The only way is up?

18 March 2002 00:00  [Source: ICB]

With poor fourth quarter results across the board, an oversupplied market and plummeting demand, the petrochemical cycle 'peak' seems further away than ever. Joe Chang finds out the analysts' views on near- and long-term prospects for the industry

Those who pegged 1999 as the trough of the petrochemical cycle have had a rude awakening. Ravaged by deteriorating industrial demand, severe inventory reductions by customers towards the end of 2001, and record low operating rates, profitability has gone the way of the dodo for the North American petrochemicals industry.

Bloodbath! -major chemical companies' Q4 2001 results



Change,
Sales % Earnings*
Dow Chemical $6.3bn -12 -$12m vs $171m profit
DuPont $5.2bn -17 $124m vs $500m
Nova $654m -36 -$88m vs $39m profit
Lyondell $1.57bn -34 -$58m vs. $45m loss
Eastman Chemical $1.3bn -7 -$12m vs $52m profit
Solutia $643m -12 -$5m vs $12m profit
Methanex $195m -41 -$13m vs $65m profit


* Earnings exclude extraordinary items

Source: Companies

Following dismal fourth quarter 2001 results, no evidence of a turnaround in the first quarter, and the surprising lack of major plant closures in the midst of trough margins, the next peak of the cycle looks ever further from the horizon.

'The peak of the ethylene cycle has moved back by about one and a half years to mid-2005', says Lehman Brothers analyst Sergey Vasnetsov. 'Because of record low operating rates, the recovery towards the pricing power zone will take much longer than market expectations of a V-shaped recovery in the second half of 2002.' The analyst does not see improving ethylene/polyethylene cash margins until mid-2003.

'We do not expect a sustained rebound in ethylene chain earnings until mid- to late 2003, with a peak unlikely before 2004 to 2005, owing to a combination of global oversupply, weak demand and a continued erosion in the US export position,' says JP Morgan analyst Donald Carson.

'I am not expecting this year to be very good for petrochemicals', adds Merrill Lynch analyst Michael Judd. 'For 2002, we are looking for improved demand to lead to some inventory restocking on the part of customers, and in 2003 improving margins as demand soaks up additional capacity. I think it is really 2004 and 2005 when things will tighten up enough for a peak in petrochemicals.'

Wall Street's crystal ball -earnings/share*



2001 2002 Change,
eps eps (E) %
Dow Chemical $0.52 $1.19 +129%
DuPont $1.19 $1.58 +33%
Nova -$2.38 -$0.92 -
Lyondell -$0.84 -$0.30 -
Eastman $1.43 $1.76 +23%
Solutia $0.19 $0.62 +226%
Methanex $0.53 $0.00 -100%


* Excludes extraordinary items; (E) estimate

Source: First Call

Recovery?



While the industry looks forward to an eventual upturn in the cycle, there was little evidence of a recovery in fourth quarter 2001 conference calls. Dow Chemical missed its already lowered guidance that profits would come in between 10-20 cent/share in the fourth quarter by posting a $12m loss. Other major public petrochemical companies, such as Lyondell, Nova Chemicals, Methanex and Solutia, all posted losses in the quarter (see table page 24).

'Basically, we have seen pretty poor fourth quarter results across the board, a gloomy first quarter and first half outlook, and so far, no imminent signs of improvement, either on the demand or pricing side,' says Lehman Brothers' Vasnetsov. In January, ethylene cash margins turned down to 6.6 cent/lb versus 9.4 cent/lb in December, notes the analyst.

For the first quarter, Dow Chemical sees results similar to those of the fourth quarter. 'That is weaker than we thought', says Morgan Stanley analyst Les Ravitz. 'The price attrition in the basics segment is so great that even though they see some pickup in volume, the margins in the first quarter are not going to recover right away.'

'Given that typically the first quarter is stronger than the fourth quarter in volume, energy costs are still sliding down, and some companies are helped by the seasonal strength in agricultural chemicals, "similar to fourth quarter" really means that fundamentals continue to deteriorate', Lehman Brothers' Vasnetsov points out.

Anticipating an upturn



However, a number of companies are hoping for a recovery some time in the second half of 2002. 'We expect the business environment to remain challenging throughout the year - stable in the first half, with the potential for improvement in the second half,' said Dow Chemical's president and chief executive officer Michael Parker following fourth quarter 2001 results.

DuPont expects an inflection point in declining volumes to happen some time in 2002.

'The first half of 2002 is going to be down for most of the major chemical companies', says Deutsche Banc Alex. Brown analyst John Moten. 'The second half will probably be flat to modestly up.'

While January trends are improving slightly over December, 'the big debate in the industry right now is whether or not the type of strength we are seeing is simply inventory restocking or the beginning of a full-fledged recovery', says Moten. 'There is cautious optimism in the industry right now.'

While more diversified chemical companies like Dow, DuPont and Rohm and Haas anticipate a second half recovery, many of the pure play petrochemical firms are running their businesses as if no recovery will take place in 2002.

'We are waiting for the second half recovery that so many experts are predicting', says Nova Chemicals' president and chief executive officer Jeff Lipton. 'While we agree with that prediction, we just cannot count on it. We are running our business as if the conditions we saw in the fourth quarter will continue throughout 2002.'

This includes further slashing capital expenditures from $168m in 2001 to under $80m in 2002. Nova also plans to raise $300-400m in cash from non-operating sources in the first half, including the sale of additional non-strategic assets.

Huntsman Corporation is in the process of taking out around $150m in structural costs from Huntsman and its affiliated companies, while increasing cash flow by reducing working capital. In December 2001 and January 2002, Huntsman Corporation and Huntsman Polymers Corp defaulted on interest payments due on their bonds. The companies are currently in negotiations with their bondholders.

The bear case for the North American petrochemicals outlook has a lot to do with the current record low operating rates in the industry. 'The single best indicator of profit margins in petrochemicals is operating rates, and so far, both US ethylene and Dow Chemical operating rates are at record low levels - similar to where they were in 1982 and 1983, and well below the last trough in 1991,' says Vasnetsov.

In January 2002, the average US ethylene operating rate was a paltry 78.1% versus 87.4% at the 1991 trough, the analyst points out. Dow Chemical's total operating rate in January was 73% versus 83.2% in 1991. While petrochemicals demand is expected to pick up some time in 2002, the problem is that pricing power really does not become evident until operating rates get into the mid-90% range.

'If there is a general recovery in the industrial economy, which we would expect to happen fairly soon, volumes will pick up,' notes Merrill Lynch's Judd. 'However, given the capacity overhang and the low operating rates, producers may not get much pricing power. Until operating rates head up to around 90-93%, you do not really get a lot of pricing power.'

Hikes on the table



In an effort to stem the tide of falling prices, the industry has put price increases on the table for some downstream products such as polyethylene and polystyrene. However, there is little optimism that these increases will go through.

'I think this is more to stem the erosion in pricing,' says Deutsche Banc Alex. Brown's Moten. 'You are not going to get a price increase when the industry is operating at such low utilisation rates.'

'We believe the announced price increases, although badly needed, have no chance of being implemented due to very low operating rates in virtually every chemical sector,' Lehman Brothers' Vasnetsov says. The analyst points out that of the five major factors that favour a price increase - operating rates, volume demand, energy costs, customer inventories and producer inventories - only one factor (very low customer inventories) is positive.

If there is one positive in the petrochemicals industry to hang your hat on, it is the extremely low level of customer inventories. Fred Peterson, president of Millwood, New York-based consultancy Probe Economics, believes volumes could pick up so sharply in 2002 as to push operating rates up into that pricing power zone because of the low level of customer inventories.

'We think volumes are going to pick up sharply - much more sharply than anyone expected - because there has been a huge amount of inventory drawdown all the way downstream,' Peterson says.

However, others believe any resurgence in inventory rebuilding in the first half will be short-lived and not strong enough to push operating rates into the pricing power zone. 'While commodity plastics prices and volumes are likely to improve if converters restock inventories as end-user demand begins to improve with the economy, we expect any restocking to be short-lived, given the prospects for a sub-par economic recovery this year,' says JP Morgan's Carson.

Overcapacity



As the demand side of petrochemicals has been plagued by some of the worst conditions in history, the supply side has also been a thorn in the side of the industry - as always. Following the recent addition of two new world-scale crackers from Formosa (820 000 tonne/year) and BASF/Atofina (820 000 tonne/year), which adds about 4.5% of capacity to the North American ethylene market, the industry is looking ahead to the addition of 225 000 tonne/year of capacity from BP in Chocolate Bayou, Texas, in about October 2002, and 545 000 tonne/year from Shell Chemicals in Deer Park, Texas in July 2003.

Despite the obvious oversupply, and looming new supply, producers have been slow to shut down high cost plants. Plants that have closed at Chevron Phillips Chemical, Huntsman and Equistar represent only about 3.1% of North American ethylene capacity, while new plants or expansions going out to 2003 will add 7.1% to current capacity, according to Lehman Brothers' Vasnetsov.

Last November, Dow Chemical announced it would build a new olefins plant in Seadrift or Freeport, Texas, by 2005, resulting in the closure of two former Union Carbide plants at Seadrift and Texas City, Texas. The company says it could close the units earlier if it can find a favourable third-party supplier.

Those units have combined capacity of about 1.1m tonne/year. Many had expected Dow to announce it would shut down the plants immediately.

Compounding the oversupply problem are widespread expectations of an economic recovery in 2002. 'The reason that some companies are not shutting down is because they are expecting that with the recovery in the economy, volumes are going to turn up significantly and save them,' Lehman Brothers' Vasnetsov points out. 'My view is that for them to avoid the pain of shutting down, they must really see very strong upside volume to get the margin improvement they are waiting for, but I don't think that is likely to happen.'

While historically, much of the talk on the petrochemicals cycle has been on the supply side, demand - or the lack thereof, is gaining prominence in this cycle trough. 'I think supply is becoming less of a story in the commodity chemicals arena,' says Deutsche Banc Alex. Brown's Moten.

'It is all about demand now. Ethylene demand actually contracted in 2001, something the industry has not seen before. The crux of the issue in the second half is not so much about how much capacity will be brought on, but how quickly demand will come back.'

Consolidation



Despite significant consolidation in the North American petrochemicals industry over the years, encompassing Dow/Carbide, Exxon/ Mobil, Chevron/Phillips, Equistar (Lyondell, Millennium, OxyChem) and BP/Amoco, this trough has been one of the worst in history.

'While it is generally true that more consolidated industries tend to have less fluctuations and more decent returns across the cycle, it does not guarantee you will have healthy returns,' notes Lehman Brothers' Vasnetsov. 'Fundamentally, even if you have five players, if you have lousy supply/demand, you are going to have lousy margins.'

Near term, prospects for further consolidation in the North American petrochemicals industry appear limited because of antitrust concerns and a depressed market. Dow Chemical's $9bn acquisition of Union Carbide in February 2001 took 18 months to complete because of regulatory issues.

'It will be tough to get major consolidation in North American petrochemicals - partly because of antitrust issues, but also because not everyone is convinced consolidation has the benefits thought of before,' says Peter Young, president of New York-based investment bank Young & Partners.

'Because petrochemicals are a global business, consolidation in North America may not have the impact it once had. There is a lot of product out there being produced by other countries.'

The latest planned transaction announced last February, whereby Lyondell Chemical agreed to swap stock for Occidental Petroleum 29.5% stake in joint venture Equistar Chemicals, will have no impact on the market, since Lyondell management has been operating the joint venture all along. If the deal goes through, Lyondell will own 70.5% of Equistar, with Millennium Chemicals owning the remaining 29.5%.

Despite deteriorating market conditions and a weak profit outlook, a number of petrochemical company share prices have recovered strongly from their September lows, and are showing renewed strength coming off fourth quarter results. Merrill Lynch's Judd points out that the best time to buy chemical stocks during the last recession in 1990 to 1991 was about six months before the trough in industrial production. Held for 12 months, the return on the S&P Chemicals Index was 41%. Buying at the trough retur- ned 23%, and buying six months after the trough returned 6%.

'If you look at the economic data in January, it was only slightly negative', he points out. The ISM's (Institute for Supply Management, formerly known as the National Association of Purchasing Management) closely watched manufacturing index came in at 49.9 in January after being well below 50 for the past year and a half. Any number above 50 indicates expansion in the manufacturing sector, while under 50 indicates contraction.

Shortly after initiating coverage on the major chemicals group, Judd upgraded DuPont and Dow Chemical to 'strong buy' in December and early January, respectively. 'Once industrial production comes back, the stocks should begin to do better because the investment community will anticipate an improvement in earnings', he says.

'It seems that when things are really going great, everyone thinks it is going to go on forever. In the same vein, things are pretty bad now, and people think they will get worse or stay where they are forever, but they never really do.'

'We are bullish. In the first half, we think chemical equities will outperform the market,' says Morgan Stanley analyst Les Ravitz. 'My bet is that Wall Street will be raising its earnings estimates on the group before the end of the second quarter.' The analyst is partial to Eastman Chemical because of new management, restructuring and a cyclical recovery in earnings.

Lehman Brothers' Vasnetsov maintains his bearish stance, and sees no need to rush into petrochemical stocks at the moment. 'If an improvement in the ethylene industry is going to happen in the first quarter of 2003, then it is still a bit too early to buy'. He is partial to diversified chemicals company PPG Industries to play the potential rebound in the US economy.

Deutsche Banc Alex. Brown's Moten likewise says it may a bit too early to buy deep cyclical petrochemical stocks such as Lyondell and Nova Chemicals. 'The petrochemicals chain is going to be very difficult in the first half.'





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