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Chemical Industry Stock Outlook - Dec 2012

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The September quarter essentially mirrored the conditions witnessed in the first two quarters of the year. A feeble economic recovery in the U.S. and persistent recessionary conditions in Europe continue to lead to depleted demand for chemical products. Growth continues to struggle due to weaknesses across some key end-markets, including electronics.

Companies in the chemicals space saw their profits sag in the September quarter, largely due to the fragile economic conditions in Europe and weak pricing. Activity across the emerging Asian economies remained subdued in the quarter given the slowdown in exports due to weak western demand. The U.S. economy, on the other hand, is treading on thin ice given the concerns regarding the looming “fiscal cliff.”

While the scenario is not expected to change in the December quarter, the industry is expected to continue to see slack demand, amplified by the production disruptions associated with Superstorm Sandy and uncertainty in the U.S. economy. Nevertheless, the fledgling recovery in the housing market may represent a potential positive for the industry heading into 2013.

Industry Fact File

Chemicals are generally used to make a number of consumer goods and are also used in the agriculture, manufacturing, construction and service industries. In fact, the chemical industry itself consumes 26% of its own output. Major industrial consumers include rubber and plastic, textiles, apparel, petroleum refining, pulp and paper and primary metals.

The chemical industry, a nearly $3 trillion global business, has grown at a brisk pace for more than five decades. The fastest growing areas have involved the manufacture of synthetic organic polymers used as plastics, fibers and elastomers. The chemical industry is mainly concentrated in three areas of the world: Western Europe, North America and Japan. Europe is the largest producer, followed by the U.S. and Japan.

The U.S. chemical industry represents more than 15% of the global chemical output and employs nearly 800,000 people. It constitutes roughly 12% of the nation’s exports, aggregating $187 billion annually. Roughly 5.5 million additional jobs are backed by the purchasing activity of the chemical industry. The U.S. chemical industry supports roughly 25% of the nation’s gross domestic product (GDP). The industry shipped more than 759 million tons of products in 2011.

The chemical industry is cyclical by nature and heavily linked to the overall condition of the U.S. economy. Chemical industry also touches 96% of manufactured goods, making the manufacturing industry the biggest consumer of chemical products.

There are 170 major chemical companies in the U.S. operating internationally with more than 2,800 facilities abroad. The chemical industry is among the biggest industries in the U.S., a roughly $760 billion enterprise. It has been consistently leading the U.S. economy’s business cycle due to its early position in the supply chain.

According to chemical giant BASF SE (BASFY), global chemical production (excluding pharmaceuticals) rose 4.8% in 2011, backed by healthy demand from major industries. In the EU, chemical production edged up 1.6% while declining 3.1% in Japan, hurt by the March 2011 quake.

The sluggish economy took a toll on growth in the U.S. as the nation’s chemical production increased a nominal 2.1% in 2011. South America and Asia (excluding Japan) witnessed growth of 4.7% and 11.1%, respectively. Growth in Asia was led by strong contributions from China.

Weak Manufacturing Hurting Production

U.S. chemical output barely rose on a monthly basis in October, according to the latest monthly report from the American Chemistry Council (ACC). The Washington-based chemical industry trade group reported that the U.S. Chemical Production Regional Index (:CPRI) edged up 0.2% in October, following an upwardly revised 0.3% gain in September. The tepid growth reflects the continued weakness in the overall manufacturing sector.

The U.S. CPRI, which was created by Moore Economics to track chemical production in seven regions nationwide, is comparable to Federal Reserve’s industrial production index for chemicals. The ACC noted that chemical production improved across all regions other than West Coast, Mid-Atlantic and Northeast on a monthly comparison basis in October.

The October reading showed that overall chemical production fell 0.2% when compared on a year-over-year basis. On a region-by-region basis, production rose across the Gulf Coast and Ohio Valley areas while the Midwest, Mid-Atlantic, Southeast, Northeast and West Coast regions saw declines. On a year-to-date basis (production for the first nine months of 2012 compared with the year-ago data), production inched up 0.1%.

On a monthly comparison basis, chemical production in the Gulf Coast region, where key building block materials are produced, edged up 0.5% in October. The Midwest and Ohio Valley regions witnessed a 0.1% and 0.6% increase, respectively. Output slipped in the Mid-Atlantic (down 0.1%), Northeast (0.1%) and West Coast (0.2%) regions. Production crept up 1% in the Southeast.

Output from the U.S. manufacturing sector dipped 0.5% in October after declining 0.2% a month ago. Within this sector, output rose in several key chemistry end-user markets including appliances, aerospace and structural panels.

The manufacturing sector serves as a barometer to gauge the overall health of the U.S. economy and has a major influence on the chemical industry. Lower investment, given the ongoing uncertainty surrounding the fiscal cliff, led to the weakness in manufacturing. The U.S. market is gripped by the fear that the economy may slip back into recession should the Congress fail to avoid the roughly $600 billion in tax hikes and spending cuts scheduled to take effect in January 2013.

The ACC said that output rose across many segments such as organic chemicals, plastic resins, consumer products, coatings, adhesives, and other specialty chemicals. This was, however, masked by declines in pesticides, fertilizers, man-made fibers, synthetic rubber industrial gases and pharmaceuticals.

Chemical output continues its declining trend in Europe. According to the European Chemical Industry Council (“CEFIC”), chemicals production in the European Union fell 2.2% year over year in the first eight months of 2012. Production fell 2.2% year over year in August 2012. Chemicals prices rose 1% year over year in August, led by an increase in the price for basic inorganics.

Raw Material Trends

The chemical industry uses oil, naphtha and natural gas as energy and feedstock inputs. Oil prices remain high despite the sub-par growth outlook for the global economy, largely owing to geostrategic reasons. BASF report states that the price of Brent crude oil rose sharply in 2011 (averaging $110 a barrel), stirred by the combined impact of strong demand and political unrest in the Middle East and North Africa.

Brent crude, which hit a four-year high of $128 a barrel in March 2012, is hovering between a high of $115 and a low of $105 since October 2012. Geopolitical tension in the Middle East, exacerbated by Iran's nuclear program and the unrest in Egypt, is keeping price from sliding given the concerns about a potential supply crunch.

Price of the other key raw material, naphtha, averaged $930 per metric ton in 2011, representing more than 30% year-over-year surge. Naphtha prices are also expected to remain elevated relative to last year’s levels. The only bright spot for the industry on the feedstock front is natural gas. In fact, the price of natural gas has dropped to its lowest level in over a decade.

Over the past five years, the U.S. natural gas markets have seen a dynamic shift due to the emergence of a new source of energy, shale gas, which exists in large quantities with sources close to many big energy-intensive cities. Shale gas is not only desirable for environmental reasons, given its low carbon footprint relative to oil or coal, but is at the same time cost effective.

Weak View for 2012, Better Days Ahead

The European debt crisis, weak U.S. manufacturing along with sluggish activity in China and other key emerging markets led to weak demand for chemical products in the September quarter, something which is expected to continue through 2012. While the U.S. is not headed toward another recession, the debt issue in Europe coupled with other economic uncertainty poses downside risks to the nation’s economic outlook.

The ACC foresees modest production growth in 2012 followed by a stronger recovery in 2013. National chemical output is expected to slow to 0.5% in 2012 from 3.8% a year ago, and then rise to 2.3% in 2013.

The ACC expects weaker growth in European chemicals output in 2012, in part, due to increased uncertainty. While developed economies, restrained by debt and stricter fiscal policies, are likely to increase chemical production at a modest pace, more rapid growth in output from the emerging markets is expected in 2012.

The ACC sees global chemical industry output to grow 2.3% in 2012, 4.3% in 2013 and 4.7% in 2014. Stronger growth is expected in specialty chemicals, consumer products and agricultural chemicals in 2012.

Growth in China is expected to be healthy, albeit at a slower pace, while production in other emerging markets is expected to expand in 2012. Chemical makers in the emerging economies are expected to deliver a 6.2% production increase in 2012 followed by a 7.5% growth in 2013.

The ACC expects strong growth in capital spending in the coming years, stemming from new investments in petrochemicals and derivatives. It envisions capital spending to reach $35.5 billion in 2012 and steadily advance to $51.5 billion in 2017. A rebound across emerging markets is expected to contribute to accelerated growth over the next several years.

A recent CEFIC report says that European chemical output will contract 2% year over year this year followed by a modest increase (of 0.5%) in 2013. The economic downturn in Europe and the region’s weak construction and automotive sector will contribute to lower output in 2012.

Moreover, chemical production in the European Union is expected be 8% below its pre-recession level in 2012, as austerity measures adopted to staunch the high sovereign debt levels have led to higher unemployment levels and weak demand. The expectation for a slim recovery in 2013 stems from the anticipated modest growth in every quarter, partly driven by export markets.

OPPORTUNITIES

According to the ACC, emerging market growth and abundant shale gas should help drive U.S. chemical exports. A string of factors are driving growth in the export markets including favorable energy costs stemming from the abundance of shale gas and strong demand from the emerging markets. Affordable natural gas and ethane (derived from shale gas) offer U.S. producers a compelling cost advantage over their global counterparts who use a more expensive, oil-based feedstock.

Further, cost-cutting measures implemented by chemical companies including plant closures and headcount reduction, should yield industry-wide margin improvements. Cash flows derived through these actions can be used for growth.

Mergers and acquisitions offer chemical companies another means to shore up growth in this difficult scenario. These companies remain focused on exploring growth opportunities in the fast-growing emerging markets, particularly in the lucrative regions of Asia-Pacific and Latin America such as China and Brazil.

We feel that chemical companies with strong earnings quality, healthy growth trajectory and liquidity profiles are better placed in the current rickety market environment considering their ability to leverage strong balance sheet and cash flows in maximizing shareholder value in form of dividends and share repurchases or use them for value acquisitions.

We have a bullish view on Eastman Chemical Company (EMN), which is delivering forecast-topping earnings and is well placed to benefit from its Solutia acquisition. The company’s diversified chemical portfolio and integrated and diverse downstream businesses represents the pillars of strength. It also benefits from business restructuring, cost-cutting measures and increased capacity additions.

We are also optimistic about Celanese Corp. (CE) despite the challenges it faces in Europe. We like the company’s initiatives to improve margins and profits by running its plants better and controlling expenses. The company’s strong presence in emerging markets, especially in China, will enable it to deliver incremental earnings in 2012. We are also upbeat about the prospect of its TCX ethanol process technology.

In specialty chemical space, PPG Industries Inc. (PPG) represents an attractive play. The company witnessed strong growth in its North American automotive OEM coatings business in the September quarter, enabling it to deliver better-than-expected earnings. It has a diversified base of products and markets, and looks to grow its businesses strategically along with controlling costs.

We also hold a favorable view on specialty chemical company Methanex Corp. (MEOH). The company has taken up a number of steps, including production ramp ups in New Zealand and the Medicine Hat unit, to boost capacity. We are upbeat about its Louisiana project, which is expected to create significant value for its shareholders and meaningfully contribute in cash generation.

WEAKNESSES

Commodity price hikes, though subsiding lately, is adding to feedstock costs for many of the U.S. chemical producers. Their ability to pass these costs on to end consumers is not always easy, given the competitive pressures at play. As a result, margins for a number of producers will continue to be under pressure.

Given the industry’s sensitivity to the global economy, any negative current in the macro economy would be reflected in the prospects of the chemical companies. The turmoil in Europe and its impact on global growth remain sources of near-term uncertainty. Western Europe continues to pose challenges on chemical stocks due to weak demand (particularly in the construction industry) and the lingering impact of debt crisis.

The U.S. housing sector, a key consumer of chemicals, has shown signs of recovery lately, manifested by a steady pick-up in home prices. However, demand from this industry still remains way below the historic levels. Weakness in the electronics and construction end-markets may continue to weigh on the results.

Chemical companies generate a considerable amount of revenues outside the U.S., and therefore are exposed to foreign exchange fluctuations. Unfavorable currency exchange translation (stemming from a stronger dollar) dented most of these companies’ results in the most recent quarter.

Another challenge comes in the form of production disruptions as a result of Hurricane Sandy, which wreaked havoc on the Northeast U.S. Production is expected to be hit by associated outages in the December quarter.

Chemical titan The Dow Chemical Company (DOW) was hammered by several headwinds in the September quarter. Its profit slid on lower pricing across all regions. The company also saw weak demand for its products in the quarter, stemming from the challenging conditions in Europe and sluggish activity across major emerging markets.  

Moreover, building and construction sales remain under pressure due to lower volume in Europe and recovery in electronics remains slow, partly due to sluggish growth China. Moreover, currency headwinds are expected to continue given the weak euro. The company announced a major restructuring program including headcount reductions, plant closures and capital spending cuts.

The other chemical giant DuPont (DD) had a drab third quarter due to lower demand across titanium dioxide and photovoltaic markets. It witnessed weakness across a number of end markets in the quarter. The company reduced its earnings forecast for 2012 and announced a restructuring plan that includes retrenchment of 1,500 workers globally.

DuPont also remains exposed to raw material cost inflation, which is expected to constrict its margin in the fourth quarter. Moreover, currency headwinds weighed on the performance of a number of segments in the third quarter and are expected to reduce its earnings for 2012.

Air Products and Chemicals Inc. (APD) also felt the heat in the September quarter as weak demand due to the sluggish economic conditions led to a big slide in its profit. Slowing U.S. manufacturing growth due to high unemployment and the concerns over the U.S. fiscal cliff coupled with the slowdown in Asia is expected to impinge its results moving ahead. We have downgraded our rating on the stock to Underperform factoring in the challenges it may face in the next fiscal year.

Agricultural chemical company Agrium Inc. (AGU) has put up a lackluster third quarter on weak potash demand and is expected see a weak December quarter due to a significant decline in international potash demand and lower ammonia sales volume in Western Canada. Moreover, global phosphate market is expected to remain weak in the near term, partly due to lower demand from India.

Specialty chemical company Valspar Corporation (VAL) is contending with the difficult global economic conditions. Persistent weakness in its Paints segment hurt its sales in the most recent quarter. The segment has been hit by a weak residential housing market in Australia, which may continue to affect revenues moving ahead.

AGRIUM INC (AGU): Free Stock Analysis Report

AIR PRODS & CHE (APD): Free Stock Analysis Report

CELANESE CP-A (CE): Free Stock Analysis Report

DU PONT (:EI) DE (DD): Free Stock Analysis Report

DOW CHEMICAL (DOW): Free Stock Analysis Report

EASTMAN CHEM CO (EMN): Free Stock Analysis Report

METHANEX CORP (MEOH): Free Stock Analysis Report

PPG INDS INC (PPG): Free Stock Analysis Report

VALSPAR CORP (VAL): Free Stock Analysis Report

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