Energy Costs Could Cause Trouble

I hope I'm wrong, but I'm a bit worried about the U.S. chemical industry. I admit that the industry is performing better than it has in the past three years. Production is finally increasing. Prices are soaring. Labor productivity is improving. Sales are showing solid gains, and earnings at most companies are jumping. And many chemical producers say there is a tight supply-and-demand balance, especially in petrochemicals.

Most producers have spent the past couple of years cutting costs, increasing efficiencies, closing underperforming and unprofitable plants, and cutting spending on items such as additions to new plants and equipment, which certainly weren't needed during the downturn, to improve cash flow.

The cuts have continued into this year. Dow Chemical implemented another restructuring in the second quarter, trimming its workforce by an additional 3,000 people. And although it has targeted $1.3 billion in capital spending in 2004, up from $1.1 billion last year, the company says it is not increasing plant capacity. One can only surmise that any spending on plants will go instead to cost efficiencies.

The result is a leaner chemical industry in the U.S., with much improved profitability.

So, if the industry is in good shape, what is there to worry about? Well, there are those pesky feedstock and energy costs. Dow's chief financial officer, J. Pedro Reinhard, in a second-quarter teleconference, said: "Dow spent more than $3.5 billion on feedstock and energy in the [second] quarter. That's a rise of over $600 million compared with the same quarter in 2003, and more than $200 million higher than in the first quarter of this year alone. Feedstock and energy costs remain a critical factor for the chemical industry, as well as for Dow."

However, there is a little good news here for the U.S. petrochemical industry. That is, while oil prices are flirting with $50 per barrel, abnormally high natural gas prices have been falling somewhat over the past couple of months. Some industry analysts are saying that the contraction in natural gas while oil prices rise is making the U.S. petrochemical industry, which uses mainly natural gas feedstocks, more competitive with Europe, where the industry is based mainly on oil.

The higher prices for basic chemicals, however, are putting a squeeze on many specialty chemical producers that use the upstream products as their own raw materials. This is the way it works: Higher prices mean higher costs for customers, who then try to pass them to their own customers, and so on.

Although the higher oil prices have had less effect on the U.S. chemical industry than did the volatility in natural gas prices over the past two years, oil prices could slow the economy, which then would have an effect on the chemical industry.

Standard & Poor's, the debt rating service, says in a report last month that, from a creditworthiness perspective, the industries that would be most negatively affected by a prolonged period of high oil prices would be the airline, automotive, and chemical sectors. Other industries, the report says, would be in a better position to mitigate any credit pressure by passing high fuel costs on to customers.

And this is why I worry about prices. The chemical industry has not been able to pass along the increases in oil costs, which have only added to its already high natural gas costs. Since July of last year, the price of West Texas intermediate crude oil has jumped some 46%, while the producer price index for all chemicals has risen 8%. The index for the sector most affected by higher petroleum and natural gas prices, basic organic chemicals, which includes upstream products such as ethylene, propylene, and benzene, among others, has risen 20%, less than half the increase for oil. Obviously, the increase in chemical profits is coming more from cutting costs than from rising prices, but the industry cannot go on shedding workers forever.

In addition, oil has contradictory effects on the economy. On one hand, the increasing price of oil contributes to inflation as it is passed down from producer to customer and, ultimately, to the consumer. On the other hand, a rapidly rising price will pull money from the economy, slowing growth. Standard & Poor's economist Beth Ann Bovino says, "We expect the rise in oil prices to their current levels to reduce consumer spending by about $50 billion."

The effect on the economy may already be taking place. Many analysts are blaming lackluster August sales growth at major retailers such as Wal-Mart and Target on lower consumer spending arising from higher gasoline prices.

The increase in oil and natural gas prices also comes at a time when the Federal Reserve Board has begun to raise interest rates in an attempt to forestall inflation. This is where I really worry. The two combined could slow the economy more than anyone wants--a situation that occurred in the late 1990s and prior to every recession since 1970. This could reverse the chemical supply-and-demand balance enough that chemical producers would have a hard time getting their price increases to stick while oil prices remain high, cutting profitability.