Chemical makers should benefit from continued strength in the automotive industry and strategic measures including expansion into high-growth markets, aggressive cost management, acquisitions and investment on capacity expansion. However, a number of challenges continue to hamstring the industry. There are a few reasons to be watchful about the chemical industry in the near term, which we have outlined below:
China Worries Continue
Economic cooling in China -- a major market for chemicals -- remains a deterrent over the near term. China’s economy hit a wall in 2015, growing at its slowest pace in 25 years as a raft of government stimulus measures (including interest rate cuts) failed to stabilize its financial markets. The world’s second-biggest economy remains hamstrung by its tepid property market and weak private investment, which is contributing to its sluggish economic growth.
China’s GDP grew 6.7% in the second quarter of 2016, the same as what was witnessed in the first, but still its weakest pace since the financial crisis.
The country’s GDP expanded 6.9% in 2015, a marked deceleration from the 7.3% a year ago. The International Monetary Fund (IMF) projects growth in China to moderate to 6.6% in 2016 and 6.2% in 2017. This partly reflects weaker investment growth as the economy continues to rebalance. As such, a sluggish Chinese economy may weigh on demand for chemicals in this significant market.
Eurozone Economy Sputtering Along
The European economy is still not out of the woods, as evident from the lackluster Eurozone GDP growth of 0.3% in the second quarter of 2016, slowing from a 0.6% growth in the first, per preliminary estimates published by Eurostat. France -- the Eurozone’s second-biggest economy -- witnessed complete stagnation in the quarter after racking up 0.7% growth in the previous quarter, hurt by disruptions from labor strikes. Political and economic uncertainties brought forth by Brexit are expected to hinder Eurozone’s economic growth in the short term.
Sluggishness in some of Europe’s major economies continues to deter recovery of the chemical industry in that region. Western Europe continues to pose challenges on chemical stocks due to weak demand, thus remaining a source of near-term uncertainty. Moreover, weak investments and lower pricing remain as overhangs on the European chemical industry.
Depressed Demand in the Energy Space
A low oil price environment is hindering investment in the energy sector. This is affecting demand for chemicals in this important end-use market. Oil prices hit a 12-year low in Feb 2016, hurt by a surge in the U.S. stockpile and prospects of weak demand. Subsequently, supply disruptions around the globe pushed up the prices of the commodity to close above the $50 per barrel mark in June.
However, oil prices tumbled more than 20% recently from the high they reached in early June on renewed concerns over a global supply glut, taking the commodity into bear market territory. Prices are expected to remain under pressure in the near term on oversupply concerns. Depressed crude oil prices will also keep chemical prices under check as they essentially move in tandem with oil prices.
Pricing, Currency Headwinds
Commodity pricing remain a concern for many U.S. chemical producers. Their ability to pass these costs on to end consumers is not always easy, given the competitive pressures in 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. A strong U.S. dollar created a significant headwind for these companies during the first half of 2016 and is expected to continue to be a drag on profits in the near term.
Challenges Linger in Fertilizer/Agrichemical Space
Fertilizer and agricultural chemical companies remain exposed to a difficult pricing environment. Potash prices, which are already at their lowest levels since 2007, remain under pressure due to elevated supply. The potash market is expected to remain oversupplied in the near future, thereby hurting prices. Moreover, depressed global energy prices and higher supply have also contributed to a softer nitrogen pricing environment.
Global capacity expansion continues to exert pressure on urea and other nitrogen fertilizer prices. Elevated supply in the global nitrogen market is hurting prices, causing farmers to delay buying activities. As such, margins of fertilizer producers remain thwarted by a weak nutrient pricing environment.
Moreover, agriculture market fundamentals remain weak and there is a continuous negative sentiment among agriculture investors that can create uncertainty in the near term. According to the U.S. Department of Agriculture (USDA), U.S. farm income is expected to slip 3% to $54.8 billion in 2016 to the lowest level since 2002. This would also mark the third straight year of decline.
The outlook reflects depressed prices resulting from excess supply of crops and livestock. While prices of major crops (such as corn and soybeans) have recovered of late, they remain at their multi-year lows.
The prevailing softness in agricultural commodity pricing is a concern for fertilizer companies as it is hindering fertilizer use by farmers given the adverse effect of lower crop pricing on growers’ income. Lower farm income has a negative influence on growers’ nutrient purchasing decisions.
Moreover, the crop protection market remains under pressure, in part, due to a slowdown in Brazil. Agricultural market conditions remain weak in Brazil impacted by cautious buying by farmers and the uncertain political and economic situation in that country. A challenging currency environment coupled with economic weakness has also contributed to sluggish demand for nutrients across certain emerging markets.
As you can see, there are a number of reasons to be cautious in the chemical industry space. We hold a bearish view on Eastman Chemical Company (EMN - Free Report) , LyondellBasell Industries NV (LYB - Free Report) and Methanex Corp. (MEOH - Free Report) . It would also be a prudent choice to get rid of certain companies in the fertilizer/agricultural chemicals space that show weak fundamentals. Companies that fit the bill are CF Industries Holdings, Inc. (CF - Free Report) , Agrium Inc. AGU, CVR Partners, LP (UAN - Free Report) , Potash Corp. POT and The Mosaic Company (MOS - Free Report) .
(Check out our latest Chemical Industry Outlook for a more detailed discussion on the fundamental trends.)
Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report>>