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Slowdown: Financial Turmoil Fuels Industry Uncertainty
Softening consumer demand in Europe and the U.S., coupled with ongoing financial turmoil, have put the global economic recovery at a turning point. The economy is slowing but, while odds of a recession have increased, growth will likely stay mildly pos
5:42 PM MDT | October 10, 2011 | By VINCENT VALK
Senior chemical industry executives acknowledge that growth has decelerated since mid-year. “It is true that growth has come down a little bit, but the first half was very good,” says Kurt Bock, chairman of BASF. “For the time being, we are doing well. We are not downgrading our guidelines. Exports of goods from China are down a little but this is positive because it will avoid inflation.”
The debt crisis in the European Union (EU) and persistent unemployment, combined with falling consumer confidence in the U.S., have during the last few months made the global economic outlook far less certain. Emerging markets are likely to continue growing so the baseline scenario points to sluggish growth through next year, although a global recession cannot be ruled out completely, economists say.
Chemical executives are concerned about the uncertain outlook, but emphasize that demand has not fallen off a cliff the way it did during the 2008 financial crisis. “Slow growth of 1% or less in the U.S., and no growth in Europe is the base case for Dow over the next 12 months,” says Dow Chemical chairman and CEO Andrew Liveris. “What mitigates that for companies such as Dow is the growth economies of the Far East, South America, and Eastern Europe.” Higher-growth economies are not likely to be impacted by “contagion or what comes out of Europe,” he adds. “The issues in growth economies are more local. And the biggest one is what happens when China goes ‘hot’ and implements its own controls.” There are signs that China did tap the brakes on its economy in June, July, and August, but Liveris says that demand in China is bouncing back. “Our businesses in China are quite strong at the moment,” he says. China’s economic policy will likely remain focused on stimulating domestic demand. “And that is creating a global engine of growth that is not only powering China and the Far East, but also the Middle East and Africa given the investments China is making around the world,” Liveris says.
Economic growth is expected to be sluggish in the U.S., says Nariman Behravesh, chief economist at IHS Global Insight (Lexington, MA). IHS is the parent company of Chemical Week. Among major chemicals end markets, automotive demand is up in the U.S., although not by much, but electronics demand has declined and construction is “bouncing along the bottom,” Behravesh says. IHS Global Insight estimates there is a 40% chance of a new recession in the U.S. and says that a mild recession is likely in Europe.
Growth Still Positive
Cefic reverted last month to an earlier forecast of 2.5% for EU chemicals output growth in 2011, having raised its growth outlook to 4.5% as recently as June. EU chemicals output rose 0.8% in July, the month with the most recently available figures. U.S. chemicals output is expected to rise 4.1% this year and 3.5% next year, according to ACC’s most recent forecast. However, ACC’s U.S. chemical production regional index (CPRI) was flat in August and fell 0.5% in July. China, however, continues to power global chemical and industrial markets, even as exceptionally strong growth rates moderate. The China Petroleum and Chemical Industry Federation (CPCIF; Beijing) says that the value of chemical industry output in China increased 37% year-over-year through August, compared with the year-ago period, to Rmb4.2 trillion ($659.3 billion). Industrial production in China increased 13.5% year-over-year through August, down slightly from a 14% gain in July.
Industry executives see a disconnect between recent turmoil in financial markets and relatively robust fundamentals in the broader economy, “Generally, there is ‘wonderment’ about what the situation is,” Ben van Beurden, CEO of Shell Chemicals, says. “There is no economic crisis. It is a financial crisis but at some point this may affect the economy.”
“We had a crackling first 7-8 months of this year but there has been a softening in demand during the last month and a half,” says Sven Royall, v.p./global intermediates at Shell Chemicals. The softness “appears to be the result of lower demand for consumer durables,” Royall says. “This year is, in the mix, like 2010, which was a better-than-expected year. There’s no reason at this point to say that 2011 will be worse than 2010.” Demand in China, meanwhile, appears to be holding up. “There’s some evidence of softening in China and that’s to do with what’s happening in Europe and the impact on Chinese exports,” Royall says. “But China is still pretty strong and the domestic market is not slowing down.”
Some softening has come from inventory adjustments, producers and analysts say. Lower raw material and energy costs have encouraged destocking, says Mark Eramo, v.p./chemical industry research and analysis at IHS CMAI. “The level of caution is increasing, and producers and consumers are holding lower inventory and seeking to cut them further if they can.”
The sovereign debt crisis in the EU, particularly Greece, lies behind the threat of recession in Europe and the U.S. There is concern that Greece may default on its debt and possibly be forced to leave the euro zone, a development that would be Europe’s “Lehman moment,” Behravesh says, referring to the Lehman Brothers collapse that triggered the 2008 financial crisis. “It would bring about a big financial crunch in Europe, it would spread to Spain and Italy, and you’d see a huge credit crunch,” Behravesh says. That would lead to a deeper economic contraction in Europe than currently forecast.
There do appear to be some liquidity constraints emerging in Europe, Liveris says. “Whether we are facing a liquidity crisis will probably be revealed within the next few months,” he adds. Dow is carefully monitoring customers, and there are some isolated problems with liquidity in Europe caused by banks that are unwilling or unable to lend. Liveris expects any liquidity issues to be contained in Europe, however. “It’s not 2008-09 all over again because it’s not the U.S. banks this time, it’s the European banks,” he says. “The U.S. banks have taken their lumps and settled into the ‘new normal’ conditions. This is one reason why we view the U.S. as a modest growth scenario.”
Growth in Latin America is expected to remain robust, with some exceptions such as Venezuela. IHS Global Insight forecasts Brazil’s GDP growth to be 3.6% this year, down from 7.5% last year, mostly due to monetary tightening. However, Brazil is expected to rebound to 4.1% growth in 2012. Deceleration of growth across major emerging economies this year is the result of reduced exports to the U.S. and Europe rather than weak domestic markets. IHS Global Insight expects 9.2% GDP growth in China for this year, slowing to 8.3% next year.
Japan’s chemical industry has been resilient following the tragic March 11 earthquake and tsunami, aided by faster-than-expected recovery in key supply chains such as automotive and electronics. “So far we have not downgraded our expectations but we are concerned at what is happening on the financial markets, particularly in Europe,” says Kenji Fujiyoshi, chairman of Mitsui Chemicals. Japan’s ethylene production through July was essentially flat compared with the same 2010 period, says Masahiro Yoneyama, v.p./Japanese operations at IHS SRI Consulting (SRIC; Tokyo). Japan’s ethylene equivalent consumption through July was 9% higher than 2010. “Consumption is not back to 2008 pre-recession levels but is higher than 2010 and 2009,” Yoneyama says. A greater proportion of demand is being met by imports, however, as Japanese chemical makers cope with high feedstock costs and a strong yen. There is growing concern about the near-term outlook, he adds. “Global economic turmoil will affect Japanese export-oriented businesses. Exports will be stagnant because of a very strong yen and weaker demand of foreign countries.”
IHS Global Insight says there is a 25%-30% chance of a global recession, contingent mostly on the outcome of the EU sovereign debt crisis. The base case is for global GDP growth of 3% this year, and a slight increase to 3.4% next year.
Despite the hazy outlook and slowing growth, most chemical companies are not in panic mode. Eastman Chemical “is seeing a normal order book,” with expected seasonal variations, says CFO Curt Espeland. However, soft demand is showing up in some parts of the business. These include solvents in North America, and packaging and oxo-alcohol derivative products in Asia, Espeland says. Eastman is in the process of scenario planning for 2012, and the company is building a recessionary environment into its baseline projections for cost and capital spending, Espeland says. However, the move is primarily a hedge against economic uncertainty, and the company plans to increase investment in new products should more certain growth expectations resume.
At Dow Chemical, some business segments have seen slower growth in the second half, but the order book does not indicate a major economic shock, executives say. “The mood is not that great,” says Howard Ungerleider, senior v.p. and president/performance plastics at Dow. “But demand is better than the mood.”
Uncertainty is chemical companies’ main concern with demand patterns in the next few quarters hard to read, industry insiders say. “Visibility has gone down over the past couple of months,” says Barry Siadat, partner at SK Capital (New York), a private equity firm with an ownership stake in Ascend Performance Materials, the former nylon business of Solutia. “Our customers aren’t telling us what they expect and nobody really knows.”
“I see the worry level as cautious,” says Michael Sison, managing director at KeyBanc Capital Markets (Cleveland). “What I am hearing from companies is that we are not going to be in a recession, but a very low growth outlook.” Industrial gases, research chemicals, and flavors and fragrances are expected to maintain growth, he says. End markets facing the weakest demand will generally be those that are closest to the consumer, says Telly Zachariades, partner with The Valence Group. Chemical buyers may start drawing down inventories in response to the sluggish consumer demand outlook, he adds.
Most chemical companies agree that a return to 2008, when customers stopped buying and lived off inventories, sending chemical prices into a downward spiral, is highly unlikely. “The situation in 2008 was a pure economic shock,” Espeland says. “Financial and credit markets almost collapsed and you had much bigger inventory in the value chain so people hit the brakes hard.” The availability of credit has gone down, but highly rated companies can still tap the credit markets relatively easily.
Company balance sheets are also much healthier than three years ago—possibly the healthiest they have ever been. There are currently record levels of cash on corporate balance sheets, Behravesh says. Chemical companies, which built up massive amounts of cash during the economic upturn of 2010, partly by slashing inventories to cut working capital, are no exception. “The balance sheets for lots of companies, including customers, are much better,” Sison says. The chemical industry has also benefitted from a period of restructuring and capacity rationalization. Lower inventories also mean that a glut of chemical products is less likely. “Most companies say inventory levels are not as bloated as they were in 2008,” Sison says.
Margins, too, are higher, by 200-500 basis points this time around, Siadat says. Rising raw material prices since the start of 2011 are putting pressure on margins, but many companies have been able to pass higher costs on to customers. Volumes in chemical value chains fell 20%-30% once the crisis hit in 2008 as customers used up inventory, and that took a several quarters to work off, Sison says. Such a scenario is difficult to imagine today, industry leaders and analysts say.
M&A May Slow
The abrupt halt in M&A activity that accompanied the 2008 crisis is also unlikely to repeat itself, although a slowdown is probable, experts say. Chemical companies are continuing to pursue deals despite the uncertain economy and turbulent financial markets, Zachariades says. Auctions of chemical assets have frequently not gone well recently and companies have pulled assets off the market due to a lack of interest or because buyers were unwilling to meet sellers’ expectations on price, Siadat says. Directly negotiated deals, including some multibillion-dollar transactions, have been more successful. “I think directly negotiated deals with strategic interest will continue to occur,” Siadat says. But, unless sellers address expectations, auctions will continue to be difficult, he says.
The initial public offering (IPO) market has most likely shut down, for now. Evonik recently postponed a planned IPO until at least 2012. Some major U.S. chemical companies including Momentive and Styron filed for IPOs earlier this year, but experts say the IPO market window has closed. Neither Momentive nor Styron have disclosed the timing or size of their planned IPOs, which were announced in May and June, respectively. The weak IPO market reflects the weak stock market, and many industry leaders are concerned about the perceptions created there. “My biggest concern is that this will be self-fulfilling,” says Espeland. A simple lack of confidence can adversely impact consumers and businesses, he says. Perception may, at some point, become reality, but for now the industry is cautiously finding its way through the fog.