Analysis: Chem stocks fall on concerns about pricing

15 April 2005 17:02  [Source: ICIS news]

NEW YORK (CNI)--After a huge run in 2004 and the early part of 2005, chemical stock prices are declining significantly on concerns about the loss of commodity pricing momentum, crude oil volatility and higher interest rates.


Most of Wall Street is maintaining its bullish stance on chem. stocks for now, viewing the pullback as temporary.


Stock prices are down from their March highs across the board for major and commodity chemical companies Dow Chemical (-17% to $46.83), DuPont (-11% to $48.69), Lyondell (-27% to $25.95), Nova (-28% to $37.70), Eastman (-10% to $55.77) and Georgia Gulf (-26% to $43.28).


"Commodity chemical shares have come under pressure in recent weeks as it has become apparent that polyethylene inventories grew substantially in the December to February timeframe," said Merrill Lynch analyst Donald Carson. "April polyethylene prices have started settling down 2 cents/pound and while certainly not unexpected given the buildup in inventories, concerns over further price erosion have led to this recent underperformance."


"Commodity-oriented major chemicals in North America continue to be hit by selling associated with a deceleration in price hikes, especially in the ethylene/polyethylene market, and by concerns with regard to a slowdown in the rate of growth," said CS First Boston analyst William Young.


"Many are concerned that high oil prices and interest rates will significantly eat into US economic expansion," added the analyst. "Moreover, other investors believe higher prices for basic chemicals and plastics will lead to demand destruction."


Prudential Financial analyst Andrew Rosenfeld recently downgraded Nova and Westlake from "overweight" to "underweight." He said: "Nova and Westlake have the highest exposure to polyethylene and its raw material ethylene."


"Our view for some time has been that there would be a bump in the road for commodity chemical producers on the way to the peak," Rosenfeld said. "We now believe this will occur in the second quarter as the vast majority of the new 2005 capacity begins to come on stream."


Temporary setback


Despite the weakness, most on Wall Street believe the setback will be temporary, with pricing and margins strengthening before long.


"We believe the near-term pressure could reflect producers attempting to accelerate how quickly they can work down inventory levels, setting the stage for tight conditions in May and June," said Deutsche Bank analyst David Begleiter.


"Despite this price erosion, it appears that PE producers have pulled back on production and that inventories at both the producer and converter level have likely started to draw down," said Merrill Lynch’s Carson. "With demand starting to pick up during this seasonally strong part of the year, we believe the key issue is how long it will take for improving demand to absorb excess capacity."


Banc of America Securities analyst Kevin McCarthy sees second quarter ethylene/polyethylene margins declining from first quarter levels, but then recovering by mid-year as inventory levels recede and Asian and domestic buyers resume normal buying patterns.


Prudential’s Rosenfeld continues to rate the chemical group "favorable." He added, "We believe the industry is entering a sustained period of improving underlying demand growth, leading to tighter supply-demand balances."


Higher chemical and resin prices are unlikely to destroy demand, according to CS First Boston’s Young. "The basic chemical or plastic resin comprises such a small part of the cost of consumer products that we envision no material impact on demand," Young said. For example, a 30 cent/pound increase in polyethylene resin costs would add less than 4 cents to the cost of making a 4 ounce plastic food container.


Broad pullback on macro factors


The pullback in chemical stock prices coincides with declines in other industrial sectors such as steel, paper and construction. US Steel is off 24% from its recent highs, while International Paper is off 18%.


The surge in interest rates since February has certainly not helped. The Federal Reserve Board continues to raise rates to keep a lid on potential inflation - moves which are aimed at slowing down the economy. Since February, the 10-year Treasury yield has risen from below 4% to a high of around 4.6% before pulling back to around 4.35%.


"We believe the key risk for the sector is that tightening monetary policy, coupled with supply shocks to energy prices, finally leads to a significant slowdown in demand," said Deutsche Bank’s Begleiter.


Poor earnings news and a massive restructuring effort at General Motors also put a damper on the entire industrial group.


Crude oil prices have been volatile, hitting a high of over $58/barrel in March and falling fast to around $50 as of mid last week. Natural gas futures have risen in past weeks from $6/m Btu to over $7.


Buying opportunity?


The widespread pullback in chemical stocks could offer opportunities for investors looking for an attractive entry point to play the cycle.


"The risk-reward has improved after recent bloodshed," said Banc of America’s McCarthy. "Dow, Westlake and Nova now appear more attractive after their declines from recent highs. Lyondell has suffered as well but remains our favourite ethylene name given its ability to crack heavier feedstocks."


"While the prospect of rising short-term interest rates, a flattening yield curve and slowing economic growth could keep a lid on chemical multiples over the next six to 12 months, we see room for a 10%-plus commodity chemical rally by mid-year as the market discounts tighter conditions in 2006, followed by a rally in specialty names as price initiatives finally start to drive margin expansion," said Deutsche Bank’s Begleiter.


Specialties pull through


The carnage in share prices has been more muted among the specialty group with Rohm & Haas down 9% from its highs to $45.37, Hercules down 9% to $14.19, and Cytec Industries off 7% to $50.55.


Specialty chemical firms stand to benefit from the weakness in commodity chemical prices.


"We suspect the specialty chemicals group could have a solid first quarter earnings season and would favour companies with leverage to the short-term break in rising raw materials and that have the capability of raising prices," said Michael Sison, analyst with KeyBanc/McDonald. He favours Rohm & Haas and Engelhard.


"We believe Rohm & Haas has the most leverage in our coverage list with raw materials moderating in the near term, and we suspect its price initiatives are gaining ground," Sison said. "Engelhard, via its chemical catalyst business, is highly leveraged to the improving profitability in the petrochemical sector, which is expected to remain strong and improve in 2005 and potentially 2006."


Sison noted that Rohm & Haas may have upside to his first quarter profit estimate of 66 cents/share.


"We hear that price increases in the specialty chemicals industry, particularly to the coatings sector, are gaining significant traction," said Sison. "We continue to hear from several in the industry that the environment to achieve pricing, predicated upon positive demand and tightening supply, is quite possibly the best seen over the last 10 to 20 years."

By: Joseph Chang
+1 713 525 2653

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