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Industry Outlook

Chemicals are generally used to make a wide variety of consumer goods and are also used in 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 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.

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 US 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 US chemical industry is responsible for 10% of US merchandise exports, totaling $145 billion annually, as well as 11% of all US patents.

Outlook

The recession had hit the chemical industry hard. As a result of lack of demand, chemical companies shelved their growth plans. With plants idled or running at historically low rates, the companies tried to protect their earnings power by streamlining operations and increasing productivity. Accordingly, they resorted to restructurings, plant closures and layoffs. Cost-cutting initiatives at industry majors like The Dow Chemical Company (DOW - Analyst Report) and EI DuPont de Nemours & Co (DD - Analyst Report) helped them save billions of dollars.

With the economic turnaround, the global chemical industry is recovering from the recession-hit lows. Domestically, chemical production volumes increased across all regions in 2010, reversing the steep declines experienced in 2008 and 2009. The largest gains 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.

Concerns about the U.S. economy’s growth momentum have increased lately following the sub-par growth pace in the first half. But all evidence points towards the economy maintaining positive, though below-average, growth going forward. While recessionary risks have no doubt increased, we remain comfortable with our view that the U.S. economy will be able to stay positive.

End-markets for chemical products are showing strong growth. This growth has been reflected in the earnings releases of most chemical companies for second quarter 2011. Eastman Chemical Company (EMN - Analyst Report), for example, reported a 26% increase in sales revenues, primarily due to growth in plasticizer product lines, increased demand for acetyl chemicals, the fourth quarter 2010 restart of a previously idled olefins cracking unit at the Texas facility, and strengthened end-market demand primarily in the packaging, transportation and durable goods markets.

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 second quarter results, Eastman Chemical Company expects third quarter 2011 earnings per share to be slightly higher than second quarter 2011 and full-year 2011 earnings per share to be slightly higher than $9.25.

Celanese Corp. (CE - Analyst Report) revenue also grew 16% year over year to $1.75 billion in second quarter 2011 driven by higher volumes across all business segments and favorable currency impacts. Encouraged by the second quarter strength, the company raised its outlook for full-year 2011.

The company now expects 2011 operating EBITDA to be at least $275 million higher than 2010’s $1,122 million and adjusted earnings per share to be at least $1.20 higher than 2010’s $3.37, based on a tax rate and diluted share count of 17% and 159.2 million shares, respectively.

The Dow Chemical Company (DOW - Analyst Report) revenue grew 17% year over year to $16.0 billion by volume (9%) and pricing (19%) 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 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.

Dow Chemical, Celanese, DuPont and Eastman Chemical have long-term Hold recommendations.

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) rose 0.5% in May 2011, following a 0.3% gain in April 2011, as chemical production increased in all regions, except the Gulf Coast.

U.S manufacturing sector output was up 0.4% in May, following a 0.5% gain during April. Output grew in many key end-use markets for chemistry products, including construction supplies, motor vehicles, electrical equipment, furniture, paper and plastic and rubber products.

The U.S. homebuilding sector is a major consumer market for the chemicals industry, accounting for about 10% of chemical demand.

Nationwide housing starts rose 14.6% to a seasonally adjusted annual rate of 629,000 units in June 2011, according to the U.S. Commerce Department. This was the best pace of starts activity since the beginning of the year, and was attributable to significant gains registered in both the single-family and multifamily segments as well as every region of the country.

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 trended upward throughout 2009, and in April 2011, crude oil prices averaged around $111 per barrel, though they have since come down lately as questions about the sustainability of the U.S. economic recovery have taken center stage. Naphtha prices are also expected to remain elevated relative to last year’s levels, though they have lost ground lately as well as crude oil prices.

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, favorable dollar exchange rates, growth in emerging markets and abundant shale gas will drive up US chemical exports and China will 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 emerging markets with strong performance in the 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.

One of the largest operators in this space, DuPont (DD - Analyst Report) entered into a definitive agreement to acquire Denmark’s Danisco for $5.8 billion in cash and the 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 enzymes.

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, photo-voltaics, alternative energy and materials.

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. 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 first quarter of 2011, reported a net income increase by EUR 1,382 million to EUR 2,411 million (+134%). The company also announced in February that it would hire approximately 2,900 employees this year.

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 such as pending rule changes within 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 and also result 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, INEOS, Mitsubishi UFJ Financial Group, Inc. (MTU - Analyst Report) and PPG Industries Inc. (PPG - Analyst Report).

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