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Industry Outlook

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

The chemical industry has shown rapid growth for more than fifty years. The fastest-growing areas have involved the manufacture of synthetic organic polymers used as plastics, fibers and elastomers. Globally, the chemical industry is mainly concentrating in three areas of the world: Western Europe, North America and Japan. Europe is the largest producer, followed by the U.S. and Japan.

Chemicals are a nearly $3 trillion global business, and the European Union (EU) and U.S. chemical companies are the world's largest producers.

The U.S. chemical industry produces 19% of the world’s chemicals output, amounting to $689 billion. The industry directly employs over 800,000 people nationwide. A total of nearly 5.5 million additional jobs are supported by the purchasing activity of the chemical industry and by the subsequent expenditure-induced activity. In addition, the U.S. chemical industry is responsible for 10% of US merchandise exports, totaling $145 billion annually, as well as 11% of all U.S. patents.

Outlook

For 2012, the global outlook for chemicals is mixed, as the U.S. and EU face sluggish local economies and debt constraints, while output from emerging markets is expected to increase more rapidly.

According to the American Chemistry Council (ACC), the U.S. chemicals industry will experience more moderate production increases in 2012 after a strong post-recession recovery.

Most major end-use markets for chemicals have recovered, helping to maintain the industry's contribution to U.S. economic growth.

The ACC forecasts gradual improvement this year, before a stronger recovery takes hold in 2013. U.S. chemical output is expected to slow to 1.6% in 2012 from 2011’s 3.8% pace, then rise to 2.1% in 2013.

The chemicals outlook indicates modest growth over the next several years, depending on certain factors including strengthening domestic demand and an improvement in exports abroad. Exports were up nearly 11% to $189 billion in 2011 and are expected to exceed $230 billion in 2014.

While the U.S. economy is not headed towards another recession, the European debt situation along with other economic factors pose downside risks to the U.S. economic outlook.

The ACC expects total growth in the European chemicals output to be weaker than its previous forecast in 2011 and 2012, due to heightened uncertainty and inventory trimming. Following a strong demand recovery with double-digit growth in 2010, much of 2011's rise in chemicals output took place in the first quarter. Since then, production has been relatively flat.

Nevertheless, the European Chemical Industry Council (ECIC) believes chemical industry growth will resume in 2012, strengthening slowly through the year. The industry group projects 2% year-over-year growth in 2011 and 1.5% expansion in 2012.

While developed nations, constrained by debt and tighter fiscal policies, are likely to expand chemical production at a moderate pace, output from the emerging markets is forecast to increase more rapidly.

Asia and other emerging markets will continue to lead the world in volume gains, with China and India showing the most significant increases. Chemical manufacturers in the emerging markets are expected to show 5.4% production increases in 2011, 6.2% in 2012 and 7.5% in 2013.

End-markets for chemical products are showing strong growth. This growth has been reflected in the earnings releases of most chemical companies for third-quarter 2011. Eastman Chemical Company (EMN - Analyst Report), for example, reported a 20% increase in sales revenues, primarily driven by increased selling prices.

Combined with the restructuring and cost-saving programs that many chemical companies implemented last year, output growth is driving high earnings across the sector, to the extent that many companies are confident of out-performing full-year forecasts.

Based on the strong third-quarter results, Eastman Chemical Company expects fourth-quarter 2011 earnings per share to be higher than fourth-quarter 2010 and full-year 2011 earnings per share to be approximately $4.62.

Celanese Corp.’s (CE - Analyst Report) revenue also grew 20% year over year to $1.81 billion in third quarter 2011 driven by higher volumes across all business segments and favorable currency impacts. Encouraged by the third-quarter strength, the company raised its outlook for full-year 2011.

The company now expects 2011 operating EBITDA to be at least $280 million higher than 2010’s $1,122 million and adjusted earnings per share to be at least $1.30 higher than 2010’s $3.37, based on a tax rate and diluted share count of 17% and 159 million shares, respectively.

The Dow Chemical Company’s (DOW - Analyst Report) revenue grew 17% year over year to $15.1 billion by volume (7%) and pricing (17%) gains across all business segments and geographical regions, particularly Latin America and Asia-Pacific.

Growth in export markets has been driven by several factors. These include favorable energy costs (natural gas) due to the abundance of newly found shale natural gas and demand from the emerging markets, where recovery and expansion have been the strongest.

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.

Celanese, DuPont and Eastman Chemical have short-term Hold recommendations, while Dow Chemical has a short-term Buy recommendation.

End-Market Scenario

In the U.S., there are 170 major chemical companies, operating internationally with more than 2,800 facilities outside the U.S., and 1,700 foreign subsidiaries or affiliates operating.

In Europe, especially Germany, the chemical, plastics and rubber sectors are among the largest industries. Together they generate about 3.2 million jobs in more than 60,000 companies.

According to the ACC, the Chemical Production Regional Index (CPRI) was flat in November 2011, following a revised 0.3% gain in October 2011. Results were mixed within the different regions, with the Gulf Coast gaining while production slipped or was flat everywhere else.

U.S manufacturing sector output was up 0.2% in November, following a 0.4% gain during October. Output in several key chemistry end-use markets rose, including structural panels, paper, rubber products, appliances, motor vehicles, aerospace, machinery and construction supplies.

Compared with November 2010, total chemical production in all regions was up 2.7% and remained ahead year-over-year in all regions. Compared with several months ago, year-over-year comparisons improved in several regions, including the Gulf Coast, Ohio Valley and Southeast.

The chemistry industry is one of the largest industries in the United States, a $720 billion enterprise. The manufacturing sector is the largest consumer of chemical products, and 96% of manufactured goods are touched by chemistry.

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 inputs.

Oil prices remain uncomfortably high despite the sub-par growth outlook for the global economy, largely owing to geostrategic reasons.

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.

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 abundant availability of shale gas is not only desirable on environmental considerations, given its lower carbon footprint relative to coal or oil, but it is also cost effective, essentially removing a key source of disadvantage for U.S. based chemicals producers.

OPPORTUNITIES

As per the ACC, growth in the emerging markets and abundant shale gas, coupled with a dollar exchange rate that is still relatively supportive, should help drive up US chemical exports. The ACC expects China to overtake the US as the largest market for chemicals.

The chemical companies are looking at mergers and acquisitions as an option to grow in the current economic environment. The companies are focused on exploring growth opportunities in the emerging markets with strong performance in the fast-growing regions of Asia-Pacific and Latin America, particularly China and Brazil.

A major deal in the space was last year’s acquisition of Danisco by DuPont (DD - Analyst Report) for $6.3 billion. The acquisition strengthened the company’s presence in the food ingredient and enzyme markets, and will expand its presence in industrial biotechnology and biofuels.

The deal is in line with DuPont’s strategy to expand beyond its chemical and manufacturing focus into the “megatrend” sectors of agribusiness and alternative energy. Both industries are expected to grow rapidly in the coming years as food demand and prices increase and clean energy policies gain more ground.

Dow is delivering cost synergies from the Rohm & Haas acquisition and is targeting synergy capture of $2 billion by the end of 2012.

WEAKNESSES

The global nature of the industry puts competitive issues into sharp focus. The U.S. producers have responded to competitive pressures by streamlining operations, relocating manufacturing facilities to low-cost regions closer to end-markets, and being overall more nimble and flexible in responding to market opportunities. And it is not always easy to pull this off.

The recent surge in commodity prices, though subsiding lately, is adding to the feedstock costs for many of these producers. Their ability to pass these costs on to end consumers is not always easy, given competitive pressures. As a result, margins for a number of producers will be under pressure in the coming quarters.

Additionally, given the industry’s sensitivity to the global economy, a diminution of growth outlook will be a materially negative development. The recent turmoil in Europe and its impact on global growth remain sources of near-term uncertainty.

German chemical company BASF (BASFY), in the third quarter of 2011, reported a net income of EUR 1,192 million versus last year’s quarter of EUR 1,245 million (+46.3%). On January 12, 2012, BASF announced it has invested $50 million to acquire an equity ownership position in privately held Sion Power, the global leader in the development of lithium-sulfur (Li-S) batteries, based in Tucson, Arizona.

This equity partnership expands upon an existing joint development agreement that BASF Future Business GmbH established with Sion Power in 2009 to accelerate the commercialization of Sion’s proprietary Li-S battery technology for electric and plug-in electric vehicles and other high-energy applications over the next decade.

Calgon Carbon Corporation (CCC - Analyst Report), a leader in the activated carbon sector, faces weak demand for carbon products. The company had weak volumes in 2010, and though activated carbon sales recovered to some 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 have yet to recover fully.

There are other possible hurdles that chemical makers may have to face including pending rule changes within the US regulatory agencies. 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 for implementation and annualized cost of $4.1 billion after accounting for savings resulting in mill closures.

The largest corporate producers worldwide with plants in numerous countries include BASF, Bayer, Braskem S.A. (BAK - Snapshot Report), Celanese Corp., Degussa, The Dow Chemical Co., EI DuPont de Nemours & Co., Eastman Chemical Company, ExxonMobil (XOM), INEOS, Mitsubishi UFJ Financial Group, Inc. (MTU - Analyst Report) and PPG Industries Inc. (PPG - Analyst Report).

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