A chemical earnings supercycle may emerge

31 December 2010 00:00  [Source: ICB]

The outlook for the global chemical sector is positive, based on solid economic growth, led by emerging markets. Is the stage being set for a longer and stronger peak?

The global recovery in chemicals in 2010 is poised to shift into expansion mode in 2011, with further volume gains across the board.

A continuing economic recovery, driven by emerging markets, and tight supply/demand balances in major products, will boost profitability further in 2011, potentially leading into a "supercycle" in certain product and geographic areas.

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"We are now in an expansion, driven by emerging markets strength, while the US is still in recovery mode," says American Chemistry Council (ACC) chief economist Kevin Swift. Global chemical production volumes are expected to rise by 8.8% in 2010 versus a 3.3% decline in 2009, according to the ACC.

"As the global expansion continues, a 5.4% gain in global output is expected in 2011, and a 5.1% gain is expected in 2012," says Swift.

"During the next two years, the most rapid growth will occur in the emerging nations in Asia-Pacific, Africa and the Middle East, Emerging Europe and Latin America. Most notable are China, India and Brazil, but Korea, Singapore and Taiwan will present good growth prospects through 2012."

Emerging markets chemical production volumes are forecast to increase by 12.2% in 2010, 8.4% in 2011 and 7.7% in 2012, according to the ACC. US production volumes are expected to gain a more muted 3.1% in 2010, 3.0% in 2011 and 3.4% in 2012.

China will overtake the US as the largest market for chemicals in 2011 in terms of both consumption and production, predicts Swift. In 2009, the latest year for which statistics were available, the US led with $674.1bn (€509.1bn) in chemical shipments, followed by China at $635.3bn.

ECONOMIC EXPANSION
Global GDP is expected to rise by 3.0% in 2011 and another 3.4% in 2012, after an estimated 3.5% increase in 2010, with US GDP lagging at a projected 2.4% gain in 2011 and 2.8% boost in 2012, versus an estimated 2.7% gain in 2010, according to the ACC. Growth in Western Europe is expected to increase by 3.0% in 2011 and 2.7% in 2012.

"After the cyclical bounce of late 2009 and into 2010, a more sustainable pace of expanding activity is expected in 2011 and 2012," says Swift. "Concerns over a double-dip recession are fading. And with the strong recovery in industry profits, a new cycle of investment will soon emerge."

Laurence Alexander, analyst with US-based investment firm Jefferies & Co, also sees the US and European economies lagging.

"Our base case for next year is high single-digit GDP growth in the emerging markets, a sluggish 2-3% growth environment in North America with short restocking cycles, and 1-2% growth in Europe," says Alexander. "Margins could weaken year over year in some commodity chains, and raw materials will likely pressure specialty chemical margins in the first half of 2011."

SUPERCYCLE
Despite lagging economic growth in the US compared with emerging market regions, the US chemical sector could be on the verge of a "supercycle" based on cheap natural gas and limited new global capacity, according to Hassan Ahmed, partner and head of research at US-based Alembic Global Advisors.

"Despite a strong rally in shares of commodity chemical names in the US, we believe the market may still not be fully appreciating what we consider to be an imminent 'stronger for longer' supercycle, provided the current disconnect between crude oil and natural gas prices persists," says Ahmed.

"We are now in an expansion, driven by emerging markets strength, while the US is still in recovery mode" Kevin Swift Chief economist, American Chemistry Council

Globally set crude oil prices have been on an uptrend, rising to nearly $90/bbl as of early December, while US natural gas prices have fallen to around $4.30/MMBtu, largely because of new shale gas production. Low natural gas prices favor US petrochemical producers, as production is primarily based on natural-gas-liquid ethane versus oil-based naphtha for European and Asian producers.

"Our analysis shows that despite strong cash margins and earnings logged by US commodity chemical producers thus far in 2010, peak earnings could be over double the levels we saw in 2010 with a peak in the cycle as early as 2013," says Ahmed. "Additionally, stemming from the evolving capacity addition vacuum, we would expect the peak to be a long drawn-out one similar to the 1988-1989 peak, rather than the short amplitude and duration 1995 one."

The analyst sees a worldwide capacity vacuum post-2011 as "two of the main culprits behind the recent capacity addition flood - Qatar and Saudi Arabia - virtually stall adding capacity."

In addition, the Western trade sanctions against Iran will have an impact on shutting the country from export markets and preventing imports of materials essential for the production of petrochemicals and plastics, such as catalysts.

US EXPORT BOOM
US chemical exports are booming, forecast to rise by 16.8% in 2010 to $169.9bn, and another 9.7% in 2011 to $186.4bn, according to the ACC. This is projected to drive a level of chemical trade surplus not seen since 2000.

"Favorable dollar exchange rates, growth in emerging markets and abundant shale gas will drive US chemical exports," says Swift. "Shale gas is very much a game-changer for the US chemical industry and will be a major factor helping exports."

"We believe the market may still not be fully appreciating what we consider to be an imminent 'stronger for longer' supercycle" Hassan Ahmed Partner, Alembic Global Advisors

He expects the abundant supply of shale gas in the US to keep natural gas prices in the range of $3.50-4.00/MMBtu, making US petrochemical and polymer producers "very competitive with the rest of the world."

Because of the favorable oil-to-gas price ratio, which has recently been above 22:1, US thermoplastic exports are expected to rise by 15% in 2010, Swift points out. He notes there has historically been a close correlation between the oil-to-gas ratio and the level of US thermoplastic exports.

"US thermoplastic exports should increase further in 2011, but any boost in domestic demand could make a dent in exports as producers are already operating at around 95% capacity utilization," says Swift.

The ACC projects the overall rise in exports to result in a chemical trade surplus of $7.2bn in 2011 - up from an estimated $3.7bn in 2010, which would be the first surplus since the 2000 figure of $5.8bn.

Imports are expected to rise as well - by 7.8% to $179.2bn in 2011. Excluding pharmaceuticals, the US trade balance is expected to improve significantly to a projected $50.0bn in 2011 - up by an estimated 13.6% from 2010.

BULLISH FORECASTS
Wall Street expects a stellar earnings year in 2011 with profit improvements across the board (see table overleaf).

Chemical companies themselves have ratcheted up long-term profit forecasts. Where in 2009, none would dare to make long-term forecasts on earnings, late 2010 saw a number of companies rolling out ambitious profit targets for the coming years.

Netherlands-based chemical company LyondellBasell Industries held its first investor day in New York on December 8, 2010. While it did not offer any earnings guidance, CEO Jim Gallogly said he expected peak petrochemical market conditions coming up in three to four years. Gallogly and other senior executives also highlighted the company's cost advantage at its US facilities based on cheap and abundant shale gas.

"We think the [ethylene] upcycle is finally in place," said Bob Patel, senior vice president of olefins & polyolefins - Europe, Asia, International, at the meeting. Demand-side uncertainty had been replaced by a more positive trend, he suggested, with close to double-digit growth in Asia.

Wall Street analysts raised profit forecasts after the meeting.

"With a sustainable benefit from the ethane advantage, better refining margins and continued demand growth for ethylene and related products, we believe LyondellBasell's margins could see greater expansion than previously expected," said Frank Mitsch, analyst at US-based BB&T Capital Markets.

Mitsch raised his 2010 earnings per share (EPS) estimate on the company from $2.20 per share, to $2.30 per share, and his 2011 EPS forecast from $2.50 per share, to $2.65 per share. He also upped his share price target from $30 per share to $36 per share.

"LyondellBasell confirmed that [shale gas] is a 'real,' multiyear phenomena. Drill-to-earn provisions require continued fractionation, regardless of economics as part of the land leases," said Mitsch.

"Currently, ethane is in balance, but fractionation capacity is set to continue expanding - favorable for ethylene producers."

Alexander has raised his fourth-quarter EPS estimate on LyondellBasell by $0.10 per share, to $0.72 per share, bringing his 2010 forecast to $2.45. For 2011, he expects EPS of $2.65 per share.

At US-based chemical major DuPont's investor day on December 9, the company put forth EPS guidance of $3.30-3.60 per share for 2011 - up from an estimated $3.10 per share in 2010. Sales are expect to grow from an estimated $31bn in 2010 to $33bn-34bn in 2011.

Chair and CEO Ellen Kullman is targeting compounded annual EPS growth of about 12% through 2015 on 7% annual sales growth. She expects sales growth to be led by the electronics & communications (10-12%), safety & protection (8-10%) and agriculture & nutrition (8-10%) segments.

US-based Dow Chemical aims to achieve earnings per share (EPS) of $3.50-5.50 in the "near term," said chairman, president and CEO Andrew Liveris at the company's investor day at its headquarters in Midland, Michigan, US in November. However, he would not specify a time frame.

Wall Street consensus calls for Dow to earn $1.84 per share in 2010 and $2.45 per share in 2011. US-based chemical firm Solutia expects to post 2011 EPS of $2.00-2.25 per share - up from an estimated range of $1.40-1.50 per share in 2010.

Sales in 2011 are expected to rise to $2.1bn-2.2bn from around $1.9bn in 2010, while earnings before interest, tax, depreciation and amortization (EBITDA) are projected to jump to $560m-600m from $480m-500m in 2010.

In the longer term, chairman, president and CEO Jeffry Quinn says the portfolio has the potential to produce $3.5bn in revenue by 2015, while raising EBITDA to over $1bn.

The outlook is "very robust but achievable," said Quinn at the company's investor day in New York in November. Growth is expected to be driven by advanced interlayers made from polyvinyl butyral (PVB) and ethylene vinyl acetate (EVA) for solar and automotive applications, as well as polyethylene terephthalate (PET) performance films.

US-based specialty chemical firm Rockwood, a producer of specialty titanium dioxide, lithium compounds, advanced ceramics and surface treatment chemicals, is aiming to boost its earnings per share (EPS) by more than 20%/year through 2015.

The company is targeting average sales growth of around 8%, with organic growth accounting for 5% and bolt-on acquisitions about 3%, said chairman, president and CEO Seifi Ghasemi at the company's investor day in New York in November.

Paul Hodges looks past the headlines, at oil prices, economic growth and the environment in his economics blog.

By: Joseph Chang
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