A tough economic backdrop in Europe, uncertainties surrounding the U.S. fiscal cliff, manufacturing slowdown, sluggish activity in China and weakness across some key end-markets weighed on the companies in the chemical space in 2012. The combined effect of these issues led to depressed demand for chemical products.
While the situation is not expected to change radically in the current quarter given the continued Eurozone problems, the industry is expected to fare relatively better this year, aided by the gradual healing in the U.S. economy and hopes of a rebound in Chinese demand. The industry is expected to benefit from strength across emerging markets and a rise in shale gas production in the U.S. The fledgling recovery in the housing market also augurs well for the chemical industry in the second half of 2013 and beyond.
Industry Fact File
Chemicals are used to make 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 chemical industry is cyclical by nature and heavily linked to the overall condition of the U.S. and world economy. The 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 cycles due to its early position in the supply chain.
According to chemical powerhouse BASF SE (BASFY), global chemical production (excluding pharmaceuticals) rose 2.6% in 2012, down from a 3.8% rise registered a year ago. The deceleration resulted from slower demand for chemical products compared with 2011, hindered by weak economic environment and subdued growth across a number of emerging markets.
Within the Zacks Industry classification, the chemical industry falls under the broader Basic Materials sector (one of 16 Zacks sectors). We rank all of the more than 260 industries in the 16 Zacks sectors based on the earnings outlook for the constituent companies in each industry. This ranking is available in the Zacks Industry Rank page.
The way to look at the complete list of 260+ industries is that the outlook for the top one-third of the list (Zacks Industry Rank of #87 and lower) is positive, while the outlook for the bottom one-third (Zacks Industry Rank #174 and higher) is negative.
We have four chemicals related industries: Chemical Plastics, Chemical Specialty, Chemical Diversified and Chemical Fibers. The Chemical Plastics industry currently retains a Zacks Industry Rank #9, placing it in the top 1/3rd of the 260+ industry groups. The Chemical Diversified industry is featuring in the bottom one-third of all Zacks industries with a Zacks Industry Rank #187, followed by the Chemical Specialty industry with a Zacks Industry Rank #228 and the Chemical Fibers industry with a Zacks Industry Rank #257.
Looking at the exact location of these chemical industries, one could say that the general outlook for the chemicals space as a whole to towards the ‘Negative’ side.
Please note that the Zacks Rank for stocks, which is at the core of our Industry Rank, has an impressive track record going back years, verified by outside auditors, to foretell stock prices, particularly over the short-term (1 to 3 months). The rank along with Expected Surprise Prediction (ESP) (Read: Zacks Earnings ESP: A Better Method) helps in predicting the probability of earnings surprises.
Key Raw Material Trends
The chemical industry uses oil, naphtha and natural gas as energy and feedstock inputs. BASF report states that the price of Brent crude oil averaged $112 a barrel in 2012 compared with $110 a barrel a year ago. Price rose sharply at the beginning of 2012 stirred by the combined impact of higher demand and political unrest in the Middle East.
Brent crude, which hit a four-year high of $128 a barrel in Mar 2012, reached a nine-month high of $119 in Feb 2013, triggered by strong Chinese crude oil import data and geopolitical tension in the Middle East, exacerbated by Iran’s nuclear program.
However, in a recent development, Brent crude prices eased to below $100 for the first time since July 2012 as reports of slowing Chinese economic growth coupled with weak U.S. economic data (disappointing New York manufacturing data coupled with a drop in retail sales) dampened the demand outlook for oil. However, a possible intervention by OPEC through a potential production cut may keep prices from sliding further.
The price of the other key raw material, naphtha, which is produced from oil, averaged $937 per metric ton in 2012 compared with $930 per metric ton in 2011. High crude prices kept the cost of naphtha elevated. Natural gas remains a bright spot on the feedstock front. The average annual price of natural gas in the U.S. dropped to $3 per million British thermal units (mmbtu) in 2012 from $4 mmbtu in 2011.
Over the last 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.
Chemical Industry on the Recovery Trail
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 2012. While the U.S. is not headed toward another recession, the lingering debt issue in Europe coupled with other economic uncertainties pose downside risks to the nation’s economic outlook.
The American Chemistry Council (ACC) foresees national chemical output (excluding pharma) to rise 1.9% in 2013 (following a 1.5% gain in 2012) and 2.3% in 2014. Strength across light vehicle and aerospace markets bodes well for the industry. U.S. chemical exports are expected to rise 4.7% this year (up from 1.8% in 2012) and 6.6% in 2014, leading to an expansion in trade surplus.
The trade group expects global chemical industry output to grow 4.3% in 2013 and 4.7% in 2014. Chemical makers in the emerging economies are expected to deliver a 7.5% production gain in 2013.
The ACC expects strong rise in capital spending in the coming years, stemming from new investments in petrochemicals and derivatives. Domestic chemical investment jumped 15.5% to around $38.1 billion in 2012. The ACC envisions capital spending to reach $64.5 billion by 2017. The shale gas boom is expected to drive investment on plants and equipment in the U.S. A rebound across emerging markets is expected to contribute to accelerated rise over the next several years.
BASF expects global chemical production to recover this year on the back of healthy gains in the emerging markets. It expects the U.S. chemical industry to benefit from lower gas prices. Asia is expected to show strong rise riding on strength across construction, electronics and automotive industries. However, output in Europe is expected to rise narrowly due to marginal gain in industrial production.
According to the European Chemical Industry Council (CEFIC), European chemical output is expected to show a modest increase of 0.5% in 2013 following a 1.5% decline in 2012. The expectation for a slim gain this year stems from the anticipated modest gain in every quarter, partly driven by export markets.
According to the American Chemistry Council (ACC), an industry trade group, 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. New methods of extraction such as horizontal drilling and hydraulic fracturing are boosting shale production, bringing down prices of ethane in the process.
Leveraging the abundant natural gas supply and cost advantage, chemical companies are investing billions of dollars for setting up facilities (crackers) that produce ethylene from ethane. ACC report indicated that over 50 projects have been announced by the U.S. chemical makers (representing capital investment of more than $40 billion) to take advantage of ample natural gas supplies. Such investments are expected to boost capacity and export over the next several years.
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 (especially China and Brazil).
China is expected to see a recovery this year following a somewhat soft 2012. Government stimulus actions coupled with efforts to staunch inflation appears to bear fruit and exports to the U.S. and other key markets are regaining momentum. An improved demand outlook for China bodes well for the chemical industry in 2013.
We feel that chemical companies with strong earnings quality, healthy growth trajectories and liquidity profiles are better placed in the current rickety market environment. In particular, this is considering their ability to leverage strong balance sheets and cash flows in maximizing shareholder value in the form of dividends and share repurchases, or use them for value acquisitions.
We have a bullish view on Eastman Chemical Company (EMN), which is well placed to benefit from its Solutia acquisition. The company’s diversified chemical portfolio and integrated and diverse downstream businesses represent the pillars of strength. It also benefits from business restructuring, cost-cutting measures and increased capacity additions.
Chemical titan E.I. DuPont de Nemours & Co. (DD) is witnessing strength in its agriculture and food businesses. Its Agriculture segment delivered healthy sales in the December quarter boosted by higher volume and strong performance of the crop protection business. The company expects continued strong gain in crop protection in 2013 driven by new products. Moreover, DuPont should continue to benefit from the synergies of Danisco acquisition and its aggressive restructuring actions.
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 2013. We are also upbeat about the prospect of its TCX ethanol process technology.
We have a favorable view on Air Products and Chemicals Inc. (APD). Impressive results from its core Merchant Gases segment coupled with Indura and DA NanoMaterials acquisitions helped it to rake in better-than-expected results in the December quarter. Air Products plans to take a number of steps including cost-control measures, restructuring actions, price improvements and volume gains. Its recent strategic moves will position it for future growth and profitability despite the soft economic backdrop.
In the 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 December quarter. Continued momentum across automotive OEM and aerospace markets helped it to post better-than-expected sales in the quarter. It has a diversified base of products and markets, and looks to grow its businesses strategically along with controlling costs.
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 and the nagging impact of debt crisis.
The U.S. housing sector, a key consumer of chemicals, has shown signs of recovery lately, manifested by rising housing starts, increase in building permits and a steady pick-up in home prices. However, demand from this industry remains way below the historic levels. In addition, weakness still persists in commercial construction and electronics, which are among the key end-markets.
Chemical companies generate a considerable amount of revenues outside the U.S., and therefore are exposed to foreign exchange fluctuations. Currency exchange translation remains a headwind for these companies.
Chemical makers may also face greater regulatory challenges in 2013. Environmentalists as well as different consumer and industry groups long argued that the existing Toxic Substances Control Act (TSCA), administered by the U.S. Environmental Protection Agency (EPA), is outdated and needs an overhaul.
Recently, Sen. Frank Lautenberg and Sen. Kirsten Gillibrand along with other co-sponsors introduced the Safe Chemicals Act of 2013, which is geared to limit the use of toxic chemicals linked to a broad range of diseases and place the burden on chemical makers to prove that their chemicals are safe.
Commodity prices, though subsiding lately, still remain a concern 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 may continue to be under pressure.
U.S. chemical kingpin The Dow Chemical Company (DOW) slipped into a bigger loss in the December quarter, clobbered by weakness across end-markets, especially in China, and weak pricing. Dow still faces challenges in Western Europe and is exposed to significant pension headwinds. Moreover, weakness in the electronics and construction end-markets may continue in first-quarter 2013 and currency headwinds are expected to persist given the weak euro.
Specialty chemical company Valspar Corporation (VAL) is grappling with the difficult market conditions. Persistent weakness in its Paints segment hurt its sales in the most recent quarter. Weakness in the residential housing market in Australia may continue to hurt paint sales moving ahead. The company cut its earnings forecast for full year citing a soft demand environment across some overseas markets.
Methanex Corp. (MEOH) put up a lackluster fourth quarter with both revenues and earnings missing expectations. Restricted supply of natural gas affected its operations in Chile, Trinidad and Egypt in the quarter. Methanex may continue to face headwinds due to curtailment of gas supply and constrained spending across its end markets.
In the agricultural chemical space, Potash Corporation (POT) is contending with macroeconomic uncertainties and a challenging demand scenario outside North America. Reduced contributions from all three nutrients arising from slack global fertilizer markets and lower demand hurt its sales in the December quarter. The company remains exposed to volatility in potash and phosphate pricing and currency exchange fluctuation.
Also, agricultural chemical company Agrium Inc. (AGU) is exposed to a soft pricing environment and somewhat weak overseas demand for potash and phosphate. The pricing environment for phosphate is expected to remain soft in the March quarter. Moreover, the global phosphate market is expected to remain weak in the near term, partly due to lower demand from India (a major phosphate import market).
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