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Factors Supporting the Bullish Case for Chemical Stocks

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The chemical industry remains besieged by a number of challenges, including weak demand in agricultural and energy markets, a sluggish Chinese economy and headwinds from a strong dollar. Nevertheless, the industry remains on the road to recovery, gaining from healthy momentum across automotive and construction markets. There are a number of reasons to be optimistic about the broader chemical industry for both the short and long haul, which we have highlighted below:

Shale Abundance Driving Chemical Spending

The shale gas revolution in the U.S. has been a huge driving force behind chemical investment on plants and equipment in the country. According to the American Chemistry Council (ACC), the U.S. has emerged as an attractive investment location and petrochemical makers are now significantly expanding capacity in the country leveraging new supplies of natural gas. New methods of extraction such as horizontal drilling and hydraulic fracturing (or fracking) are boosting shale production, bringing down prices of ethane (derived from shale gas) in the process.

Driven by the abundant natural gas supply, chemical makers are ratcheting up investment on shale gas-linked projects which is expected to beef up capacity. The shale boom has incentivized a number of chemical companies to pump in billions of dollars for setting up facilities (crackers) in the U.S. to produce ethylene and propylene in a cost-effective way.

Per ACC, domestic chemical investment related to shale gas has reached as high as $164 billion, more than 60% of which are from firms outside the U.S. Already 264 projects -- many backed by the Federal government -- have been announced by chemical makers to take advantage of ample natural gas supplies with 40% of them already complete or under construction. Such investments are expected to boost capacity and export over the next several years. The ACC expects average annual gains of more than 8% in U.S. chemical industry capital spending through 2018.

Automotive in High Gear

The automotive sector -- a major chemical end-use market -- is witnessing significant momentum. The sector is enjoying the fruits of low gasoline prices. Outlook paints a rosy picture as global automotive sales are expected to rise 2.7% to 89.8 million units in 2016 on the back of strong volume growth in the U.S. and Europe, according to IHS Automotive.

The U.S. auto industry also remains in top gear. U.S. light vehicles (a key end-user market for chemicals) sales hit all-time high of around 17.5 million units in 2015 and are expected to rise further this year, aided by an improving job market, rising personal income, lower fuel prices and attractive financing options. New car and light truck sales are expected to reach to 17.7 million units in 2016 on the back of reduced gasoline prices and rising employment, as per The National Automobile Dealers Association (NADA) estimates.

The Auto industry in Asian countries, especially China, is also expected to thrive over the next several years. As such, chemical makers are expected to gain from higher demand from this important end-market.

Strategic Moves

Chemical companies continue to shift their focus on high-growth markets (driven by megatrends) in an effort to whittle down their exposure on other businesses that are struggling with weak demand and input costs pressure. Moreover, cost-cutting measures -- including plant closures and headcount reduction -- and productivity improvement actions by chemical companies are expected to yield industry-wide margin improvements. Several chemical makers are also disposing non-core assets as they shift their focus on high-margin businesses.

Consolidations Gathering Steam

Chemical makers remain actively focused on mergers and acquisitions to diversify and shore up growth in a still-difficult global 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 industry saw a pick-up in consolidation activities in 2014 and the momentum continued in 2015.

Chemical companies are increasingly looking for cost synergy opportunities and enhanced operational scale through consolidations. The $130 billion proposed mega-merger of Dow Chemical DOW and DuPont DD -- the biggest chemical deal ever -- is a huge testimony to these strategic moves.

Other major deals that have taken place in the chemical space in the recent past include Albemarle Corp.’s (ALB - Free Report) $6.2 billion buyout of Rockwood Holdings, Inc., Eastman Chemical Company’s (EMN - Free Report) purchase of specialty chemical company Taminco Corp. for $2.8 billion, PPG Industries Inc.’s (PPG - Free Report) acquisition of Mexican paint company Comex, Olin Corp.’s (OLN - Free Report) acquisition of a significant portion of Dow Chemical’s chlorine business for $5 billion, Merck KGaA's $17 billion acquisition of Sigma-Aldrich and FMC Corp.’s (FMC - Free Report) acquisition of Cheminova A/S.

Construction Sector Gaining Momentum

A recovery across housing and commercial construction -- major chemical end-markets -- has been another tailwind for the chemical industry. After being hit hard in the recession, the construction sector has recovered on the back of strong housing fundamentals.

The U.S. housing sector saw steady recovery in 2015 backed by stabilizing mortgage rates, improving job market and moderating home prices, and the momentum continues this year. The underlying demand trends in the housing space remain strong, supported by an improving employment levels, affordable interest/mortgage rates, rising consumer confidence and a recovering economy.

Recent housing data has been fairly upbeat with reports of higher sales of new single-family houses coupled with mid-single-digit growth in housing starts. Moreover, the home remodeling market is also picking up pace.

The renewal of long-stalled construction projects and long awaited access to credit from lending institutions has also helped invigorate the commercial construction sector. U.S. architecture firm billings continue to rise. The US Architecture Billings Index (ABI), an indicator that offers a glimpse into the future of U.S. non-residential construction spending activity, clocked 50.6 in April 2016 (a reading above 50 indicates an increase in billings).

Moreover, the American Institute of Architects (AIA) expects healthy growth in non-residential construction spending this year based on strong demand for hotels, office space, manufacturing facilities and amusement and recreation spaces. The AIA sees spending to go up 8.3% in 2016. This augurs well for demand for chemicals in the construction markets.

Wrapping Up

As you can see from the above-mentioned factors, there are a few good reasons to be optimistic about the chemical industry. Chemical stocks that are well placed in the current operating backdrop include DuPont, FMC Corp., Air Products and Chemicals Inc. (APD - Free Report) , The Dow Chemical Company, PPG Industries Inc. and Celanese Corp. (CE - Free Report) .

(Check out our latest Chemical Industry Outlook for a more detailed discussion on the fundamental trends.)

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