LONDON (ICIS)--European chemicals firms have navigated through one of the most tumultuous six-month periods in modern history, with the economy starting to recover but normal conditions still far in the future.
The most recent private sector output data shows hints that the eurozone may be on track for a V-shaped recovery, but the speed of the rebound still hints at how sluggish the next phase may be.
Purchasing managers’ index (PMI) data for the manufacturing and service sectors show that activity in July rebounded substantially month on month, rising to 47.9 points, compared to 31.9 in May and 13.6 in April.
A reading below 50.0 points shows economic contraction, however.
Despite the speed of that acceleration, that fact remains that the eurozone manufacturing sector has been in contraction for 17 months, long before coronavirus, with industrial output at 47.9 in January even before the coronavirus outbreak had spread through Wuhan.
The implications of this are that Europe could see a V-shaped recovery where the apogee of the rebound remains below growth, a shift from a calamity to a common or garden recession.
Markets remain febrile, rising sharply during periods of relative calm in spite of a continuous flow of apocalyptic economic data, but taking fright at any signs that widespread lockdowns may be re-imposed.
Lawmakers are hoping that regional lockdowns
when contagion rates spike will reduce the
danger of being pushed to bring back national
restrictions, but the efficacy of localised
measures is untested, and any spread could push
the recovery into a saw-tooth formation of
peaks and troughs.
SUPPLY CHAIN DISRUPTION, END-MARKET CRASHES
Asian countries have largely kept a tighter control on infection rates than Europe or the US, partly a result of lessons learned in earlier SARS and MERS epidemics.
While chemicals supply chains are normalising in the region as business operations shift back to traditional patterns, conditions in Europe remain difficult.
“March and April were very challenging months, especially after many European countries had unilaterally decided to close down their borders,” said Dorothee Arns, director general of the European Association of Chemical Distributors (FECC).
“This led to domino effects, triggered shortages of transport possibilities and partly also packaging material – an additional stress test for anyhow strained supply chains in the absence of import possibilities from other continents and air freight alternatives.”
The impact of the downturn at end of the first quarter and through much of the second varied by end market, with the worst-hit firms exposed to commodity chemicals chains, as well as the automotive and aerospace sectors.
Some of that demand may never return; Belgium-headquartered chemicals major Solvay is to close two plants that produce materials for the aviation sector and shedding 20% of its composites workforce.
The International Energy Agency (IEA) projects that air traffic will fall 55% this year and take some time to rebound.
Other sectors such as packaging and medical goods have been more resilient, although the slowdown has weighed even on more robust sectors.
Aside from a few products such as isopropanol (IPA) where unprecedented demand has driven pricing to historic highs, the trend is slightly bearish even for the most resilient sectors, with Moody’s projecting a 5% fall in earnings for the consumer goods and medical application sectors.
Olefins, aromatics, and chlorvinyls producers are expected to be the worst-hit by the demand declines this year, with demand drops of up to 40% expected, while the average drop in earnings before interest, taxes, depreciation and amortisation (EBITDA) for the sector expected to be around 20% in 2020.
The second-quarter financial reporting season will gear up over the next few weeks, with the period expected to be the nadir of the crisis, depending on whether a fresh wave of coronavirus cases forces subsequent widespread lockdowns.
TRANSPARENCY IN A CRISIS
A profit warning by BASF last year took the markets by surprise and led to a sell-off across the sector, and the Germany-based chemicals giant has been more assiduous in signposting the extent of falls expected this time around.
The company initially guided for earnings before interest and taxes (EBIT) in the low triple-digit millions for the second quarter as the best-case scenario, which CEO Martin Brudermuller updated in June to a potential operating loss.
Covestro, another firm with significant exposure to weak end markets such as automotive and isocyanates, has also been pro-active in guiding markets on the impact it has experienced through the crisis, confirming a 30% overall drop in group core volumes in April and May.
While such disclosures are painful, guiding market expectations closely at a time when visibility is so opaque may be essential for a company to keep its stock from becoming radioactive, according to Baader Bank chemicals equity analyst Markus Mayer.
“I think several companies, including Covestro or BASF, already guided the market very well for Q2, and for a few companies in general, expectations are at such a level that there is not much downside risk,” he said.
Defensive stocks such as industrial gases firms are often used as a safe haven at times of investor uncertainty, but the extent of the downturn, plus the demand impact of widespread shutdowns through much of March and April in Europe, means that investors may have become complacent about shocks to share prices in that sector, according to Mayer.
BELT-TIGHTENING TO TIGHTEN
Companies have also moved to calm investors by locking down additional liquidity reserves and publicising the amount of cash and debt headroom they have to get through the worst of the downturn, as well as cutting costs.
Cost-cutting was also the order of the day during the 2008-2009 financial crisis, but that downturn – primarily a financial crash, rather than industrial – followed a period of widespread prosperity, whereas the years leading up to the 2020 crisis were also difficult, leaving companies with less of a cushion.
The focus on cost-cutting by many firms over the last decade to strengthen margins in the face of weak demand growth means that there may be little fat to trim, meaning that cutbacks may fall more on operations.
Looking at the patterns of previous downturns, this may lead to tighter supply for some chemicals, which could stand to provide some uplift in the years to come, according to Mayer.
“A potential positive of these capex [capital expenditure] cuts [by oil and gas as well as chemicals], looking at 2014-2015, is that the capex cuts resulted in one of the highest force majeure rates the sector had ever seen, meaning chemical value chains became tight," he said.
"We might see that afterwards; not this year, but in 2021-2022.”
WRITE-DOWNS TO COME, RE-FI COSTS
A wave of impairments could also be on the horizon, due to the level of multiple paid out for some acquisitions in recent years and the bearish growth prospects on the table for the next few years.
Some oil and gas firms have already slashed the value on tens of billions of dollars’ worth of assets based on revisions to price and refining margin expectations, and some chemicals players may be set to follow suit.
This could be exacerbated by rising refinancing costs, which could place pressure on recently-acquired assets purchased at levels that may now seem expensive, while the cost of debt for new acquisitions may also be creeping up.
“The refinancing cost spreads have exploded, they are now at levels seen in the financial crisis… So this is throwing many off in what previously had been interesting investment cases,” Mayer said.
“So far, from what I've heard, is that refinancing of existing assets is easier, but financing of new purchases is definitely not easy. This asset really has to have an interesting investment case and a very low valuation for it to become interesting to PE.
"For strategic buyers, a few still have M&A [mergers and acquisitions] firepower and are really communicating that they are willing to purchase, but only smaller assets,” added the analyst.
While chemicals markets seem to be stabilising, with sellers gradually regaining some of the ground surrendered in contract price negotiations, the second quarter results season is likely to be the worst period for players in the sector in a long time.
Demand levels are recovering from historic lows, but restocking activity remains subdued, according to analysts, meaning that the sector may be set to lag the general industrial sector in terms of a rebound.
Whether the sector recovery is an L to the eurozone’s V, the ‘new normal’ of the post-pandemic era is likely to bring subdued growth and unprecedented challenges for the sector for years to come.
A substantive rebound in chemicals could potentially not arrive until later in the year.
Front page picture: Paris' financial
district La Defense, archive image
Source: Pierre Stevenin/ZUMA Wire/Shutterstock
By Tom Brown