INSIGHT: Managing runaway commodity costs will never be easy

27 May 2011 15:35  [Source: ICIS news]

LONDON (ICIS)--Chemical Producers Enjoy High Commodity Prices and Runaway Demand From China is the title of a sector report released this week by Moody’s.

“The US and European chemicals industry will continue to grow over the next 12–18 months, although more slowly than in 2010,” the ratings agency says.

"Strong demand from Asia – especially China – and Latin America will sustain the industry's positive momentum, while chemical producers will also enjoy a high oil-price environment," senior credit officer Elena Nadtotchi adds.  

"BASF, Dow, AkzoNobel, Celanese, Syngenta and other companies selling heavily in the emerging markets will reap the greatest benefits during this period – as long as the growth of Chinese demand remains strong."

The high price of oil, and other commodities, is one thing and theoretically can be passed on in higher costs; but there are limits. And cost/price volatility is a curse.

Moody’s makes the point that the fortunes of  upstream commodity players will be driven by price as they strive to offset raw material cost increases, while specialties makers could suffer.

Gas feedstock cost advantages will benefit petrochemicals suppliers such as LyondellBasell, Chevron Phillips, INEOS, Westlake, NOVA Chemicals, Georgia Gulf and the diversified Dow Chemical.

Moody's expects US fertilizer producers such as Potash Corp, Mosaic, CF Industries and Agrium to outperform the segment given surging agricultural prices and low production costs.

Yet the risks remain high, particularly if the oil price tracks up enough to trigger emerging market inflation and damage consumer sentiment in the US and Europe.

The risk of stagflation in the EU is high; it is less so in the US, Not surprisingly, perhaps, Moody’s is concerned that “any increase in dividends or a return to share buybacks would also constrain the sector's positive credit momentum”.

The recent robust financial performance of sector companies has filled coffers and raised the appetite for rewarding shareholders. It has underpinned the return of a much higher level of merger and acquisition (M&A) activity.

But companies have to decide just how far they want to run with their ambitions and their largesse in this still relatively unstable market environment.

Recent swings in commodity prices expose current market fragility, never mind nervousness. The extent of China’s inflation problems loom large, as does the eurozone debt crisis and slower US economic growth.

Chemicals sector reports from Bernstein Research show that Europe’s industrial gases producers have not been able to pass on commodity cost inflation over the past six months, for instance.

Industrial gases prices have levelled out over the past two years while costs have increased at greater pace, senior analyst Jeremy Redenius says. The recent trend perhaps calls into question the pricing power that has been critical to Air Liquide and Linde, he suggests.

Over the three months to the beginning of May, commodity costs for chemicals rose 5% year on year. For manufacturing industry in general, of which chemicals is a major part, commodity input costs were up by about 15% in 2010.

Price increases of 6–10% were required merely to offset that inflation, the Bernstein analysis says.

Chemicals producers have come close to achieving that level of price increase.

Bernstein says that in the US the cost of energy, metals and chemicals over the three months to the start of May rose by 14%, 11% and 8% respectively, year on year. It has assessed the impact on downstream manufacturers.

“Plastics material and resin manufacturing has faced the steepest commodity cost headwinds, but has also benefited from the steepest pricing tailwinds,” it says. “Other communications equipment, on the other hand, has faced relatively steep commodity cost headwinds, but in one of the weakest pricing environments, with continuous deflation.”

It clearly depends on where you sit in the chain – and in what business.

Turning back to Europe, and the analysis which assesses the impact of commodity inflation in a constant other-cost environment, Bernstein estimates that the paints & coatings industry has been able to maintain prices since the economic downturn. This helped sector firms benefit from the sudden drop in input costs during the recesiion.

“However, costs have risen faster than prices, since paints & coatings manufacturers have struggled to pass on commodity cost inflation to their end consumers,” it says.

AkzoNobel, as an example, continued to experience gross margin pressure in the first quarter of 2011 in Europe and the US but is expected to enjoy some relief in the second quarter as price increases catch up. In crop protection chemicals, the research firm sees flat prices and increasing commodity costs.

The flat pricing is due in part to the price war in fungicides in 2010 caused by high inventory levels, it adds.

“The crop protection chemicals producers have said they do not expect commodity inflation to hit until 2012, due to currently high inventory levels. We calculate that to offset the rise in costs since 2010, the crop protection chemicals producers will need to increase prices by 5%, greater than the historical 0–2%."

Passing costs down the chain has never been easy and will never be so, although upstream producers in chemicals and plastics have achieved a great deal since the downturn and retained significant pricing power.

Petrochemicals producers saw the most significant commodity cost impact of 14% in the three months to the middle of April, according to Bernstein Research, but were able to agree price increases approaching 7% to offset that inflation within about a month.

Retaining this position, however, depends on how well individual businesses are managed, particularly inventories and other costs.

It also depends on how well others manage theirs and how closely supply is matched to demand.

Read Paul Hodges’ Chemicals and the Economy blog

By: Nigel Davis
+44 20 8652 3214

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