forth which would indicate that we have had a lower caustic output. So I think that's been exacerbated here in the third quarter. We've seen that decline and we've seen it in specific pockets like pulp and paper and alumina that are actually driving that. Having said that I think there's some inventory corrections and so forth that are taking place in those markets and as we look into 2020 we need to see some kind of a, what I would call, an industrial production rebound to see increasing demand and we need to get that. As was mentioned earlier we need to get the industrial production side of things which is driving -- drives caustic demand moving to the upside in excess of chlorine demand which will help bring balance back to the market.
And then I had a follow-up question if I may on Winchester. On Slide 11 I think you reference $25 million of transition costs. Can you talk a little bit about what those are and also whether you need to reinvest capital to serve this contract and whether or not there are any other meaningful contracts that might roll off or roll on over the next year or so?
The $25 million is the expense that Olin will occur to take over what is effectively a $500 million business in a different location. We have to provide the entire management team which is somewhere between 12 and 15 people. They have to be relocated, they have to have a what I'll call a transition period living there. There are certain investments that we need to make in terms of getting what I'll call the management systems up to speed. There are 2000 employees at Lake City that become our employees, we have to put them on our benefit programs etcetera, etcetera. So that's what the $25 million is about. In terms of investments by Olin, the only real investment we are obligated to make is in working capital and I would tell you I think that's in the $60 million to $80 million range which will occur late next year.
That's helpful. Thank you.
Our next question comes from Jim Sheehan of SunTrust. Jim, please proceed.
Good morning. Thanks for taking my question. Would you expect caustic soda customers to be in need of restocking inventories sometime in early 2020?
Yeah, we would expect that, I mean they've been in destock mode for quite some time so we would expect that at some point here that restocking has to occur. Right now with prices moving down with we say industrial production in general demand in kind of a malaise they've been destocking and will probably continue to do that until they see something to the positive side that will cause them or give them a trigger to restock. But it's got to happen at some point in time.
Thank you. And what is your expectation for a turnaround cost in 2020 relative to 2019?
We haven't given a specific number Jim but I would tell you qualitatively they will be higher. We've talked about the large turnarounds, there's one in the VCM plant that occurs every three years, it will occur in the second quarter of next year, and that will all other things being equal make turnaround costs higher next year than this year.
Thank you.
Our next question comes from Frank Mitsch, Fermium Research. Frank, please proceed.
Thank you and congrats on the Lake City contract. John, interesting factoid on the chlorine customer not buying anything for four weeks starting in September, I was wondering what industry or what end market that was and do we have to go back to like the 2008-2009 timeframe for the last time you saw that occur?
That is the longest outage from that type of customer we've seen since 2000 -- the end of 2008. So yes, you do have to go back that far. I'd rather not say where they came from but I would just take the opportunity to say we were moving along through the month of August last, this past August with relatively high demand across the spectrum of what we're doing. And it's like we hit a wall in September and that's what we're really experiencing now. Things dropped off dramatically and they've stayed down up till today anyway.
Okay, that's helpful. And in discussing not just customer inventories but I'm more curious on the caustic soda side in terms of producer inventory levels, we had heard that they were somewhat elevated. Can you talk about how that trended, how do you believe that trended through the third quarter and where producer inventory levels are on caustic here today?
I would say that I don't feel qualified to comment on the competitors or the other participants in the market. I would tell you that as we sit today our caustic inventory is equal to or slightly below our normal levels.
And was it above it during the third quarter and you've been able to work that down, is that the way that we should think about that?
Now we've had a series of turn -- we built a little bit of inventory in the third quarter because we have a series of turnarounds that are going on early in the fourth quarter. Those turnarounds have had the effect of bringing inventory levels below normal.
Terrific, thank you.
Our next question comes from Neel Kumar of Morgan Stanley. Neel, please proceed.
Thanks. I just wondered if you can give any preliminary expectations on how to think about 2020 EBITDA, I mean given the softness we are seeing in demand, do you think it's fair to think about it as you annualize fourth quarter EBITDA expectations, plus perhaps the quarter and new Winchester contract?
What I would say is we intend to give full year 2020 when we report our fourth quarter earnings. I would just go back to the comment I made to Frank about how strong the slowdown was. And I would say based on that and the ability of this industry to move very rapidly one way or the other it would be imprudent to really give the 2020 guidance at this moment.
Okay. And then I just was wondering if you can talk about what you're seeing in terms of the EDC market going forward, seems that prices started to strengthen a bit in October, so just curious as to what you're seeing in that market?
Yeah Neel, this is Jim. EDC I think at the last call what we said was that we expect that EDC demand to continue fairly solid in the third quarter, we did see that. Prices did come down as we expected and we mentioned that we were going to be buffered from a good bit of that movement and we in fact did see that. So that's the third quarter. Heading into fourth quarter there is -- there has been still some pressure on EDC prices to the downward side. But you're correct in your observation that here in the last few weeks we've actually seen some movement to the upside on EDC. And as I've spoken before we oftentimes see EDC demand pick up as people start to restock in the fourth quarter. So we'll have to see where the rest of the quarter takes us in terms of pricing but we would expect to see some increased volume in the latter part of the quarter.
Okay, alright. Thank you.
Our next question comes from Mike Leithead of Barclays. Mike, go ahead.
Thanks. Good morning guys. If we were to just flat line pricing for your key products right now what would the year-over-year EBITDA headwind be next year versus this year?
I don't think we want to -- I don't know what flat lining means because it'll move -- you want a flat line at this moment I would say --
If we just took third quarter levels and just ran them straight.
I don't have that calculation I would prefer to answer that with more information.
Fair enough. And then on cash flow, I think Slide 12 is helpful to think about 2021. But if we were to just bridge from 2019 to 2020 for free cash we'll pick whatever level of earnings next year but just agnostic of that how should we think about the changing cash calls next year versus what we have this year in 2019?
Well, we've talked about a couple of things that what I would call onetime cash flow. Todd talked in his remarks about the ethylene. We also talked about the bond call, there's a premium to be paid on that and we talked about the need. There was an earlier question define working capital at Winchester. That said I would expect given the environment we're in that you will see lower capital spending for us next year and if the business stays where it is we should see working capital ex the Lake City thing be a positive for us next year.
Thank you.
Our next question comes from Eric Petrie of Citi. Eric please proceed.
Hi, good morning. It seems the alumina industry is oversupplied with recent producer announcements to review capacity, has this impacted you at all and have you seen what the slowdown in industrial production, customers for caustic switch much more to spot versus contract?
As I mentioned before Eric, this is Jim. As I mentioned before we have seen weakness in the market and I think the best -- the alumina market I think the best indicator of that actually is the pricing and the price declines that have taken place in that market where they have come off all the way down into the LMEs or way down into levels that they haven't seen in several years. So that would indicate the weak demand. As far as individual capacities in alumina and so forth I think you'd have to speak to them about what the right size and whether capacity needs to come off. We have seen weaker demand coming out of the alumina sector but to your comment about spot or whatever as spot caustic pricing and so forth and spot versus contract I would say we haven't seen a significant change in the action of that industry.
Helpful and secondly, how much of epoxy volumes are in the extra raw materials?
Index through.
Jeff this is -- sorry Eric this is Pat. But the index seems very little quite frankly. Most of the indexing where we index to raw materials is in our upstream, things like benzene and propylene. So benzene we can pretty much immediately offset any changes there in our upstream. Very little indexing gets done in the midstream and downstream parts of our portfolio.
Thank you.
Our next question comes from Jeff Zekauskas with J.P. Morgan. Jeff please proceed.
Thanks very much. What South American demand for caustic been like for you if you look at the third quarter and compare it to the second?
Jeff this is Jim. Demand in Latin America has declined in the third quarter. Latin America had been a very strong growth area over the past couple of years. Again, I would focus on pulp and paper and alumina markets which drives Latin American growth and specifically Brazilian growth. And those have been softer and so we see the same things in Latin America as we've seen elsewhere respective to those two sectors.
You know what, in thinking through the last few conference calls I think when we began 2019 there was a general optimism around caustic prices and obviously caustic prices have been weak, when you think through the change from a more optimistic approach to a less optimistic one do you think that the nature factors were really in the paper and alumina or do you think that the factors were wider than that, leading to the weakness in caustic prices?
I think they're much wider than just those two sectors. I really think that when you look at the -- whether you want to call it an economic malaise, the impact of trade wars, uncertainty around BREXIT and so forth I think that's weighing across a variety of different industries and it backs up into what we're seeing. Clearly pulp and paper and alumina have seen declines and we have a tendency to highlight those because they're larger end use segments. But at the end of the day I think it's a broader decline and I think that's also why we saw the significant drop off in the middle of the third quarter. There was an awful lot of negative economic data and so forth and forecasts that came out during that period and I think that affected the mindsets of many of our customers.
Okay, thanks very much.
Our next question comes from Hassan Ahmed of Alembic Global. Hassan, please proceed.
Again and again in your prepared remarks I keep hearing that there is no incremental capacity on the horizon but over the last couple of weeks certain reports have popped up that overseas player may invest as much as $3 billion in the U.S. towards a fairly integrated chlor vinyl facility. So how are you -- I mean have you heard similar things and how should we be thinking about that?
Hassan, this is Jim. I think the way to think about capacity and the future capacity, I think what we've consistently said is that we believe over the long term that demand for cost of products will outstrip the capacity that's being added. I don't think anybody believes that there won't be some incremental capacity or even longer-term there may be some larger capacity that will be added at some point in time. What we've said is that demand will outstrip capacity additions and that right now reinvestment economics did not exist on a large world scale integrated facility. So I think suppliers in various whether they are PVC producers or integrated players continuously evaluate when and if the most opportune time might be to invest. So I think that's an ongoing process. But we firmly believe that this imbalance between growth and capacity will continue for some period.
And there was probably -- there was something published about an overseas producer adding capacity in North America but that was capacity associated with PVC, some chlor alkali with the targeted date of installation of 2025 to 2026. And it was a relatively small amount when you look at an 80 million ton market that if it grows would happen -- that was half, less than half of 1% of the GDP market or the caustic market.
Understood, very helpful. And just sticking to the supply side, in -- during sort of the course of Q3 earnings, some of the company's reporting have talked about increased environmental sort of inspections and the like in China, are you hearing similar things within chlor vinyls, are you hearing of any curtailments in China based off of these sort of inspections and the like?
Hassan, this is Pat. Certainly you have seen a lot of volatility over the past year in China around these environmental issues and epoxy and specifically in epi chlor hydrant. So as volatility continues to persist around these supply disruptions and that has lead to epi prices going up 40% year-over-year. Now it's important to keep in mind that very little epi leaves China because it's just not cost effective and only time it comes out if epi prices go up outside of China. So what does 40% year-over-year increase has done in China on epi it's now caused LER prices in China over the past 30 to 45 days to go up significantly and actually prices for LER in China are now about $500 a ton higher than outside of China. And so if this arbitrage persists and there will be increased LER imports into China from producers probably primarily North East Asia but many parts of the world. So I think this could bode well for LER pricing around the world and of course we saw some of this same movie before in late 2017 and 2018 which led to LER prices not just going up in China but in other parts the world as well. So stay tuned, the environmental issues continue to persist and it definitely continues to impact both chlor alkali and epoxy capacity.
Very helpful, thank you so much.
Our next question comes from Mike Sison, Wells Fargo. Mike, please proceed.
Hey good morning. Let me think about Slide 6 and if you go back to the last downturn in 2015 and 2016 for industrial demand, contract -- North American contract prices were similar to spot and now spot is a lot lower and contract is a little bit higher. So do you think contract will sort of follow through with spot or does the spot come up or how does that dynamic kind of unfold over the next couple quarters do you think?
Mike, this is Jim. I think that as long as spot and export prices remain below the contract prices there will be some pull down on those prices just because that's the trade off that companies make. Having said that however, we still believe in the fundamentals of this marketplace and we're still getting a lot of requests from a contract standpoint we're customers continue to be focused on security of supply and so forth. So we believe that we're not going to see a dive off here in terms of the contracts but because of that security of supply and so we think there is going to continue to maintain this spread and in fact the first thing that will move when we have them go to the upside is the export on the spot pricing and it can be fairly dramatically as obviously you see on this chart.
Right and then just could you maybe just give us where you think operating rates are for North American spot export market is now and maybe where it was over the last year, just to give us perspective of and where we're sort of at?
Well from an operating rate standpoint I think the most recent operating rate was 84% which is a significant decline from 92% in the previous month. And I think what you see over the course of the year is that we're about 1% to 2% -- percentage points lower this year than last year in terms of operating rate. The September drop-off they were a significant amount of turnarounds that affected that operating rate. So, 1% to 2% lower than last year is what we're seeing from an operating rate standpoint.
Great, thank you.
Our next question comes from Matthew Blair of Tudor, Pickering, Holt. Matthew please proceed.
Hey, good morning everyone. On the last call I think you talked about expectations for pretty strong volumes in the back half of 2019 and I just want to clarify, is that still occurring and it's just the pricing that's come off or are you also seeing this weak demand environment pressure in your volumes as well?
The demand environment that we based our second half outlook on when we had the conference call in August has not materialized. As I said to answer an earlier question sometime in September we saw a pretty significant slowdown in demand, pretty much across the chemicals portfolio. So what is impacting us today is a combination of weaker demand and weaker pricing, some of which the pricing follows the demand obviously.
Makes sense and then Slide 20 shows chlorine prices holding steady but some of the derivatives like HCL and chlorinated organics are seeing price declines. I was just hoping you could provide some commentary on this dynamic and when this happens are you able to adjust your production slate to I guess minimize some of the downside?
What I would say on each of those, there's a discrete market around selling chlorine as a merchant product, selling chlorinated organics which is a global product, and selling HCL which is North American product. And we do toggle back and forth across the entire portfolio which includes EDC, which includes epoxy resins. According to where pricing is and where demand is for all three and that's kind of how we manage it. If you look at just a simple trade off in HCL for the last probably year or so, it has had pricing higher than the merchant chlorine market we would favor making HCL versus merchant chlorine. Merchant chlorine has held relatively steady, that's positive and there might be a moment now where we would favor that over some chlorinated organics products.
Sounds good, thanks.
Our next question comes from Steve Byrne of Bank of America. Steve, please proceed.
Yes, thank you. Several of your large petrochemical peers do not provide specific earnings guidance just reflecting on certainty in commodity pricing and just would like to hear your view on your level of commitment to continuing this to the level of detail you provide?
That something we evaluate on an annual basis. And it varies, it has evolved over time when we were a smaller company. Prior to the Dow acquisition we had a different view there and we're doing something different now than we did then and it just continues to evolve.
Okay, fair enough. Thank you John. I did want to ask you about your view of your competitors in epoxy resins, do you have an estimate of what fraction of your epoxy resin competitors are back integrated into benzene and propylene and how much of those raw materials do you have long-term supply agreements for?
So, Steve this is Pat. I mean first of all no one, none of the epoxy competitors are back integrated into the hydrocarbons, into benzene or propylene. So, that's pretty clear. Quite frankly very few of our competitors -- actually I think we're the only one that's fully back integrated into chlor alkali. And we use both chlorine and caustic and that liberator of caustic soda when we're making our epi chlor hydrants. So we have the best integrated position than anyone out there and people like Huntsman have moved really downstream and are no longer really in the upstream or quite frankly the mid stream. So I hope that answers your question.
Yes, thank you.
Our next question comes from Arun Viswanathan of RBC Capital. Arun, please proceed.
Great, thanks. Good morning guys. I just wanted to ask back on the caustic price kind of evolution and outlook. So I think going into Q4 the thought was that operating rates would come down on the chlorine side and that would support potentially some pricing on caustic. I guess what you're communicating is that did happen but the demand in caustic has been materially weaker than you expected and so we are in a little bit of a state of oversupply in caustic. My question is assuming that the pricing doesn't necessarily go up in Q4, usually when we enter Q1 and Q2 we see a pick back up in operating rates and potentially that would further prevent pricing progress. So, is that kind of your base case for the progression over the next quarter or two that pricing will remain muted and if so is demand improvement in caustic the main driver of what's going to drive the slightly better caustic pricing environment?
I would come back to start the basic issue for our chlor alkali producer is not necessarily the absolute demand for chlorine or caustic but the demand for one relative to the other. So to answer your question we would have to make or establish the premise of what happens to chlorine demand. We are seeing as I gave the example of a large chlorine customer not buying any chlorine for four weeks earlier this quarter we are seeing chlorine demand slowdown also. We talked about that as it related to chlorinated organics and some other things. I don't know that we see clearly enough right now to know what's going to happen. I think -- I don't think chlorine demand is that much greater than caustic demand, it doesn't feel that way to us. And if we had a couple percentage point decline in operating rate more than what we see in the fourth quarter carrying over into the first quarter you could see caustic prices move up somewhat. I think we're sort of on the what I'll call the edge of balance and imbalance.
And then just as a follow up, so if you look at your three businesses you've laid out the incremental improvement that could happen in Winchester relatively clearly so we can understand that I guess chlor alkali as you just pointed out it's going to depend on chlorine caustic demand and assuming you know those are maybe driven by construction and industrial production and then I guess what about epoxy I guess, if you think about the drivers from here you've mentioned kind of a 250 million level of normalized EBITDA in the past, is there a path to that still that you lay out in 2020 or 2021?
Yeah, I think this is Pat again. Clearly we're very confident that there's a path of 250 million to 300 million in epoxy and the real drivers to that is around the demand side, first of all historically demand in epoxy has grown around 3%. I mean this year we see growth flat at best. Europe, the second largest epoxy market in the world has been flat since the middle of 2018 so no question we need to see that demand come back in this whole industrial funk that we have seen hitting us has really impacted the demand for epoxy. Certainly centered around what's happened in automotive, electronics, and industrial coatings. So we need to see demand come back but as we outlined at the February investors discussion you've got operating rates today in epi and liquid epoxy resins in the mid to high 80's. And so if we just get some demand coming back we think we're in a good position in our cost position and we think we're in a good position to grow and expand these margins through volume increases here over the next several years.
Okay, great. And then just lastly just wanted to come back to the idea of no new capacity. You know again it does appear that there are several players who are looking at building some extra chlor vinyls capacity here. There has been some installations and a lot of athletes here and so just wondering at what point would you expect you could pass the announcements, what is it going to take, is it going to take a much better caustic pricing environment, some improved environment on the chlorine side and ethylene and so I guess implicit in your assumption that there's not going to be much capacity build would that also imply that the pricing for these products is going to stay relatively muted? Thanks
I think the biggest two factors that you have to look at is what's the price of PVC. And what's the price of caustic and right now neither of them are any word close to what it would take to justify a significant investment in the entire core of vinyls chain at least through PVC and depending on who it is maybe through ethylene. So, I think you and I -- we showed a slide back in February that showed we're a long way from where reinvestment economics are for those today.
Okay, great, thanks.
Our next question comes from John Roberts of UBS. John please proceed.
Thank you. Back on Lake City a lot's been going on with ATK since its orbital deal and then its Northrop Grumman deal did it become non-core for them just trying to get a sense of how competitive the bidding was or what it was that allowed Olin to win this back after so many years?
John, to the best of my knowledge ATK was not a bidder for the contract. I believe other bidders were General Dynamics and Northrop Grumman and I think that orbital business is actually today sitting in Northrop Grumman.
Right that's what I meant. When -- the operator went to orbital then in to Northrop Grumman but they did tend to keep it than.
They said they will keep it, yes.
Okay, and then you think IMO 2020 could increase export caustic and EDC freight cost here and maybe results in a little bit lower netbacks as we get into next year?
This is Jim, I wouldn’t expect it to have a major impact there, may be some demand but it's probably going to be small enough that we may have a hard time finding it but it will take anything to deposit. But I don't think it's going to be a big impact.
No, I was asking you whether your freight costs would go up and therefore maybe the net backs be a little bit lower?
I don't think that's going to drive freight cars.
Okay, thank you.
Our next question comes from Travis Edwards of Goldman Sachs. Travis, please proceed.
Hey, good morning, two quick questions of clarification for me. First on free cash flow next year, you provided a little bit of detail on some of the elements impacting that. But as you think about the upcoming ethylene payment to Dow you're generating cash, maybe buying back shares opportunistically, are you planning to address that payment just using cash on the balance sheet or are you thinking you'll have to pull down a bit on that revolver?
I would say at this point we haven't given any guidance on what we intend to do there.
Got it, thank you. second question is on the Lake City contract. You touched on this a bit on the prepared remarks but again just a question of clarification, is there any sort of sensitivity to that 40 million to 50 million of incremental EBITDA, is there any possible changes to the contract itself whether that be in the volume or pricing side between now and when you take over?
Well, the majority of that business is the government's business and they have a pretty good idea because we had -- our winning proposal, the prices that we bid were based on a set of volumes that they're sort of obligated to buy. So I think that's a positive. There's an ability to use that facility commercially which I would tell you has a high degree of probability because we've been in that commercial market for 150 years. So I feel that there's a relatively small deviation around those numbers.
Got it….
[Multiple Speakers]
We would have a lot of warning or there will be a change.
Got it, appreciate it, thank you.
As there are no further questions this concludes our question-and-answer session. I would now like to turn the conference back over to John Fischer for any closing remarks.
Thank you all for joining us today and we look forward to talking to you again when we review our fourth quarter 2019 results.
The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.