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Industry Outlook

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OVERVIEW

Chemicals are essential to millions of consumer goods, enabling hi-tech advances in industries as diverse as aerospace, computing and telecommunications. The chemical industry comprises companies engaged in the conversion of raw materials -- oil, natural gas, air, water, metals -- that are then used to make a wide variety of consumer goods, as well as inputs for agriculture, manufacturing, construction and service industries.

Globally, the chemical industry is mainly concentrated in three areas of the world: Western Europe, North America and Japan. The European community is the largest producer, followed by the U.S. and Japan. The chemical industry, one of the largest in the U.S., is an enterprise worth $674 billion. This industry is also one of the top exporters in the country.

The U.S. chemical industry operates through 170 major chemical companies with international operations spanning more than 2,800 facilities outside the U.S. and 1,700 foreign subsidiaries or affiliates. The sector generates an annual chemical output worth $400 billion. The U.S. industry records large trade surpluses and employs around a million people. It is also the second largest consumer of energy in the manufacturing sector.

Outlook

The recession had hit the chemical industry hard. Shying from a lack of demand, chemical companies shelved their growth strategies. With plants idled or running at historically low rates, the companies looked for avenues to streamline operations and increase productivity. Accordingly, they resorted to restructurings, plant closures, and layoffs. Cost-cutting initiatives at industrial majors -- The Dow Chemical Company  (DOW - Analyst Report) and EI DuPont de Nemours & Co.  (DD - Analyst Report) -- amounted to billions of dollars.

The global chemical industry is, however, recovering from the recession-hit lows. Domestically, chemical production volumes have increased across all regions of the United States in 2010, reversing the steep declines experienced in 2008 and 2009. The largest gains have occurred in the Gulf Coast and Ohio Valley regions, boosted by export demand for basic chemicals and plastics. Output is expected to grow moderately in all regions in 2011 and continue to improve through 2012.

Growth in export markets has been driven by several factors. These include favorable energy costs, resulting from developments in extracting natural gas from shale; and demand from emerging markets, where recovery and expansion have been the strongest. As per the American Chemistry Council (ACC), U.S. exports would grow by 9.7% in 2011, outpacing the expected 7.8% growth in imports.

Further, the cost-containment measures implemented by chemical companies, such as plant shutdowns, aggressive cost cutting and production improvements, should continue to bolster industry-wide margins. The resultant large cash flows could then be leveraged for growth opportunities.

Following a massive decline in fertilizer sales and consumption in 2009, the speed and extent of the recovery in the first half of 2010 has been stellar, leading to an annual increase of 13% and 7% over 2009, respectively. The International Fertilizer Industry Association (IFA) is projecting growth in global fertilizer consumption of 4.7% for 2010/2011 and 3.8% for 2011/12. By 2011/12, nutrient application rates would fully recover to levels seen prior to the economic crisis of 2008.

The fertilizer industry will be able to absorb the incremental demand for food, feed, fiber and energy production on the strength of its investments hitherto made. Between 2010 and 2015, some 55 urea units, 20 potash expansion projects and 40 processed phosphates facilities are planned for completion worldwide.

The industry has spent close to $40 billion on new capacity for all three major nutrients since 2008. IFA estimates that another $80 billion will be invested between 2011 and 2015, with the highest levels of production, sales and consumption seen to date occurring in 2011. Global urea capacity is projected to expand by 30% between 2009 and 2014 to 222 million tons (Mt). During the same period, world potash and phosphates capacity is forecast to grow by 25% and 31%, respectively.

End-Market Scenario

The U.S. home building sector is a major consumer market for the chemicals industry accounting for about 10% of chemical demand. According to the ACC, every 100,000 group of housing starts generates $1.5 billion in chemical sales. As per the National Association of Home Builders (NAHB), new housing starts marginally rose 7% for 2010. However, on the plus point, NAHB expects annual housing starts for single-family homes to climb a much stronger 21% to 575,000 units in 2011.

On the flipside, U.S. unemployment will remain high in 2011; credit markets remain tight and mortgage rates will likely increase in 2011, thus limiting any noteworthy rebound in the housing market. We expect the housing sector to begin a slow recovery toward its pre-recession peaks in 2011.

The Auto sector accounts for 10% of the chemical industry’s demand. The automotive industry has started showing signs of recovery. The ACC estimates U.S automobile sales will reach 12.7 million units in 2011. The remaining demand comes from the agriculture, architectural and industrial coatings, paper and textile, electronics and other industries.

Growing emerging markets should propel production in the paper and textile industry while the electrical industry is expected to pick up with increased industrial investment. Other industries, including food and agriculture, are also likely to gain momentum with the recovering economy.

Trends in Raw Material Markets

The chemical industry is a large consumer of oil, naphtha and natural gas, which are widely used as energy and feedstock input.

Oil prices trended upward throughout 2009, and in 2010 crude oil prices averaged around $79 per barrel. With current economic conditions improving worldwide, global demand for oil is rising, leading to higher prices. Naphtha prices are also expected to rise in early 2011, fueled by robust global crude prices, as bitterly cold winters in Europe and U.S. spark demand for home heating.

Natural gas working inventories ended 2010 were 3.1 trillion cubic feet (Tcf), about 1% below the record-setting end-of-December 2009 level. Inventories are expected to remain at or near record-high levels through most of 2011. EIA expects total natural gas consumption to decline by 0.9% in 2011 and residential and commercial consumption to drop 2.7% in 2011 due to fewer heating days in the winter months this year compared with last year.

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. The shales ensure a cleaner power source than coal or oil.

OPPORTUNITIES


Chemical companies spent much of the past two years on their core business and tailoring their business processes and structure toward becoming more efficient. Consequently, many of these companies have ended up with excess cash on their balance sheets. Growth by further reducing costs is not a viable option anymore as most companies have already taken drastic measures to cut costs and improve operating efficiencies.

The chemical companies are seeing mergers and acquisitions as an option to grow in the current economic environment. Thus, there has been a pickup in the volume of deals announced during 2010, a substantial increase from the previous year, indicating that that the global economy is stabilizing.

The companies are focused on exploring growth opportunities in emerging markets with strong performance in fast-growing regions of Asia-Pacific and Latin America, particularly China and Brazil. The United States expects growth to continue, albeit at a slower rate than last year. Business conditions are improving, with corporate profits and investments rising and industrial production showing solid gains compared with the year before.

The world’s second-largest seed maker, DuPont recently entered into a definitive agreement to acquire Denmark ’s Danisco for $5.8 billion in cash and assumption of $500 million of Danisco’s net debt. This marks the company’s largest acquisition since its $7.7 billion buy of Pioneer Hi-Bred International in 1999. The deal will enable DuPont to expand the company’s offerings in more specialized areas like biofuels and food enzyme.

DuPont is focused on capturing $1 billion in working capital productivity gains during the 2011−2013 timeframe. The company is also on track to achieve a cumulative $600 million in benefits from fixed cost productivity and restructuring actions in 2011. It is executing strategies for further development and growth of new products, particularly for agriculture, photovoltaics, alternative energy and materials.

Dow is delivering cost synergies from the Rohm & Haas acquisition and, in its 2010 third quarter, the company delivered more than $975 million in sales on a run-rate basis, already exceeding the year-end target of $500 million. Dow is targeting an acquisition growth synergy run-rate of $2 billion by the end of 2012.

In April 2010, CF Industries Holdings Inc. (CF - Analyst Report) acquired its long-chased rival Terra Industries for $4.7 billion. With this acquisition, CF has become the global leader in the nitrogen fertilizer industry with a wide geographical footprint and a total capacity of 6.3 million nutrient tons of nitrogen and 2.1 million nutrient tons of phosphate.

Similarly, fertilizer manufacturer Agrium is growing through a combination of acquisitions and organic expansion. Agrium’s recent acquisition of AWB Ltd., a leading agricultural retailer in Australia, will broaden its rural product sales business, including fertilizers and herbicides, in Australia, the world’s fourth-largest wheat exporter and third-largest shipper of canola.

Another major deal in the chemical space is the pending Airgas Inc. (ARG - Analyst Report) - Air Products & Chemicals Inc. (APD - Analyst Report) merger valued at around $5.9 billion, excluding debt. If it materializes, the Air Products and Airgas association would form the world’s largest industrial gas company. With the acquisition of Airgas, Air Products plans a foray into the North American packaged gas business.

Dow Chemical, DuPont, Agrium, Air Products and CF Industries have long-term Neutral recommendations.

WEAKNESSES

The chemical industry as a whole remains heavily exposed to economic cycles and pretty much all of the industry’s underperformance of the last two years can be attributed to the economic turmoil. The global economic meltdown led to weak industrial demand for chemicals, resulting in an under-utilization of production capacity, perpetrating a dramatic fall in operating profits worldwide.

While the global economic recovery appears to be firmly in place, the recent turmoil in Europe and its impact on global growth remain sources of near-term uncertainty. Chemical stalwarts like Dow and DuPont have significant exposure to Europe with around 25% of their net sales coming from the region.

In Europe, disparate growth rates have been reported across the continent. Economic conditions have shown improvement in northern Europe and in the emerging countries of eastern Europe. Meanwhile, growth in southern Europe continues to be restrained by sovereign debt concerns and tightening in government spending.

On the domestic front, we expect the U.S. economy's recovery to continue to face headwinds from high unemployment, slow job growth, and continued weakness in residential and commercial construction. Moreover, expected monetary easing could lead to inflation in dollar-denominated commodity prices and deflationary pressure on wages and asset values.

Weak residential and commercial construction demand continues to affect companies engaged in paint and coatings. Revenues and margins for Sherwin-Williams (SHW - Analyst Report), the largest US producer of paints and coatings, declined significantly in 2009. Although demand in these end-markets is beginning to turn around of late, it essentially remains weak, and industry-wide volume is down significantly from peak levels achieved a few years ago.

We do not expect a near-term recovery in the housing and construction markets with declining home sales and consumer spending. We are highly concerned about further declines in commercial construction, which comprises around 30% of the company’s architectural paint sales.

Sherwin’s peer, The Valspar Corporation (VAL - Analyst Report), however fared better on the revenue front in its Paint segment in its recent quarter driven by investment in new brands as well as higher volumes in the global consumer and automotive refinish product lines. However, operating income was affected by higher costs.

Valspar will find it extremely difficult to achieve the level of price increases necessary to fully offset these higher costs. Moreover, there is a huge lag between high raw material costs and Valspar’s pricing gains, which would continue to restrain margins.

Calgon Carbon Corporation (CCC - Analyst Report), a leader in the activated carbon sector, faces weak demand for carbon products. The insipid global economy hurt volumes in 2009 and, though activated carbon sales recovered to an extent in the last reported quarter, we are skeptical about its sustainability. We expect sales volumes in the segment to remain challenging as the end-markets are yet to recover fully.

There are other possible hurdles that chemical makers may have to face such as pending rule changes within US regulatory agencies. Recently the U.S. EPA has proposed a sweeping new rule that could impose stricter hazardous air pollutant emissions limitation and other requirement on operators of new and existing boilers and process heaters.

According to EPA’s calculations, compliance with these rules would cost boiler owners $12.2 billion to implement and annualized cost of $4.1 billion after accounting for savings and also result in mill closures.

Sherwin-Williams, Valspar, and Calgon Carbon have long-term Neutral recommendations.

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