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Volume 87 Issue 2 | pp. 12-14
Issue Date: January 12, 2009

Cover Stories: World Chemical Outlook

United States

Chemical industry mirrors larger economy, where a rebound will require home values to stabilize
Department: Business

THE U.S. ECONOMY is beginning 2009 in the teeth of a recession that started way back at the end of 2007. Within the chemical industry, companies as diverse as industrial gas maker Praxair and fertilizer producer Mosaic have warned of weak earnings in the fourth quarter of 2008 through the first quarter of this year.

Executives are wary of making predictions much beyond that. One reason is that they and their customers are ridding themselves of excess inventories and aren't sure how things will look after the destocking period.

In its end of the year forecast, the American Chemistry Council (ACC), the U.S. chemical industry's main trade organization, predicts that demand for U.S. chemicals will continue to weaken in 2009. ACC estimates that chemical output, excluding pharmaceuticals, will shrink by 3.6% in 2009. Pharmaceutical chemical production will increase by 1.9%, a slight improvement from 2008, when it edged up only 1.1%.

Although the output decline is enough to worry chemical executives, it is slightly less steep than during the 2001 recession, when output of chemicals excluding pharmaceuticals dropped by 6.9%.

Chemical firms have already begun to cut back on production because of softening consumer demand for housing, durable goods such as cars and appliances, and consumer goods including electronics. In 2009, ACC projects plant idlings and shutdowns will bring operating rates down to 75.0% from a recent high of 79.2% in 2007. Slowing production means companies will continue to cut payrolls. Overall, there will be a 3% drop in chemical employment this year, according to ACC.

Economists agree that a turnaround in demand for chemicals will hinge on factors outside of industry's control: home prices, consumer confidence, and a possible federal stimulus package. Given the outlook for the overall economy, however, ACC's projections seem optimistic.

"The deterioration in the capital markets has turned a 'slow motion' recession into one of the worst recessions in the post-war period," asserts Ethan S. Harris, an economist at Barclays Capital. To counteract the downward momentum, Harris expects a "full-court press from policymakers" including rate cuts by the Federal Reserve, regulatory action to pry open capital markets, and a $600 billion or larger stimulus package.

Adding to the cloudy conditions inside the chemical industry's crystal ball is the unpredictability of energy costs. In December, the price of a barrel of oil fell to less than $40, compared with a high of $147 in July. Volatile costs create havoc in the ability of chemical firms to set prices. Overall, however, fuel should cost less this year. The U.S. Energy Information Administration projects prices will average about $60 per bbl.

Early in 2008, the possibility of $60-per-bbl oil would have been happy news to chemical industry executives. They started the year railing against the high cost of energy and raw materials as they struggled to maintain profit margins. Even then, however, the months-long decline in housing values signaled that a new economic enemy was on the horizon.

In March, the subprime mortgage fiasco and resulting credit crisis nearly took down the U.S. financial industry. Chemical companies looked comparatively stable thanks to their strong balance sheets, although firms that supplied the U.S. housing and auto markets experienced sales declines.

During the first quarter of 2008, the chemical industry countered soft U.S. demand by selling in emerging markets. For example, DuPont had earnings growth of 19.5% compared with the year before, with 62% of its sales coming from outside the U.S. Companies that produced chemicals in the U.S. to sell overseas also benefited from the weak dollar. The currency exchange benefit, as high as 7% for some firms, went straight to the bottom line.

For most companies, earnings increased because strong international demand allowed them to raise prices. Overall, the producer price index for chemicals shot up 10.9% in 2008, almost three times the increase in 2007.

During the second and third quarters, however, the credit crisis that began with sinking U.S. home values infected the global financial system. In Europe, which is still a large market for U.S. chemical makers, Germany and the U.K. entered recessions.

Third-quarter chemical earnings were mixed because of the strength in the market for agricultural goods. But C&EN's earnings index for 24 companies showed a grim 8.7% drop when the results from fertilizer makers Terra Industries and Mosaic were removed.

Although companies won't report fourth-quarter results for a few weeks, expectations aren't high. "Trade had previously been the bright spot. Exports had been up by 10 to 12% early in the year but slowed in the summer and hit a wall in September," says T. Kevin Swift, chief economist at ACC.

Anticipating that the drop in demand would continue, chemical companies announced plant shutdowns and other cost-cutting moves late in the fourth quarter. For instance, Dow and DuPont announced restructurings and layoffs, as well as cutbacks in capital spending. Industrial gas makers Praxair and Air Products & Chemicals announced layoffs and operational slowdowns despite having posted earnings gains earlier in the year.

Even in the strong agricultural market, with grain inventories at historically low levels, fertilizer makers are cutting back production while farmers wait for prices to come down. "Like every other industry, agriculture has felt the impact of the global financial downturn," wrote PotashCorp Chief Executive Officer Bill Doyle in a December earnings warning. But he went on to promise better times in the new year. "Given the essential nature of our products ... we anticipate strong demand will return as 2009 progresses," he wrote.

During 2008, production fell in agriculture and most other chemical sectors. Government data show that U.S. output of the fertilizer feedstock ammonia slowed. Overall, agricultural chemical volume decreased about 3%.

The biggest U.S. production drop in 2008 was in basic organics, which decreased 13.4% from 2007 after three years of slow but steady increases. A significant portion of the difference in ethylene and propylene production was due to hurricane-related shutdowns on the U.S. Gulf Coast in the third quarter.

In 2008, overall chemical plant operating rates slipped 2.4% to an average of 76.8%. And December's announcements of U.S. plant shutdowns foreshadow a difficult year for workers in the chemical industry.

On Dec. 8, 2008, Dow announced it would eliminate 5,000 positions, or 11% of its workforce. Earlier that week, Chief Financial Officer Geoffery E. Merszei outlined the challenges facing Dow in a presentation at the Citi Chemicals Conference for investors. His observations for Dow, the largest U.S. chemical company, point to trends affecting the industry as a whole.

Demand dropped in late October, Merszei said, tracing the weakness to the broader economic slowdown. The credit crisis has prompted Dow's customers to begin to work from their current inventory. And with raw material prices dropping, purchasing managers are delaying orders in hopes of getting a better deal in the future. "We're seeing volumes drop significantly," Merszei said.

The impact of lower sales volumes could be long lasting, according to Merszei. "We're operating at our lowest capacity in over seven years, which means our fixed costs are increasing," he said. And it will take 60 to 180 days for lower fuel and raw material costs to work through Dow's inventory, he added. In the meantime, the downward pressure on prices has combined with lower volumes, resulting in a greater than 20% drop in sales revenue.

POSITIVE SIGNS for economic growth this year are difficult to find. According to a survey by the Institute for Supply Management, purchasing and supply executives for manufacturing firms "lack their usual optimism about their organizations' prospects, as they consider the first half of 2009; however, they are somewhat more positive about the second half," thanks to anticipated lower raw material prices.

Economists agree that business indicators will begin to improve only when housing values stabilize and consumer spending rebounds. But they differ on when that will be. "The sectors that went into recession first are also likely to be the first to recover. Thus, two of the most cyclical sectors—autos and home construction—are likely near their bottoms for this cycle," Barclays' Harris says.

Members of the National Association of Home Builders (NAHB) are not so optimistic. "We have seen no improvement over the past month in terms of sales conditions for new homes," said NAHB Chief Economist David A. Crowe in mid-December. "In fact, certain factors have gotten progressively worse, not the least of which is the job market, where massive layoffs are having a devastating effect on consumer confidence."

A December survey of NAHB members about home sale expectations for the next six months fell two points to an all-time low reading of 16—on a scale where a score of 50 marks the boundary between "good" and "poor."

And consumer spending has a long way to go to get back into positive territory. According to the Department of Commerce, the nation's economy contracted 0.5% in the third quarter of 2008 as measured by gross domestic product. Consumer spending decreased 3.8% in the same period, and spending on durable goods fell 14.8%.

For carmakers, the impact of restricted credit and declining consumer confidence has been dramatic. In November, North American auto sales fell to their lowest level, on a seasonally adjusted basis, in at least two decades, according to a report by consultants J. D. Power & Associates. Sales plunged from an annualized rate of just over 16 million per year at the end of 2007 to only 10.2 million in November, an unprecedented decline.

Also in November, the National Association for Business Economics (NABE) released a consensus of forecasts by 50 leading economists. The panel trimmed its expectations for gross domestic product growth in 2009 to just 0.7%, down from 2.2%, based heavily on a dimmer outlook for consumer spending. On a more positive note, more than 60% of the forecasters expect that the depth of the recession should be relatively contained, with a peak-to-trough decline in productivity of less than 1.5%.

Nearly three-fourths of NABE respondents think the recession could persist beyond the first quarter of 2009. And when the recovery comes, Barclays' Harris predicts, it will likely be slow and highly dependent on continued government action. "If the recovery is as weak as we believe," he says, "the Fed will keep its foot planted on the accelerator to ensure there is enough growth to eliminate economic slack."

 
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