The chemical industry comprises 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 services industries. The European Union and the U.S. house the world’s largest chemical companies.
The entire US chemical industry is broadly divided into four segments — basic chemicals, life sciences, specialty chemicals and consumer products. While most of the larger companies operate in one or more of these segments, specialized operators in niche segments are also numerous.
Of these, basic chemicals or commodity chemicals form the largest segment and includes products like polymers, petrochemicals, plastics and inorganic chemicals, as well as fertilizers. Polymers form the largest product category, generating the biggest chunk of revenue. It includes products like polyethylene, polyvinyl chloride, polypropylene and polystyrene. Petrochemicals such as propylene, benzene, methanol, ethylene oxide are the major raw material for polymer products.
Plastics are next in line, with application across several end-markets including packaging, home construction, containers, appliances, pipes and transportation. Synthetic rubber, dyes and pigments, resins, carbon black, explosives and rubber products are the other derivatives under the category. Inorganic chemicals include acids like phosphoric, nitric and sulfuric, as well as caustic soda, chlorine and soda ash. Phosphates, ammonia and potash chemicals form the fertilizers category.
Pharmaceuticals, diagnostics, biological substance, animal health products and crop protection chemicals including herbicides, insecticides and fungicides form the Life sciences segment.
Specialty chemicals cover industrial gases coatings, electronic chemicals, adhesives and sealants.
Consumer products include products such as soaps, detergents and cosmetics that are chemically produced.
We expect a slow recovery in global chemical production after a sharp decline in the last couple of years. The recovering global economy has resulted in improved demand for chemicals in several end markets. In North America, we expect chemical production to rise notably this year, however production levels are likely to remain below pre-recession levels. Chemical giant BASF is expecting about 10% growth in the US chemical industry on the back of rising demand for exports.
Given that the rate of recovery in demand is slow, chemical companies have had to resort to plant shutdowns and right sizing, resulting in meaningful improvements in their bottom lines. Aggressive cost cutting and production improvements should continue to help margins in the industry. Large cash flows, which should benefit from cost-cutting efforts and healthier balance sheets should support growth opportunities for chemical producers in the offing.
About 10% of chemical demand comes from the housing sector and another 10% from the auto sector. Rest of the chemical demand comes from the agriculture, architectural and industrial coatings, paper and textile, electronics and other industries. The chemical industry was particularly affected by weak industrial demand in the second half of 2008 and in 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.
However, the automotive industry has started showing signs of recovery while the housing sector continues to be sluggish. We expect automotive production to be higher in North America, though weakness is expected to persist in Europe. Growing emerging markets should propel production in the paper and textile industry while the electrical industry is expected to pick up with increased industrial investment. Other industries, including food and agriculture, are also likely to gain momentum with the recovering economy. The construction industry, however, is expected to remain weak.
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 input. Crude oil prices have shown an uptrend since the second half of 2009. Oil prices have now reached near 2008 levels, when prices were historically high. Naphtha prices also soared through 2009 and are expected to rise further.
U.S. natural gas prices declined in the first nine months of 2009, but moved slightly upward thereafter. According to the U.S. Energy Information Administration, average annual gas price in the US was around $4 per mbtu in 2009 and remained at the same level in the first half of 2010, considerably below 2008 prices. Natural gas prices are expected to remain weak in the near-to-medium term, positively impacting profits for North American chemical manufacturers.
The overall chemical industry is in consolidation mode, driven by the need for creating scale economies in operations and supply-chain management. Major chemical makers are expanding through mergers, acquisitions and joint ventures. While we can cite multiple examples from recent history, the more noteworthy cases are those of Dow Chemicals (DOW), Agrium (AGU) and CF Industries (CF).
Dow Chemicals is delivering cost synergies from its recent Rohm and Haas acquisition. 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 a global leader in the nitrogen fertilizer sector.
After a tough 2009, chemical producers remain cautious about capital expenditures. Aggressive cost cuts and superior technology have been key techniques employed by most chemical manufacturers. DuPont (DD), 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.
PPG Industries (PPG), a major global supplier of protective and decorative coatings, responded to the economic turmoil with aggressive restructuring and cost reduction measures, while further increasing its focus on cash flows.
Additionally, leading chemical companies are consolidating mature businesses and are moving to low-cost regions. Fertilizer companies such as Potash Corporation (POT) benefits from geographic diversification as nearly 60% of its total production is exported. Other chemical manufacturers, such as Eastman Chemical Company (EMN) are benefiting through diversification into downstream businesses that have helped boost revenue and margins.
Dow Chemical, DuPont, Agrium and CF have long-term Neutral recommendations while PPG Industries and Eastman have long-term Outperform recommendations.
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 be put down to the economic turmoil. The global economic meltdown led to weak industrial demand for chemicals, which led to under-utilization of production capacity, resulting in a dramatic fall in operating profits worldwide.
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. Chemical giant’s like DOW and DuPont have significant exposure to Europe with around 25% of their net sales coming from the region.
Weak residential and commercial construction demand especially affected companies engaged in paint and coatings. Revenues and margins for Sherwin-Williams (SHW), the largest US producer of paints and coatings, declined significantly in 2009. We do not foresee any significant momentum in earnings growth for SHW unless there is some substantial growth in macro trends.
Recently, we downgraded Valspar Corporation (VAL), the sixth largest paint and coatings manufacturer globally, to Neutral from our previous Outperform recommendation. The downgrade was driven by concerns over rising raw material costs and pricing pressures that are taking a toll on the company’s paint business.
Recessionary trends, coupled with inventory de-stocking led to a sharp drop in volumes in the activated carbon sector last year, affecting Calgon Carbon Corporation (CCC), a leader in the activated carbon sector, and Celanese Corporation (CE – Analyst Report), the global hybrid chemical company. A continuation of weak economic trends, particularly in the housing market, could hamper the growth of chemical makers.
Sherwin-Williams, Valspar, Celanese and Calgon Carbon have long-term Neutral recommendations.