The chemical industry started the year on a positive note following a bumpy 2013. With the U.S. economy getting its groove back, the first two quarters of 2014 showed encouraging demand trends for chemicals and continued recovery across end-use markets such as commercial construction and electronics after being in a rut for the most part of 2013.
The chemical industry also saw a pick-up in consolidation activities so far this year. Although some industry-specific challenges and slow economic recovery in Europe remain roadblocks, the industry is expected to continue to recuperate through the balance of 2014, backed by cost benefits from a shale gas boom in the U.S. and significant capital investment.
Chemical makers are ramping up investment on shale gas-linked projects to take advantage of abundant natural gas supplies which is expected to beef up capacity and export in 2014 and beyond.
Strength across agriculture and automotive markets in North America and healthy demand in emerging geographies represent tailwinds for the industry. A gradually convalescing housing market also augur well for recovery prospects this year and the next.
The Industry in a Nutshell
Chemicals are used to make consumer goods and are also used in the agriculture, manufacturing, construction and service industries. In fact, the chemical industry -- a roughly $5 trillion global business – 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 is among the biggest industries in the U.S., a more than $800 billion enterprise. It is cyclical by nature and heavily linked to the overall condition of the U.S. and world economies. The chemical industry 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 constitutes roughly 12% of the nation's exports. Roughly 6 million additional jobs are backed by the purchasing activity of the chemical industry. The U.S. chemical industry supports around 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 2.8% share of total earnings for the S&P 500 in 2014. 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.
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 three chemicals related industries: Chemical Specialty, Chemical Plastics and Chemical Diversified. Both Chemical Specialty and Chemical Plastics industries lie in the middle one-third with a Zacks Industry Rank #90 and #110, respectively. The Chemical Diversified industry currently retains a Zacks Industry Rank #225, placing it in the bottom 1/3rd of the 260+ industry groups.
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 Materials sector, earnings for 95.2% of the sector participants in the S&P 500 index reported so far are up 11.9% in second-quarter 2014, a marked turn around from a 2.4% fall in the first.
Total revenues for these companies are up 3.7% in the second quarter versus a 1.4% rise a quarter ago. The sector racked up a healthy earnings beat ratio (the percentage of companies coming out with positive surprises) of 70% and revenue beat ratio of 50% in the second quarter.
The earnings momentum is expected to continue into the third quarter with a projected rise of 9.7%. Revenues are forecast to move up 1.5% in the quarter.
For 2014, earnings are expected to show an 8.3% increase, further accelerating to a 19.4% rise next year. Revenues are forecast to expand 2.1% this year and 5.2% in 2015.
Key Feedstock Price Trends
The chemical industry uses oil, naphtha and natural gas as energy and feedstock inputs. According to chemical giant BASF SE (BASFY), Brent crude oil prices averaged $109 per barrel in 2013, below 2012 average of $112.
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 Apr 2013 on weak demand outlook for oil. Brent crude has hovered between a high of roughly $116 and a low of $104 so far this year, averaging at around $110. Prices crossed $115 in Jun 2014 on concerns over possible supply disruption stemming from violence in Iraq.
The price of the other key raw material, naphtha, which is produced from oil, ranged between $985 per metric ton and $820 per metric ton in 2013, based on the BASF report. Naphtha prices averaged $902 last year, lower than the 2012 average of $937. The average annual price of natural gas in the U.S. was $3.73 per million British thermal units (MMBtu) in 2013, higher than $2.75 in 2012.
Chemical Industry on the Mend
The 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 2.5% in 2014 (up from a 1.6% increase in 2013) and further improve to a 3.5% gain next year. Growth will be backed by strong agricultural market fundamentals, healthy demand from light vehicles market and a recovery in the housing market.
U.S. chemical exports are expected to cross $200 billion this year and rise roughly 8% annually through 2018, leading to continued generation of trade surplus. Trade in chemicals is expected to rise with a recovery in global manufacturing activities.
On the global front, ACC sees production to move up 3.8% in 2014 and 4.1% in 2015 with healthy gains expected across North America and emerging markets.
The ACC expects strong capital spending in the coming years, stemming from new investments in petrochemicals and derivatives. It envisions U.S. capital spending to reach $61.2 billion by 2018.
The shale gas boom is expected to drive investment on plants and equipment in the U.S. The ACC expects U.S. chemical shipment value to surpass $1 trillion and the industry to rake in record trade surpluses by 2018, partly boosted by significant share gas-driven chemical capacity.
According to the European Chemical Industry Council (CEFIC), which represents the European chemicals industry, chemical output will rise 2% this year following a 0.2% fall in 2013. The gain will be driven by increasing demand from customer industries (especially automakers) and stabilization in construction markets. While CEFIC expects continued growth in production in 2015, it expects output to rise at a slower pace (of 1.5%) next year. Pace of growth is expected to be stymied by high-energy prices that place European chemical makers at considerable disadvantage versus their North American counterparts.
Shale Bounty Driving Chemical Spending
According to the ACC, emerging market growth and favorable oil-to-gas price ratios resulting from abundant shale gas production are driving 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 healthy 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. The U.S. has emerged as an attractive investment location and chemical makers are aggressively expanding capacity in the country.
According to an ACC report, potential domestic chemical investment related to share gas has reached as high as $100 billion, more than 50% of which are from firms outside of the U.S. Already 148 projects -- backed by Federal government support -- have been announced by chemical makers to take advantage of ample natural gas supplies.
These projects may lead to $81 billion in new chemical industry output annually and 637,000 permanent new jobs by 2023. Such investments are expected to boost capacity and export over the next several years.
Agriculture: A Lucrative Prospect
Major chemical makers are increasingly shifting their focus on businesses that cater to agriculture and health and nutrition markets in an effort to cut their exposure on other businesses that are grappling with weak demand and input costs pressure. In particular, agriculture is emerging as a lucrative market as evident from recent trends.
Strong planting activity by growers across North and Latin America, solid order book and healthy supply of seeds and crop protection products represent driving factors.
Strategic Measures: M&A Heating Up
Chemical companies remain actively focused on mergers and acquisitions to diversify and shore up growth in a still challenging economic environment. These companies continue to explore growth opportunities in the fast-growing emerging markets, particularly in the lucrative regions of Asia-Pacific and Latin America.
The chemical industry is expected to witness high levels of consolidation activities in 2014 with some major deals have already been announced this year including Albemarle Corp.’s (ALB) proposed buyout of Rockwood Holdings, Inc. (ROK - Analyst Report) for $6.2 billion. Chemical makers are also divesting non-core assets as they shift their focus on high margin businesses.
Moreover, cost-cutting measures implemented by chemical companies -- including plant closures and headcount reduction -- are expected to yield industry-wide margin improvements. Cash flows derived through these actions could be directed for growth initiatives.
Recovery in Chinese Demand
Recovery in China, a major market, is expected to continue through the balance of 2014. Government stimulus actions coupled with efforts to stem inflation appear to bear fruit and exports to the U.S. and other key markets are regaining momentum. Strength in the automotive market represents another positive. An improved demand outlook for China bodes well for the chemical industry this year.
Stocks We Like
Chemical stocks that look good in the prevailing operating backdrop include LyondellBasell Industries NV (LYB - Analyst Report), Celanese Corp. (CE - Analyst Report), The Dow Chemical Company (DOW - Analyst Report), PPG Industries Inc. (PPG - Analyst Report), The Sherwin-Williams Company (SHW - Analyst Report) and Eastman Chemical Company (EMN - Analyst Report).
While there have been some signs of improvement of late, the European economy is still not out of the woods. Western Europe continues to pose challenges on chemical stocks due to weak demand, thus remaining a source of near-term uncertainty. In addition, given the chemical industry's sensitivity to the global economy, any negative current in the macro economy would be reflected in the prospects of the chemical makers.
In addition, demand from some of the major manufacturing industries remains below their historic highs. While non-residential construction activities are improving, the market remains way below its peak levels.
Pricing, FX Pressure
Commodity prices, though subsiding of late, 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 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.
A Still-Cloudy Fertilizer Space
Fertilizer and agricultural chemicals makers continue to face challenges from weak pricing, affecting their margins. Prices for potash have been under pressure following the exit of world's largest potash maker Uralkali Group from one of the biggest potash cartels -- the Belarus Potash Company (BPC) -- that influence potash pricing by controlling the production and supply. Uralkali's Board decided to end export sales through BPC and direct all potash export through its Switzerland-based trade arm Uralkali Trading.
Moreover, demand for potash and phosphate remains somewhat weak in India, a key import market. Potash subsidy cuts by the Indian government coupled with a weak local currency contributing to depressed demand for the nutrient in that country. Moreover, the demand environment for phosphate will remain uncertain in India in second-half 2014 due to monsoon rainfall.
Stocks Warrant Caution
We hold a bearish view on FMC Corp. (FMC - Analyst Report), DuPont (DD - Analyst Report), Methanex Corp. (MEOH - Analyst Report) and Air Products and Chemicals Inc. (APD). We steer clear of certain companies in the fertilizer space. Companies that fit the bill are The Mosaic Company (MOS - Analyst Report) and CF Industries Holdings, Inc. (CF - Analyst Report).