While chemical makers are poised to gain from strength across automotive and construction sectors, strategic growth measures and investment on capacity expansion, the industry remains saddled by a spate of challenges. There are a few reasons to be watchful about the chemical industry in the near term, which we have outlined below:
China Woes Continue
Economic cooling in China -- a major market for chemicals -- remains a deterrent over the short haul. 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 plagued by persistent industrial overcapacity, weak private investment, rising corporate debt and a flagging export sector. In particular, ballooning debt levels (manifested by rising debt to GDP ratio) and rapid credit expansion have raised a big red flag on the Chinese economy.
China’s GDP grew 6.7% in the third quarter of 2016, the same as what was witnessed in the second, 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 Continues to Sputter
The European economy is still not out of the woods, as evident from the paltry Eurozone GDP growth of 0.3% in the third quarter of 2016 (according to recently released data by Eurostat), same as in the second. While France (the Eurozone’s second-biggest economy) returned to growth in the quarter after contracting in the second due to disruptions from labor strikes, growth slowed in Germany -- the biggest economy in the bloc -- partly due to weak export activity. Political and economic uncertainties brought forth by Brexit and uncertainties surrounding the trade policies of U.S. President-elect Donald Trump are expected to weigh on sentiment in the Eurozone in the near term.
Sluggishness in some of Europe’s major economies continues to deter recovery of the chemical industry in that region. Moreover, weak investments and lower pricing remain as overhangs on the European chemical industry.
Still-Difficult Fertilizer/Agrichemical Space
Fertilizer and agricultural chemical companies are still grappling with a difficult pricing environment. Potash prices, which are already at their lowest levels in almost a decade, remain under pressure due to elevated supply. The potash market is expected to remain oversupplied in the near future, thereby weighing on 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 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 drop 11.5% to $71.5 billion in 2016, the lowest level since 2009. This would also mark the third straight year of decline. The USDA outlook reflects depressed prices resulting from excess supply of crops. Prices of major crops (such as corn and soybeans) remain at their multi-year lows.
The prevailing softness in agricultural commodity pricing is a concern for fertilizer and agricultural chemicals 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.
Insipid economic growth in certain key markets is also affecting demand for nutrients. 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.
Depressed Demand in the Energy Sector
A low oil price environment has been hindering investment in the energy sector, affecting demand for chemicals in this important end-use market. Depressed crude oil prices have also kept chemical prices under check as they essentially move in tandem with oil prices.
Oil prices hit a 12-year low of $26.21 per barrel in Feb 2016, hurt by a surge in the U.S. stockpile and prospects of weak demand. Notwithstanding a marked recovery since then, crude oil is still trading at levels that are well below the breakeven price for many oil and gas firms. This has forced several energy companies to cut spending on drilling activities in the face of shrinking profit margins. While the recently announced OPEC deal to cut output by 1.2 million barrels per day is expected to bring some stability to the oil market, strong North American supply and prospects of a potential increase in U.S. production amid rising oil rig counts could restrict any meaningful recovery in oil prices, at least in the short haul.
Pricing, FX 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 three quarters of 2016 and is expected to continue to be a drag on profits in the near term.
Stocks to Steer Clear Of
As you can see, there are a number of reasons to be cautious about the chemical industry. We hold a bearish view on Huntsman Corp. (HUN - Free Report) , Olin Corp. (OLN - Free Report) , Ashland Global Holdings Inc. (ASH - Free Report) and Kraton Corp. (KRA - Free Report) , each holding a Zacks Rank #5 (Strong Sell), as well as PPG Industries Inc. (PPG - Free Report) and Trinseo S.A. (TSE - Free Report) , both carrying a Zacks Rank #4 (Sell).
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) , carrying a Zacks Rank #5, and CVR Partners, LP (UAN - Free Report) , holding a Zacks Rank #4.
(Check out our latest Chemical Industry Outlook for a more detailed discussion on the fundamental trends.)
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