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Factors that Could Dampen Chemical Industry Momentum

Zacks Equity Research

The chemical industry is gradually gaining strength on continued momentum across major end-markets. While chemical makers are poised to gain from strength across automotive and construction sectors, strategic growth measures and investment on capacity expansion, the industry is still reeling under many challenges. There are a few reasons to be watchful about the chemical industry in the near term, which we have outlined below:

China Worries Continue

Slowdown in China -- a major market for chemicals -- remains a deterrent over the short haul. The world’s second-biggest economy remains plagued by persistent industrial overcapacity, weak private investment, rising corporate debt and a flagging export sector. In particular, ballooning debt levels (manifested by rising debt to GDP ratio) and rapid credit expansion have raised a red flag on the Chinese economy.

The country’s GDP expanded 6.7% in 2016, a deceleration from 6.9% a year ago, also the weakest annual growth in 26 years. The International Monetary Fund (IMF) projects growth in China to moderate to 6.5% in 2017 and 6% in 2018. Capital outflow pressures, rapid credit expansion, continued reliance on stimulus measures and geopolitical uncertainties are among the key risks to the country’s economic growth. As such, a sluggish Chinese economy may weigh on demand for chemicals in this significant market.

Eurozone Faces Risks

The European economy is still not out of the woods despite a string of positive data that suggest a recovery is steadily firming in the region. The Eurozone GDP rose 0.4% in the fourth quarter of 2016 (according to revised Eurostat data), same as witnessed in the third and also in line with expectations. However, political and economic uncertainties brought forth by Brexit, risks related to elections in major countries in the region (including Germany and France), and uncertainties surrounding the trade policies of President Trump are expected to weigh on sentiment in the Eurozone in the near term.

Sluggishness in some of Europe’s major economies continues to deter recovery of the chemical industry in that region. Moreover, weak investments and lower pricing remain as overhangs on the European chemical industry.

Still-Difficult Fertilizer/Agrichemical Space

Fertilizer and agricultural chemical companies are still grappling with a difficult pricing environment. Potash prices, which are already at their lowest levels in around a decade, remain under pressure due to elevated supply. The potash market is expected to remain oversupplied in the near future, thereby weighing on prices.

Moreover, higher supply has also contributed to a softer nitrogen pricing environment. Abundant nitrogen supply driven by new production capacity is expected weigh on global prices in 2017. Additional nitrogen capacity including a significant increase in North America is expected to come online globally in the back half of the year.

Global capacity expansion continues to exert pressure on urea and other nitrogen fertilizer prices. Elevated supply in the global nitrogen market is hurting prices, causing farmers to delay buying activities. As such, margins of fertilizer producers remain thwarted by a weak nutrient pricing environment.

Moreover, agriculture market fundamentals remain weak and there is continuous negative sentiment among agriculture investors that can create uncertainty in the near term. According to the U.S. Department of Agriculture (USDA), net U.S. farm income is expected to drop 8.7% to $62.3 billion in 2017. This would also mark the fourth straight year of decline. The USDA outlook reflects a slump in prices of most crops. Prices of major crops (such as corn and soybeans) remain at their multi-year lows.

The prevailing softness in agricultural commodity pricing is a concern for fertilizer and agricultural chemicals companies as it is hindering fertilizer use by farmers given the adverse effect of lower crop pricing on growers’ income. Lower farm income has a negative influence on growers’ nutrient purchasing decisions. Given the bleak forecast for farm income, growers are expected to remain cautious while making crop input decisions in 2017.

Insipid economic growth in certain key markets is also affecting demand for nutrients. The crop protection market remains under pressure, in part, due to a slowdown in Brazil. Agricultural market conditions remain weak in Brazil impacted by cautious buying by farmers and the uncertain political and economic situation in that country.

Subdued Demand in the Energy Sector

A low oil price environment is still hindering investment in the energy sector, affecting demand for chemicals in this important end-use market. Depressed crude oil prices have also kept chemical prices under check as they essentially move in tandem with oil prices.

Oil prices hit a 12-year low of $26.21 per barrel in Feb 2016, hurt by a surge in the U.S. stockpile and prospects of weak demand. Notwithstanding a marked recovery since then on OPEC-induced rally, crude oil is still trading at levels that are below the breakeven price for several oil and gas firms. Oil prices sank below the important psychological level of $50 a barrel recently after U.S. crude inventories surged to a record level amid a rise in production.

Rising U.S. drilling activities and production, renewed concerns surrounding global crude supplies and uncertainties over whether an OPEC-led production cut would be extended into the second half of 2017 are weighing on oil prices of late.

Pricing, FX Headwinds

Commodity pricing remain a concern for many U.S. chemical producers. Their ability to pass these costs on to end consumers is not always easy, given the competitive pressures in play. As a result, margins for a number of producers may be under pressure.

In addition, chemical companies generate a major chunk of their revenues outside the U.S. and therefore are exposed to foreign exchange fluctuations. A strong U.S. dollar created a significant headwind for these companies during 2016 and is expected to continue to be a drag on profits in the near term.

Stocks to Get Rid of Now

As you can see, there are a number of reasons to be cautious about the chemical industry. As such, it would also be a prudent choice to get rid of certain companies in the space that show weak fundamentals and carry an unfavorable Zacks Rank.

We hold a bearish view on Kraton Corp. (KRA), Innophos Holdings, Inc. (IPHS), Trecora Resources (TREC) and Rayonier Advanced Materials Inc. (RYAM), each holding a Zacks Rank #5 (Strong Sell). We also suggest staying away from stocks such as Air Products and Chemicals, Inc. (APD), Chemtura Corp. (CHMT), Olin Corp. (OLN) and Landec Corp. (LNDC), all carrying a Zacks Rank #4 (Sell).

(Check out our latest Chemical Industry Outlook for a more detailed discussion on the fundamental trends.)

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Olin Corporation (OLN): Free Stock Analysis Report
Landec Corporation (LNDC): Free Stock Analysis Report
Kraton Corporation (KRA): Free Stock Analysis Report
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