INSIGHT: Chemicals players count the cost of collapsing demand in key markets

LONDON (ICIS)–As the market impact on of the coronavirus outbreak continues to ripple through the financial system, chemicals players are starting to reckon with the impact on end markets.

Chemicals firms are currently digesting the impact of government-mandated shutdowns of non-essential businesses to encourage social quarantine measures, the closing of borders and the grounding of flights, as well as corporate decisions to shutter sites amid cratering demand.

The impact of some of the closures and demand drops are likely to take weeks to filter back up through supply chains to chemicals firms, but some signs are already starting to emerge of which end markets are likely to be the most disrupted.

The situation is volatile and fast-moving. Within the space a couple of days in mid-March, economist TS Lombard projected an 8% decline in US second-quarter GDP and investment bank Goldman Sachs forecast a 24% contraction.

A 16 percentage point swing between market observers for the GDP growth of a developed country is extremely unusual, and in normal times would raise eyebrows even for the worst points in Venezuela’s recent collapse. This underlines how dramatic the last few weeks have been, with a huge swathe of the world taking on the characteristics of a frontier market in free-fall.

Analysts at Belgium-based banking group ING dubbed the current situation a “virus-driven ice age”, in light of the stasis that citizens and multiple industries have been placed in, either by direct government action or by collapsing public demand.

The common expectation is for a U-shaped rather than V-shaped recovery, where the trough before the rebound is more protracted than in the case of a sudden sharp drop and recovery. A common point of comparison is the 2008-9 financial crisis, although it is necessary to go back a century to find data as grim as some of the figures emerging in recent weeks.

A key difference between the two crises is that the 2008 crash was largely a financial sector calamity, with demand rebounding as soon as banking industry liquidity issues stabilised, according to Lukac Janco, an analyst at ratings agency Moody’s, with the current situation much bleaker for the chemicals sector.

“In 2008-9 we had a banking crisis, not a real industrial crisis, which is why I think the chemicals sector recovered so quickly. There was a short-term shock but underlying product demand was okay, so once the banking system was taken care of, the chemical sector improved,” he said.

Players in the sector with the fiscal headroom have already started drawing down cash from their loans to help weather the storm and avoid being caught out if bank capital becomes more scarce later in the year, but more leveraged companies are in a significantly more precarious position.

“What we have seen so far is that many companies have pre-emptively drawn down their liquidity lines, not really because they need it yet, but more to be extra prudent in case things start to get worse and banks start to activate material adverse clauses,” Janco noted.

SECTOR IMPACT
The most visible impact so far has been in the automotive sector where demand, as seen in China earlier in the year, has fallen off a cliff, along with the aerospace industry and the hotel field. The automotive sector is the most crucial of those for the chemicals sector, with engineering plastic and rubber producers dependent on the space for a significant proportion of earnings.

With longer supply chains and more diffuse end markets, the extent of the impact on consumer and capital goods demand is slower to be felt but with retail businesses shut down across much of the world and e-commerce sites such as Amazon prioritising medical and essential goods, the disruption is set to be substantial.

“I would say we see slowing activity almost through the whole capital goods sector, along with everything consumer-related,” Janco said. “Colour chemicals, textile chemicals and leather chemicals should be impacted quickly impacted I guess, as well as for plastics, especially as a lot of plastics producers also have significant automotive exposure.”

Austria-based fibres specialist Lenzing has already thrown out its 2020 guidance due to expected dramatic impact on the textiles sector, which it is attempting to mitigate by shifting 35% of its production to non-woven applications.

The last couple of weeks has seen collapses in pricing for building block chemicals to an extent not seen in decades on the back of slumping demand and the oil price crash, and players with significant commoditised and cyclic chemicals exposure are likely to feel the pain, no matter how strong their market position.

“You could also see impact on cyclical companies such as parts of the INEOS group. INEOS built up some very strong companies with good cost positions but as a meaningful portion of its portfolio contains more commoditised chemicals, they are likely to see an impact, as will synthetic rubber players like Styrolution and Trinseo at some point,” Janco said.

The coatings sector is likely to be more resilient than plastics or fibres, but there are still likely to be particularly areas of demand slump there, such as the oil and gas and marine end markets, which may weigh on particular producers active in the space, Janco noted.

The traditional investor safe haven among chemicals stocks in recent years has been flavours, fragrances and ingredients, a space which  is likely to hold up relatively well in the downturn, but pharmaceutical, biocides and water treatment producers are likely to be among the strongest performers over the next several quarters.

A big question mark has been the construction sector, which has found itself in a hinterland between essential and non-essential industry, partially because at 9% of EU GDP shuttering the sector entirely would have a substantial impact.

Some European nations have moved to tighten restrictions on the sector and even in countries like the UK, where lawmakers have resisted calls to shut down the sector, new order volumes have shrunk to their lowest level since the crash.

There are also numerous macroeconomic shifts where the specific impact on particular chemicals is harder to gauge, but will indisputably have an effect, such as the extent of the rise in US jobless claims over the past two weeks, reaching over 10m and leaving the country’s unemployment rate potentially as high as 13%.

“The US job claims spiked… and we can’t draw a direct line from that to a precise impact on propylene demand, but things like that will dictate whether we see growth in H2 again,” Janco noted.

There are also likely to be acute issues that could have substantial impact on a more localised level, such as mandatory shutdowns in chemicals parks if the virus impacts on the active personnel levels for on-site fire brigades, a statutory requirement in many countries.

The outbreak also raises questions about the upcoming cracker turnaround season. So far refiners and chemicals producers have postponed turnarounds due to the difficulty in adding large numbers of people to a site. It remains to be seen whether the issue will have abated by summer.

DOWNGRADE ACTIVITY INTENSIFIES
The agency has already moved to downgrade some players or put them on watch, particularly those with automotive sector exposure. Covestro and BASF were placed on watch for downgrade, due to Covestro’s polycarbonates exposure and the fact that BASF still derives around a fifth of its revenues from the automotive sector.

Both players have strong polyurethanes operations, and pricing in that sector was expected to reach its nadir this year even before the spread of coronavirus to Europe.

The first chemicals firm to receive a full downgrade since the introduction of quarantine measures in Europe is Roehm, the former methacrylates business of Germany’s Evonik, now owned by buy-out house Advent International, due to its substantial coatings and automotive sector exposure.

Another difference between 2020 and 2008 is that, where the economy had been booming 12 years ago, companies are coming into the present crisis after 18 months of weak demand and extremely tepid expectations for GDP even before the virus spread across the world from Asia.

Some companies have also become accustomed to cheap debt finance that has been available in most of the years since the financial crisis, and those with heavy leverage and weak cashflows may find the next few months especially painful, according to Janco.

“So far the impact has been rather limited. For investment-grade companies, it’s obviously something which is not nice and will cause additional costs and delays but I think they can withstand that,” he said.

“It is more an issue for smaller companies or companies that are already quite levered up, because if you have weak end markets and at the same time problems with getting raw materials, then you are in not such a pleasant situation,” he added.

Insight by Tom Brown.