07 April 1993 00:00 [Source: ICIS news]
Despite these structural problems, the clouds on the horizon as far as US producers are concerned clearly have more to do with the stance of the Clinton administration and its actions over the coming year as it attempts to tackle the budget deficit. The administration has some bold ideas and has shown an impressive determination to meet head on intractable problems which have been neglected for decades. The plans put forward thus far are, however, only partial, and it is this uncertainty which is causing so much unrest in the business community.
Also much of the cost of the reforms will be borne by business. Funds to finance the new programmes will be hard to find and the trend is to raise corporate taxes, franchises and energy taxes in order to do so. The reforms will also be highly inflationary leaving some to beg the question whether economic growth can be maintained before the cost of them proves overwhelming.
New levels of taxation were described as one of the three enemies to continued US growth by one of the industry speakers at NPRA, Mr Dexter Baker, the former chairman of Air Products, the others being excessive litigation and regulation. As far as the latter two topics are concerned, outside legal counsel, including that spent to handle Superfund suits, costs industry some $125 billion each year, some $50 billion more than the amount industry spends on research, Mr Baker stresses. Compliance with local, state and federal environmental legislation costs $80 billion and will rise to $100 billion by 1997.
Since the November elections, however, the issue of taxation has come to the fore as a major obstacle to continuing US industrial competitiveness from an international standpoint. Mr Baker suggests that federal taxes on work, capital and investment are the highest anywhere and that a sweeping overhaul of the entire taxation system is needed. Rather than see the prospects for moves in that direction, however, industry is now faced with a tax on the energy it consumes.
As proposed the Btu tax will be applied to the thermal energy content measured as British Thermal Units (Btus) of various energy sources such as coal, oil and natural gas. In many respects it is a tax designed to reduce energy consumption, bring some environmental improvement and lessen reliance on foreign energy supplies. It is, however, more widely recognised as a measure simply to raise tax revenues by more than $22 billion dollars when fully implemented in 1997 and help reduce the budget deficit.
As they stand the proposed levels of taxation are more heavily weighted towards oil and natural gas; both are important to the chemical industry in terms of its fuel and feedstock requirements. There will be feedstock exemptions and so-called 'exemptions for downstream credits' relating to exports although it is far from certain how particularly the latter considerations will be applied. Such broad based energy taxes also raise other problems that are unique to chemical producers.
The Chemical Manufacturers' Association (CMA) believes that with the feedstock exemptions contained in the current proposals, net energy costs would rise by $1.15 billion. International competitiveness would be damaged which in turn would depress productivity and potential output. By 2000, the negative effect on productivity and trade could depress output by 3% below what might have been expected, with the loss of 9900 jobs in the industry and 8300 jobs in other sectors.
Clearly, the main thrust of the proposals is to tax domestic energy consumption but the industry is concerned at the effect on its costs in regard to exports. It is certainly not clear how export credits might be applied to the thousands of products the industry handles. It is also right to question the proposed arrangements and any adjustments that might be made which could be contrary to the General Agreement on Tariffs and Trade (GATT) and the US-Canada Free Trade Agreement.
The industry is also uncertain as to how taxes might be applied to energy products such as liquid refinery gases or other hydrocarbons which are used as feedstocks and the co-products such as pyrolysis gasoline which are returned for credit to the oil refiner. These all vary as to the type of feedstock used but additional taxes in this area alone could amount to $115 million a year.
Each of these measures will impact on international competitiveness which has been eroded significantly over the past 10 years through tax increases and environmental costs which US producers feel their counterparts elsewhere in the world do not have to bear. Approximately $4.9 billion was spent on pollution abatement control in 1992 and during the 1990s spending is expected to double in real terms. The industry also pays a broad-based corporate environment tax and pays over $300 million each year in Superfund chemical feedstock taxes.
A consumer tax, along the lines of Europe's value addex tax, has been talked of as an alternative to many of the taxes on US industry but executives would do well to look more closely at the implications of VAT and the burdens it places on manufacturers before espousing its virtues too widely. There are good arguments against the Btu tax, which are having an impact as regards exemptions, but I find it difficult to believe that it will not be introduced in one form or another.
In such circumstances, producers will have to work even harder at improving productivity. Improvement has been disappointing for a decade, as Mr Teleki suggests, with an average increase of only 0.5%. However, years of investment in computerisation, training and moves to restructure do appear to be paying off. The rise last year was 2.6% and gains of 2.0% are expected for 1995 and 1996.
Despite the extremely poor conditions currently being experienced by European petrochemical and polymer producers there is a growing feeling that the bottom of the cycle has been reached, or if it has not it will be very soon. Losses by most producers in all the major polymers are at such a level that they do not look as though they can be sustained for much longer. The much needed action to tackle oversupply in the market place by one means or another does indeed look as though it is just around the corner.
Certainly there has been much talk of the need for rationalisation in European petrochemicals but little action apart from a few rearrangements of relatively minor significance. Companies are, however, considering steps to restructure their businesses in products such as polypropylene and these will bring productivity improvements in the longer term. The situation is such though that more drastic rationalisation measures may be on the cards.
Even if plant rationalisations are announced soon this is likely to be a particularly poor year for producers of olefins and the majority of the polyolefins. In the first quarter of the year, petrochemical industry profitability fell to its lowest level since the second quarter of 1981 and cash flow to its lowest annual rate since 1982. There may be some improvement in the second quarter, linked with maintenance shutdowns and higher plant occupancy, but prospects for the third quarter and the year as a whole are not bright, as was indicated by some of the delegates I spoke to at the NPRA meeting and the seminars preceding it.
None show any optimism for this year and point to the dramatic slump during the most recent two quarters. Chem Systems, for example, suggests that the average return on capital is now -7% and that operating rates are 79%. The all time low as far as return on investment is concerned was in the second quarter of 1981 when it fell to -8%. As I have mentioned before, operating rate has correlated well with profitability for more than 10 years although the first quarter of 1993 exhibits performance which is well below this trend and much worse than the position for 1992 as a whole.
Chem Systems' most recent analysis shows that most so called laggard producers of ethylene and intermediates, such styrene and phenol, are losing money and that profitability from the best plants is perhaps, not surprisingly, very low. As far as the major polymers are concerned, all laggard producers are in the red as well as the most efficient producers of linear low and high density polyethylene.
It is becoming more generally accepted, however, that action to combat the effects of capacity overhang downstream will have the most beneficial effect on both olefins and petrochemicals suppliers' fortunes over the next few years. Perhaps polymer marketers will be prepared, as Mr Peter Jordan, of De Witt, suggested at their seminar to eschew market share in favour of higher prices. If this were indeed the case, there could be higher prices all round which would bring an immediate profit improvement. Producers would not have to wait for the effects of any rationalisation steps to be felt.
Mr Jordan believes that it is wrong to view the highly complex West European ethylene market in simple terms of oversupply, or in other words, too much ethylene capacity chasing a limited market potential or too many suppliers chasing too few buyers. He makes the point that the volume of ethylene business that can be swung from one supplier to another is really quite small no matter how much ethylene capacity is perceived to be pressing on the market because of the supply agreements which bind buyers and sellers.
Cracker overcapacity makes itself felt primarily through derivatives and in these markets, which are suffering from significant over investment, buyers' discretionary tonnage is high. Ethylene buyers are concerned with ensuring that their derivatives are competitively priced. Perceived ethylene overcapacity, although not oversupply, merely serves to make their job easier.
The fact that both ethylene and most derivative prices are dismally low has more to do with the attitude of marketers than conditions in the market place. With capacity utilisation generally relatively high a small improvement in prices would benefit all. Ethylene buyers are often guided in their pricing objectives by marginal derivative economics and they are looking for a derivative price which wins market share from their competitors.
As soon as lower ethylene prices are settled at levels which are consistent with buyers' objectives then they begin to have an impact on the mainstream of derivatives pricing and a downward spiral begins. This fact is often denied among marketers but, as Mr Jordan says, is more generally accepted among polymers business managements.
If marketers were, therefore, to adopt a less aggressive approach to market share and stop demanding ethylene prices to support marginal sales economics there would be gains all round. Ethylene prices would become stronger and these would provide the basis for higher polymer prices. The volume of polymer sales would, of course, decline, imports would be encouraged and the volume of export sales could be less. This may, however, be an acceptable price to pay for the immediate prospect of an improvement in industry profitability.
Mr Jordan provided little information concerning regional supply and demand trends for ethylene during his presentation at the request of some of his industry contacts. Indeed, as he says, these would perhaps cause a great deal of unnecessary pain considering the present circumstances. Certainly, there is general agreement that the short term trends are depressing, as I have suggested. This is not to say, however, that there are not prospects for a considerable improvement in margins as demand begins to catch up with supply.
There is no doubt that Europe will remain a high cost producing region but the cyclical nature of the ethylene business suggests that margins should improve by the middle of the decade. In the view of Chem Systems operating rates will be in the high 80s by 1998 or 1999 at which time the most efficient producers will be making healthy returns once again. These could be substantial should the rate move over 90%.
While there may well be growth in the US economy of 4% this year, as suggested by Dr Robert Barbera of Shearson-Lehman, this rate of expansion will be insufficient to lift the economies of continental Europe from the mire of recession in 1993. As reported in issue 505, there is, particularly, growing disquiet over the economic circumstances in Germany. Since the start of the year there has been further deterioration both in private consumption and the industrial economy and the effect has been dramatic.
The recent round of annual press conferences in Germany has highlighted the significant decline in operating conditions and drawn attention to expectations for 1993. Certainly, there is little to be optimistic about and as Dr Jürgen Strube, chairman of BASF says, 1993 will be a year of recession. In western Europe it expects GNP growth of 0.5% at best and in western Germany a decline of 0.5% in real terms although this could be lifted to zero growth when forecasts for eastern Germany are taken into account.
Even these predictions could be on the high side if current operating conditions persist. In the first two months of the year, sales declined significantly with a collapse at BASF of 17% and at Hoechst of 15%. The unrelenting pressure on prices continues but this is coupled with an exceptionally low level of demand. For BASF, this is most apparent in plastics and agricultural products. At Hoechst the sharp fall in demand is being seen in most industrial sectors, agriculture and pharmaceuticals.
With no reliable signs of improvement, both companies intend to accelerate the steps they have been taking to reduce costs still further and to restructure where appropriate, although no drastic measures can be expected. Dr Strube says that his company is well equipped to handle extreme fluctuations in the economic cycle and, therefore, has no intention of restricting its portfolio by placing undue emphasis on less cyclical 'economically insensitive' areas.
BASF has, however, taken a more critical look at marginal areas over the past few years as the business slowdown has become more widely apparent. Divestments have included the Augusta Victoria coal mine, its infusion solution and medical supplies business and the structural materials operations. Meanwhile it has taken stronger positions in some areas with the acquisition of Mobil's polystyrene business and the polypropylene-polymethylmethacrylate portfolio swap with ICI.
The significant investments in the Midal and Stegal natural gas projects and the relationship with Gazprom are providing a new major business area which reduces dependence on more cyclical businesses. Acquisition of Agfa's magnetic media products was intended to improve earnings in this sector but this has clearly not been the case. There has been an unprecedented erosion of prices and losses in 1992 were more than DM 300 million ($185 million).
BASF is a European producer with a relatively unfavourable cost structure here and must make some difficult decisions if it is to succeed. Product differentiation has brought some relief but the aim has been to cut costs in the long term by reducing the workforce substantially and closing plants. These moves have been costly and the company has only been able to defend its position in some sectors. It feels the way forward now is to seek joint ventures or partnerships so that most can be gained from remaining manufacturing capacity.
Improved productivity has to be attained so that the impact of recession can be mitigated against. The divestitures since 1990 have resulted in a drop in sales of DM 2000 million and the number of jobs has been reduced by 10,000. Over the same period sales productivity has improved by 13%. The drive for improved productivity continues and numbers employed in Germany will be reduced further in 1993 but this is a costly exercise.
For BASF AG, the growth in productivity since 1990 is lower than that in unit labour costs because of sharp increases in the cost of wages and salaries. As a consequence of dwindling margins 77.2% of added value achieved last year was spent on personnel. In 1991 the similar proportion was only 72.9% so clearly the efficient deployment of staff has become a critical factor.
There is already some short-time working in Germany, some parts of the Knoll pharmaceuticals production site have been closed, and there are prospects for further job losses this year. Efforts are also being made to streamline operations where possible, an example of which is the concentrating of European computing into two centres from the previous 20. Bought-in services are being cut back as a short term measure to reduce costs.
BASF, of course, is not alone in taking such actions to improve the cost base and Dr Wolfgang Hilger, chairman of Hoechst, has described how his company is putting its efforts into restructuring and cost cutting. He says that there is no scope for manoeuvre on the profit side in Hoechst AG and that apart from strictly limiting expenditure the most urgent measure is to shut down plants which are making a loss and which have no hope of a return to profitability.
Staff reduction has become a painful reality for the German chemical industry as it has in other sectors, some of which are being hit even harder by the current recession. For Hoechst's German operations this has meant a reduction of some 4100 in the number employed in 1992 to a total of 81,000. About 2500 employees opted for early retirement in 1992 and an equivalent number are expected to do so this year, although Hoechst notes that staff reductions in the German affiliates and works will have to continue.
The extremely poor order situation has also meant that short-time working had to be introduced in Germany at the end of 1992 and this affected 3100 employees, mainly in fibres. In the current circumstances, the company has also opted for short-time working at a number of other plants so far this year, including those making converted films, paints and polyethylene, bringing the total towards the end of March to 3900. The process has not stopped there and beginning in April a further 500 employees working in PVC films are likely to be affected, as are more of the paints workforce.
Statistics released by Britain's Chemical Industries Association (CIA) not surprisingly show that companies spent less than might have been expected last year on new plant, machinery and equipment. Pressure on margins, reduced cash flow and lower demand, however, combined to force many to delay capital spending plans rather than abandon them entirely and several producers highlight the change in emphasis to maximise the efficiency of existing plant.
The latest figures from the association's investment intentions survey also indicate that capital investment authorisations fell back sharply between 1991 and 1992 by some £600 million ($900 million) which was $300 million worse than had been expected. The total for 1992 of $2300 million reflects the depth of the recession and the poor economic outlook but the suggested amount for this year, of $2900 million, does indicate growing confidence in the UK economy.
That confidence is also reflected in the survey when total fixed capital expenditure by the UK industry is considered. The decline last year was severe and of the order of 11% on a constant price basis. A further fall of 10% is expected this year, after allowing for inflation, but the trend in 1994 is expected to be upward when new investment is projected to rise by 16% in real terms.
The survey results this year are clouded to some extent by the use of official government statistics which makes comparison with earlier years difficult. The data indicate, however, that spending fell to $3300 million in 1992 and will fall further to $3000 million this year. Nevertheless, companies suggest that their spending in 1994 could reach a total of $3600 million.
As has been the case in the recent past, most expenditure will be made on pharmaceuticals and speciality products. The proportion of the total spent on petrochemicals continues to decline. Spending on environmental protection, although affected by the recession in 1992, is expected to climb sharply and the average annual rise between 1993 and 1995 could be as high as 22%.
Increased productivity, the floating pound and lower interest rates have put the chemical industry in a good competitive position but companies will need a climate of growing economic confidence if their investment plans are to be realised. In the view of the director general of the CIA, Mr John Cox, the kind of boost which is needed would come from early conclusion of the GATT Uruguay round and reductions in cost burdens, especially electricity prices.
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