While the September quarter mirrored some of the challenging issues witnessed earlier, it elicited signs of recovery in the chemical industry on strength across agriculture and automotive markets and healthy demand in emerging geographies.
Although the quarter showed improvement across commercial construction and electronics end-markets, they are still not out of the woods. Moreover, a still-challenging economic backdrop in Europe continued to muffle a meaningful upturn in chemical demand.
The European economy continues to limp along and effects of sequestration and fiscal gridlock in Washington are weighing on the domestic economic recovery. Nevertheless, the September quarter portrayed healthy demand trends across a spate of industries in the U.S.
While a material recovery is not expected in the final quarter of 2013 given a still-challenging global economic scenario, the chemical industry is expected to end this year on a positive note and fare relatively better in 2014, aided by healthy Chinese demand and a shale gas boom in the U.S. Strong agricultural market fundamentals in Latin America and a gradual revival in the housing market also augur well for the industry.
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, paper and primary metals.
The chemical industry, a roughly $5 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 chemical industry is among the biggest industries in the U.S., a roughly $770 billion enterprise. It is cyclical by nature and heavily linked to the overall condition of the U.S. and world economy. The chemical industry has been consistently leading the U.S. economy's business cycles due to its early position in the supply chain. It also touches 96% of manufactured goods, making the manufacturing industry the biggest consumer of chemical products.
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).
Zacks Industry Rank
Within the Zacks Industry classification, the chemical industry falls under the broader Basic Materials sector (one of 16 Zacks sectors) which is expected to have a 3% share of total earnings for the S&P 500 in 2013. 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. To learn more visit: About Zacks Industry Rank.
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 #88 and lower) is positive, the middle 1/3rd or industries with Zacks Industry Rank between #89 and #176 is neutral while the outlook for the bottom one-third (Zacks Industry Rank #177 and higher) is negative.
We have four chemicals related industries: Chemical Plastics, Chemical Specialty, Chemical Diversified and Chemical Fibers. Both Chemical Plastics and Chemical Fibers industries currently retain a Zacks Industry Rank #110, placing them in the middle 1/3rd of the 260+ industry groups. The Chemical Diversified industry also lies in the middle one-third with a Zacks Industry Rank #165. The Chemical Specialty industry with a Zacks Industry Rank #235 is placed in the bottom one-third of all Zacks industries.
Looking at the exact location of these industries, one could say that the general outlook for the chemical industry as a whole is leaning toward ‘Neutral.’
Sector Level Earnings Trends
Looking at the overall results of the broader Basic Material sector, earnings went up 3.6% in the third quarter, a turnaround from a 9.9% decline in the second quarter. Total revenues were up 1.1% in the third quarter versus a 1.4% fall a quarter ago. The sector racked up earnings beat ratio (the percentage of companies coming out with positive surprises) of 62.5% and revenue beat ratio of 41.7% in the third quarter.
The Basic Material sector is expected to continue its uptrend in the fourth quarter with an expected 5% rise in earnings. Revenues are forecast to move up 1.5% in the quarter with an expected 0.7% rise for 2013.
For 2014, earnings are expected to show a 17.6% increase, a rebound from a projected 0.2% fall in 2013. Revenues are expected to expand at a higher clip (3.6%) compared with 2013.
Key Feedstock Trends
The chemical industry uses oil, naphtha and natural gas as energy and feedstock inputs. Brent crude prices touched a nine-month high of $119 in Feb 2013, triggered by geopolitical tension in the Middle East, exacerbated by Iran's nuclear program. Prices eased to below $100 in April 2013 for the first time since July 2012 on weak demand outlook for oil.
However, Brent has been hovering around $110 per barrel of late, supported by stabilization of Chinese oil demand and concerns over supply disruption from Libya due to unrest amid higher winter oil demand.
The price of the other key raw material, naphtha, which is produced from oil, averaged $937 per metric ton last year. High crude prices kept the cost of naphtha elevated. Natural gas has been a bright spot on the feedstock front. The average annual price of natural gas in the U.S. was $3 per million British thermal units (mmbtu) in 2012.
Over the last few 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. Shale-driven cheaper natural gas production is expected to keep natural gas prices down.
Recovery Picking up Steam, Brighter Outlook for 2014
While lingering crisis in Europe coupled with other industry-specific challenges continues to pose downside risks, the global chemical industry is poised for a recovery this year and the next.
The American Chemistry Council (ACC), an industry trade group, 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 ACC 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 sees strong capital spending in the coming years, stemming from new investments in petrochemicals and derivatives. The trade group 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.
However, the European Chemical Industry Council (CEFIC), which represents the European chemicals industry, expects chemical output to contract 1% in 2013 (versus a 1.5% decline in 2012) given tough economic conditions in the region and weak demand across automotive and construction markets. Nevertheless, the association expects European chemicals industry to return to a growth of 1.5% in 2014 on stabilization of industrial production in Europe and a modest uptick in exports.
Shale Boom Driving U.S. Chemical
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. 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.
Boost from Agriculture
Major chemical makers are increasingly focusing on businesses that cater to agriculture and nutrition markets in an effort to cut their exposure on other businesses (such as titanium pigment) that are grappling with weak demand and input costs pressure. In particular, agriculture is emerging as a lucrative market as evident from recent trends.
A healthy start in the North American growing season, strong planting activity by growers across North and Latin America, solid order book and healthy supply of seeds and crop protection products represents driving factors.
Mergers and acquisitions offer chemical companies another means to shore up growth in a still challenging economic 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.
Moreover, 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.
Recovery in Chinese Demand
China, a major market, is expected to see a recovery in 2014. 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.
China's economy grew at its fastest clip this year in the third quarter. The nation’s GDP rose to 7.8% in the quarter from 7.5% in the second riding on government stimulus measures, improving domestic demand and a recovery in exports. Government-backed investments in infrastructure are supporting growth. An improved demand outlook for China bodes well for the chemical industry next year.
Stocks We Like
Stocks in the chemical space that we like include E.I. DuPont de Nemours & Co. (DD - Analyst Report), The Dow Chemical Company (DOW - Analyst Report), PPG Industries Inc. (PPG - Analyst Report) and Methanex Corp. (MEOH - Analyst Report). DuPont and Dow, in particular, are witnessing significant momentum in agriculture, driven by higher demand for crop protection products. We also have a bullish view on specialty chemical company The Valspar Corporation (VAL - Analyst Report).
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 crisis 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.
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, which is among the key end-markets.
Chemical makers may also face regulatory challenges. 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.
Sen. Frank Lautenberg along with other co-sponsors introduced the Safe Chemicals Act of 2013 in April 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. Nevertheless, the government shutdown has caused policymakers to put aside the issue for the time being.
Pricing, FX Headwinds
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.
In addition, chemical companies generate a major chunk of their revenues outside the U.S., and therefore are exposed to foreign exchange fluctuations. Currency exchange translation remains a headwind for these companies.
Uncertainty in Agrichemical Space
Moreover, agricultural chemicals and fertilizer makers face significant challenges following the exit of world's largest potash maker Uralkali Group from one of the biggest potash cartels -- the Belarus Potash Company (BPC). Uralkali’s Board decided to end export sales through BPC and direct all potash export through its Switzerland-based trade arm Uralkali Trading.
BPC is one of the two largest cartels (along with North America’s Canpotex) that influence potash pricing by controlling the production and supply. Uralkali’s game-changing move has triggered industry-wide fear of a price war and put pressure on fertilizer makers.
Moreover, demand for potash remains somewhat weak in India, a key import market. Indian government’s move to trim potash subsidy levels coupled with higher retail pricing and local currency devaluation contributing to lower demand in that country. Also, global phosphate market is expected to remain weak in the near term, partly due to lower demand from India.
Stocks Warrant Caution
We steer clear of chemical stocks including Eastman Chemical Company (EMN - Analyst Report), Air Products and Chemicals Inc. (APD - Analyst Report) and Celanese Corp. (CE - Analyst Report). We also have a bearish view on companies in the agricultural chemical space. Companies that fit the bill include Potash Corporation (POT - Analyst Report) Agrium Inc. (AGU - Analyst Report) and CF Industries Holdings, Inc. (CF - Analyst Report).