Chemicals Industry Outlook & Review - May 2010

OUTLOOK

After the sharp declines in the last two years, we expect worldwide chemical production (excluding pharmaceuticals) to recover, albeit at a slow rate. At a global level, we currently expect that chemical production will require another couple of years to return to production levels seen before the crisis. In industrialized countries, severe declines in production as a result of the global financial and economic crisis will have longer-lasting effects.

The North American chemical production is expected to experience above-average growth in 2010, with domestic demand improving from the key customer industries. Chemical giant BASF is expecting about 10% growth in the U.S. chemical industry on the back of rising demand for exports.

We believe aggressive efforts in working capital reductions, supply chain optimization and productivity improvement should yield margin benefits. There is also a chance of accelerating capacity growth in 2011–2012, assuming that older projects do not get cancelled. We expect a strong cash flow and an underleveraged balance sheet to support growth opportunities for chemical producers going forward.

The chemical industry remains heavily exposed to economic cycles. 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.

Detailed Look

The chemical industry consists of companies engaged in the processing and refinement of agricultural and industrial chemicals as well as gases. Chemicals are used to make a wide variety of consumer goods, besides being necessary in the agriculture, manufacturing, construction and service industries. The European Union and the U.S. house the world's largest chemical companies.

The entire US chemical industry is divided into four segments – basic chemicals, life sciences, specialty chemicals and consumer products. Many of the larger companies operate in all or most of these segments, while specialized operators are also numerous.

Basic chemicals or commodity chemicals form the major chunk of the chemical industry. Products here include polymers, plastics, bulk petrochemicals and intermediates, other derivatives and basic industrials, inorganic chemicals and fertilizers. Of this, polymers generate the largest revenue. The major end-markets for plastics in this segment are packaging, followed by home construction, containers, appliances, pipes, transportation, toys and games.

Other derivatives and basic industrials include synthetic rubber, surfactants, dyes and pigments, turpentine, resins, carbon black, explosives, and rubber products. Inorganic chemicals make up the oldest of the basic chemical categories and include products such as salt, chlorine, caustic soda, soda ash, acids (such as nitric, phosphoric and sulfuric), titanium dioxide and hydrogen peroxide. Fertilizers include phosphates, ammonia and potash chemicals.

Life sciences include differentiated chemical and biological substances, pharmaceuticals, diagnostics, animal health products, vitamins and crop protection chemicals. Crop protection chemicals include herbicides, insecticides, and fungicides.

Specialty chemicals include electronic chemicals; industrial gases; adhesives and sealants; coatings, industrial and institutional cleaning chemicals; and catalysts. These are relatively high valued and rapidly growing chemicals with diverse end product markets.

Consumer products include the direct product sale of chemical-based products such as soaps, detergents and cosmetics. It also includes products such as sulfuric acid, nitrogen, ethylene, oxygen, lime, ammonia, propylene, polyethylene, chlorine, phosphoric acid and diammonium phosphates.

OPPORTUNITIES

The overall chemical industry is in a consolidation phase, driven by the need for creating scale economies in operations, supply-chain management and capital market needs. Major players are expanding activity through mergers, acquisitions, alliances and joint ventures.

While we can cite multiple examples from recent history, the more noteworthy ones are those of Dow Chemicals ( DOW - Analyst Report ) , Agrium ( AGU - Analyst Report ) and CF Industries ( CF - Analyst Report ) .

Dow Chemicals continues to progress in delivering cost synergies from its latest acquisition of Rohm and Haas. Similarly, fertilizer manufacturer Agrium is growing through a combination of acquisitions and organic expansion. Agrium’s acquisition of United Agri-Products is expected to drive growth through an expanded product line. The take-over of rival Terra Industries has made CF Industries a global leader in the nitrogen fertilizer sector. CF Industries has a leading market share in many key fertilizers.

Leading chemical companies have been consolidating mature businesses and have started migrating to low-cost locations. Fertilizer companies such as Potash Corporation ( POT - Analyst Report ) benefits from its geographic diversification as nearly 63% of its production is exported.

Demand for fertilizers is driven by crop prices. The crop input sector is recovering and demand for potash has improved slightly. Crop nutrient margins are expected to improve significantly in 2010 due to strong demand and lower inventory costs than replacement costs.

Agrium, for instance, expects a strong demand for crop nutrients and other crop inputs this spring, despite some recent weakening in crop prices. Both CF and Agrium are prepared for a reasonably good application season and spring demand due to attractive corn farming economics and restocking needed by downstream fertilizer channels.

Other chemical manufacturers, such as Eastman Chemical Company ( EMN - Analyst Report ) , are benefiting through diversification into downstream businesses that have help boost revenue and margin growth. Focus on aggressive cost reduction and improving yield from better technology have been a key techniques for chemical manufacturers.

DuPont ( DD - Analyst Report ) , for instance, plans to capture $1 billion each in the years between 2010 and 2012 by way of reducing fixed costs and working capital productivity gains. Fertilizer company Valspar Corporation’s ( VAL - Analyst Report ) solid results and robust margin gains in the past few quarters stem from a dramatic cost reduction, increasing product prices and productivity gains. These measures helped the industry during the downturn.

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 chalked up to the economic turmoil. The global economic slowdown led to a weak industrial demand for chemicals, which led to significant regional and global production overcapacities, resulting in a dramatic fall in operating profits across the world. 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.

Demand for chemicals tracks global industrial production and global GDP very closely. The chemical industry was particularly affected by the weak industrial demand in the second half of 2008 and the first half of 2009. The drop in production in the chemical industry has been almost in sync with lower production in the key customer industries of housing, construction, automotive, electrical, furniture and paper. Nearly 10% of the chemical demand in the country is directly tied to the housing sector, and an additional 10% is tied to the auto sector.

Weak residential and commercial construction demand especially affected companies into paint and coatings. Revenues and margins for Sherwin-Williams ( SHW - Analyst Report ) , the largest U.S. producer of paints and coatings, declined significantly in 2009 and are likely to continue decline in 2010.

Recessionary trends coupled with inventory de-stocking resulted in sharp volume declines in the activated carbon sector last year, affecting Calgon Carbon Corporation ( CCC - Analyst Report ) , a leader in the activated carbon sector, and Celanese Corporation ( CE - Analyst Report ) , the global hybrid chemical company.

Trends in Raw Material Markets

The chemical industry is a large consumer of oil, natural gas and energy, which are widely used as an energy and feedstock input. During 2009, the oil price rose 87% from about $40 per barrel to more than $75 per barrel, reaching October 2007 levels. Prices for the chemical raw material naphtha soared in almost exactly the same way as the oil price; naphtha rose throughout 2009 from an average level of $340 per metric ton in January to well over $600 per metric ton from October.

In both the US and Europe, natural gas prices fell during 2009 initially before increasing again in the last quarter of the year. The average annual gas price in the US was around $4 per mbtu, less than half the cost in the previous year. In Europe, the average gas price was well over $8 per mbtu.