Chemical Industry Stock Outlook: August 2013

June quarter results continued to portray a persistently challenging economic backdrop in Europe along with slow economic activity in China, which weighed on demand for chemical products. These factors together with weaknesses across some key end-markets such as non-residential construction and electronics continued to squelch a meaningful recovery in the chemical industry.

While higher taxes from fiscal cliff and the impact of sequestration are weighing on domestic economic growth, the U.S. has been a bright spot in the quarter with signs of a revival in the housing market and improving consumer confidence. On the other hand, the European economy continued to contract and growth in China slowed in the second quarter.

While second-quarter results elicit signs of a recovery in the chemical industry, a material turnaround is not expected in the current quarter given the continued Eurozone problems. Nevertheless, the industry is expected to fare relatively better in the second half of 2013, aided by the gradual healing in the U.S. economy and hopes of a rebound in Chinese demand.

The chemical industry is expected to benefit from strength across emerging markets and a rise in shale gas production in the U.S. Strength across automotive and aerospace and a recovery in the housing market also augurs well for the industry in the second half and beyond.

Industry Dynamics

Chemicals are used to make consumer goods and are also used in the agriculture, manufacturing, construction and service industries. In fact, the chemical industry itself consumes 26% of its own output. Major industrial consumers include rubber and plastic, textiles, apparel, petroleum refining, pulp, paper and primary metals.

The chemical industry, a roughly $5 trillion global business, has grown at a brisk pace for more than five decades. The fastest-growing areas have involved the manufacture of synthetic organic polymers used as plastics, fibers and elastomers. The chemical industry is mainly concentrated in three areas of the world: Western Europe, North America and Japan. Europe is the largest producer, followed by the U.S. and Japan.

The U.S. chemical industry represents more than 15% of the global chemical output and employs nearly 800,000 people. It constitutes roughly 12% of the nation's exports, aggregating $187 billion annually. Roughly 5.5 million additional jobs are backed by the purchasing activity of the chemical industry. The U.S. chemical industry supports roughly 25% of the nation's gross domestic product (GDP).

The chemical industry is cyclical by nature and heavily linked to the overall condition of the U.S. and world economy. The Chemical industry also touches 96% of manufactured goods, making the manufacturing industry the biggest consumer of chemical products. The manufacturing sector serves as a barometer to gauge the overall health of the U.S. economy and is a major driver for the chemical industry. However, uneven manufacturing activity during first-half 2013 has led to softer demand for chemicals.

There are 170 major chemical companies in the U.S. operating internationally, with more than 2,800 facilities abroad. The chemical industry is among the biggest industries in the U.S., a roughly $770 billion enterprise. It has been consistently leading the U.S. economy's business cycles due to its early position in the supply chain.

According to chemical powerhouse BASF SE (BASFY), global chemical production (excluding pharmaceuticals) rose 2.6% in 2012, down from a 3.8% rise registered a year ago. The deceleration resulted from slower demand for chemical products compared with 2011, hindered by weak economic environment and subdued growth across a number of emerging markets.

Industry Rank

Within the Zacks Industry classification, the chemical industry falls under the broader Basic Materials sector (one of 16 Zacks sectors). We rank all of the more than 260 industries in the 16 Zacks sectors based on the earnings outlook for the constituent companies in each industry.

The way to look at the complete list of 260+ industries is that the outlook for the top one-third of the list (Zacks Industry Rank of #88 and lower) is positive, the middle 1/3rd or industries with Zacks Industry Rank between #89 and #176 is neutral while the outlook for the bottom one-third (Zacks Industry Rank #177 and higher) is negative.

We have four chemicals related industries: Chemical Plastics, Chemical Specialty, Chemical Diversified and Chemical Fibers. The Chemical Fibers industry currently retains a Zacks Industry Rank #119, placing it in the middle 1/3rd of the 260+ industry groups. The Chemical Specialty industry is featuring in the bottom one-third of all Zacks industries with a Zacks Industry Rank #181, followed by the Chemical Diversified industry with a Zacks Industry Rank #218 and Chemical Plastics with a Zacks Industry Rank #241.

Looking at the exact location of these industries, one could say that the general outlook for the chemicals space as a whole is leaning towards the negative side.

Sector Level Earnings Trends

Chemical industry falls under the broader Basic Material sector which is expected to have a 3% share of total earnings for the S&P 500 in 2013. The Basic Material sector had earnings beat ratio (the percentage of companies coming out with positive surprises) of 71.4% and revenue beat ratio of 19% in the first quarter.

Looking at the overall results of the Basic Material sector, earnings dipped 1.8% in the first quarter of 2013, a disappointing performance compared with the 13.2% rise in the previous quarter. Total revenue decreased 2.1% in the first quarter versus a 1.3% gain a quarter ago.

Based on the latest available information, 91.3% of the sector participants have already reported June quarter results with earnings and revenue beat ratios of 52.4% and 42.9%, respectively. Total earnings for the companies that have reported so far have shown a 12.1% year over year decline on a 1.6% fall in revenues.

Earnings for the Basic Material sector is expected to be down 11.9% in the second quarter while revenues are forecast to fall 2%, placing it among the laggards in a whole bunch of 16 sectors covered by Zacks.

For the third quarter, earnings are expected to inch up 0.5% and accelerate further by 13.6% in the fourth quarter. Revenues are expected to edge up 0.4% in the third quarter and fall 2.4% in the fourth quarter.

Key Feedstock Price Trends

The chemical industry uses oil, naphtha and natural gas as energy and feedstock inputs. BASF report states that the price of Brent crude oil averaged $112 a barrel in 2012 compared with $110 a barrel a year ago. Prices rose sharply at the beginning of 2012, stirred by the combined impact of higher demand and political unrest in the Middle East.

Brent crude, which hit a four-year high of $128 a barrel in Mar 2012, reached a nine-month high of $119 in Feb 2013, triggered by strong Chinese crude oil import data and geopolitical tension in the Middle East, exacerbated by Iran's nuclear program.

Brent crude prices eased to below $100 in April 2013 for the first time since July 2012 on weak demand outlook for oil. However, Brent topped $110 a barrel for the first time since April recently on upbeat U.S. manufacturing data for July and concerns over supply disruption in the Middle East and Africa.

The price of the other key raw material, naphtha, which is produced from oil, averaged $937 per metric ton in 2012 compared with $930 per metric ton in 2011. High crude prices kept the cost of naphtha elevated. Natural gas remains a bright spot on the feedstock front. The average annual price of natural gas in the U.S. dropped to $3 per million British thermal units (mmbtu) in 2012 from $4 mmbtu in 2011. In fact, natural gas spot price hit a ten-year low of $1.82 per mmbtu last April on a surge in supply.

Over the last 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. Shale gas is not only desirable for environmental reasons given its low carbon footprint relative to oil or coal, but is at the same time cost-effective. Natural gas price, which is currently hovering around $3.60 per mmbtu, is expected to remain depressed on shale-driven cheaper natural gas production.

Chemical Industry Poised for a Recovery

The European debt crisis, weak U.S. manufacturing along with sluggish activity in China and other key emerging markets led to weak demand for chemical products in 2012. While lingering crisis in Europe coupled with other industry-specific challenges continues to pose downside risks, the global chemical industry is poised for a recovery this year.

The American Chemistry Council (ACC), an industry trade group, foresees national chemical output (excluding pharma) to rise 1.9% in 2013 (following a 1.5% gain in 2012) and 2.3% in 2014. Strength across light vehicle and aerospace markets bodes well for the industry. U.S. chemical exports are expected to rise 4.7% this year (up from 1.8% in 2012) and 6.6% in 2014, leading to an expansion in trade surplus.

The trade group expects global chemical industry output to grow 4.3% in 2013 and 4.7% in 2014. Chemical makers in the emerging economies are expected to deliver a 7.5% production gain in 2013.

The ACC expects strong rise in capital spending in the coming years, stemming from new investments in petrochemicals and derivatives. Domestic chemical investment jumped 15.5% to around $38.1 billion in 2012. The ACC envisions capital spending to reach $64.5 billion by 2017. The shale gas boom is expected to drive investment on plants and equipment in the U.S. A rebound across emerging markets is expected to contribute to accelerated rise over the next several years.

BASF expects global chemical production to recover this year on the back of healthy gains in the emerging markets. It expects the U.S. chemical industry to benefit from lower gas prices. Asia is expected to show strong rise riding on strength across construction, electronics and automotive industries. However, output in Europe is expected to rise narrowly due to marginal gain in industrial production.

However, in a recent release, the European Chemical Industry Council (CEFIC) downwardly revised its production outlook for European chemicals citing tough economic conditions in the region and weak demand across automotive and construction markets.

CEFIC, which represents the European chemicals industry, now expects chemical output to contract 1% in 2013 (versus a modest increase of 0.5% expected earlier). European chemicals output declined 1.5% in 2012. However, the association expects European chemicals industry to return to a growth of 1.5% in 2014 on stabilization of industrial production in Europe and a modest uptick in exports.

OPPORTUNITIES

According to the ACC, emerging market growth and abundant shale gas should help drive U.S. chemical exports. A string of factors are driving growth in the export markets including favorable energy costs stemming from the abundance of shale gas and strong demand from the emerging markets.

Affordable natural gas and ethane (derived from shale gas) offer U.S. producers a compelling cost advantage over their global counterparts who use a more expensive, oil-based feedstock. New methods of extraction such as horizontal drilling and hydraulic fracturing are boosting shale production, bringing down prices of ethane in the process.

Leveraging the abundant natural gas supply and cost advantage, chemical companies are investing billions of dollars for setting up facilities (crackers) that produce ethylene from ethane. ACC report indicated that over 50 projects have been announced by the U.S. chemical makers (representing capital investment of more than $40 billion) to take advantage of ample natural gas supplies. Such investments are expected to boost capacity and export over the next several years.

Further, cost-cutting measures implemented by chemical companies including plant closures and headcount reduction should yield industry-wide margin improvements. Cash flows derived through these actions can be used for growth.

Mergers and acquisitions offer chemical companies another means to shore up growth in a still challenging economic scenario. These companies remain focused on exploring growth opportunities in the fast-growing emerging markets, particularly in the lucrative regions of Asia-Pacific and Latin (especially China and Brazil).

China is expected to see a recovery this year following a somewhat soft 2012. Government stimulus actions coupled with efforts to staunch inflation appears to bear fruit and exports to the U.S. and other key markets are regaining momentum. An improved demand outlook for China bodes well for the chemical industry in 2013.

Major chemical makers are increasingly focusing on businesses that cater to agriculture and nutrition markets in an effort to cut their exposure on other businesses (such as titanium pigment) that are grappling with weak demand and input costs pressure. In particular, agriculture is emerging as a lucrative market as evident from recent trends.

A healthy start in the North American growing season, strong planting activity by the growers across North and Latin America, solid order book and healthy supply of seeds and crop protection products represents the driving factors.

Chemical titan E.I. DuPont de Nemours & Co. (DD) is witnessing significant momentum in its agriculture business, driven by higher volume and market share gains in seed genetics and crop protection. Its Agriculture segment delivered healthy sales in the June quarter boosted by higher seed pricing. The company expects continued strong gain in agriculture in the second half driven by new products and strength in Latin America. DuPont should also benefit from synergies of Danisco acquisition and its aggressive restructuring actions.

U.S. chemical giant The Dow Chemical Company (DOW) saw its profit skyrocket in the June quarter on strength in its agriculture business, buoyed by higher demand for crop protection products. While Dow still faces challenges in Western Europe, it is benefiting from strong fundamentals in agriculture and food markets.

The company is also leveraging its North American feedstock advantage and its investments in the U.S. and Middle East are focused on boosting this advantage. A string of innovative products in its pipeline adds to its strength.

We have a bullish view on Eastman Chemical Company (EMN), which delivered better-than-expected results in the most recent quarter and is well placed to benefit from its Solutia acquisition. The company's diversified chemical portfolio and integrated and diverse downstream businesses represent the pillars of strength. It also benefits from business restructuring, cost-cutting measures and increased capacity additions.

We also have a favorable view on Air Products and Chemicals Inc. (APD). Strength across merchant and tonnage gases businesses coupled with acquisitions helped it to rake in healthy sales gain in the June quarter. Air Products benefits from a diverse customer base, pricing power and cost-reduction measures. New business deals and strategic investments are expected to support results this year. We are also encouraged by the incremental opportunities in liquefied natural gas (LNG) market.

In the specialty chemical space, PPG Industries Inc. (PPG) represents an attractive play. The company saw a healthy rise in profit in the June quarter on strong results from its coatings business and cost reduction initiatives. PPG Industries has a diversified base of products and markets, and looks to grow its businesses strategically along with controlling costs.

WEAKNESSES

Given the industry's sensitivity to the global economy, any negative current in the macro economy would be reflected in the prospects of the chemical companies. The turmoil in Europe and its impact on global growth remain sources of near-term uncertainty. Western Europe continues to pose challenges on chemical stocks due to weak demand and the nagging impact of debt crisis.

The U.S. housing sector, a key consumer of chemicals, has shown signs of recovery lately, manifested by rising housing starts, increase in building permits and a steady pick-up in home prices. However, demand from this industry remains way below the historic levels. In addition, weakness still persists in commercial construction and electronics, which are among the key end-markets.

Chemical companies generate a major chunk of their revenues outside the U.S., and therefore are exposed to foreign exchange fluctuations. Currency exchange translation remains a headwind for these companies.

Chemical makers may also face greater regulatory challenges. Environmentalists as well as different consumer and industry groups long argued that the existing Toxic Substances Control Act (TSCA), administered by the U.S. Environmental Protection Agency (EPA), is outdated and needs an overhaul. Sen. Frank Lautenberg along with other co-sponsors introduced the Safe Chemicals Act of 2013 in April 2013, which is geared to limit the use of toxic chemicals linked to a broad range of diseases and place the burden on chemical makers to prove that their chemicals are safe.

Commodity prices, though subsiding lately, still remain a concern for many of the U.S. chemical producers. Their ability to pass these costs on to end consumers is not always easy, given the competitive pressures at play. As a result, margins for a number of producers may continue to be under pressure.

Moreover, fertilizer and agricultural chemicals makers face significant challenges following the exit of world's largest potash maker Uralkali Group from one of the biggest potash cartels -- the Belarus Potash Company (BPC). Uralkali’s Board decided to end export sales through BPC and direct all potash export through its Switzerland-based trade arm Uralkali Trading.

BPC is one of the two largest cartels (along with North America’s Canpotex) that influence potash pricing by controlling the production and supply. Uralkali’s game-changing move has triggered industry-wide fear of a price war which may push potash prices down and put pressure on fertilizer makers.

Celanese Corp. (CE) put up a tepid second quarter with both revenues and earnings missing expectations. Celanese is witnessing weak demand and pricing in its core acetyl business. Moreover, it is exposed to raw material supply issues and currency headwinds and continues to face challenges in Europe. A weak demand scenario coupled with persistently challenging economic conditions may affect its results in the back half of 2013.

We also hold a bearish view on Methanex Corp. (MEOH). Restricted supply of natural gas continues to hurt its operations in Chile, Trinidad and Egypt, reflected by lower production in the June quarter. Methanex may continue to face headwinds due to curtailment of gas supply and constrained spending across its end markets.

Specialty chemical company Valspar Corporation (VAL) is faced with difficult market conditions and is seeing irregular demand trends across a number of end-markets. It continues to witness weak coatings demand for general industrial products. A soft demand environment across some overseas markets is weighing on Valspar’s earnings outlook.

We are wary about the prospects for companies in the agricultural chemical space in light of the recent Uralkali cartel exit event. Potash Corporation (POT) is struggling with weak potash pricing. It saw a double digit decline in average realized price of potash in the second quarter as competitive pressure pulled down contract and spot market prices. It cut its earnings forecast for the full year factoring in the price decline. Weak potash demand in India, a key market, and oversupply in the market is keeping potash prices under pressure.

Agricultural chemical company Agrium Inc. (AGU) is also exposed to similar headwinds. Cold weather conditions and pricing pressure led to a decline in its profit in the June quarter. Agrium remains challenged by a soft pricing environment and somewhat weak overseas demand for potash and phosphate. The global phosphate market is expected to remain weak in the near term, partly due to lower demand from India, a key phosphate import market.

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