The chemical industry is under pressure

Overcapacity will be most pronounced in the market for polyethylene (PE), a basic thermoplastic that is one of the most widely produced and traded petrochemicals in the world. The situation in the PE market mirrors that of several other major basic chemical products. By 2010, excess capacity in the global PE market is estimated to reach 17 million tons, or 15% of total world demand, according to estimates by consultancy Chemical Market Associates. By comparison, previous cyclical downturns in the PE market in 2002 and 1993 both saw a surplus of 7% of demand. Most importantly, this projection assumes that plant closures over the coming years will take 9 million tons of product out of the market--which has an estimated size of approximately 125 million tons--in order to reduce surplus capacity to more manageable levels by 2013. Most new plants are being built in the Middle East and China, and therefore plant closures will likely occur in North America, Europe, Japan, and Korea. Those plants that use naphtha (a form of heavy crude oil that is commonly used as feedstock in Southeast Asian petrochemical plants) could be closed first, since this input is typically more expensive than natural gas. However, shutting naphtha crackers can be difficult, as often they sit at the heart of petrochemical complexes and provide other useful byproducts in addition to ethylene. Furthermore, it can be exceedingly difficult to close facilities in Europe, where stringent labour laws can make layoffs relatively difficult.

At the heart of the wave of new capacity is the Middle East. Countries such as Saudi Arabia have been investing heavily in petrochemical assets in order to promote employment and find alternative uses for their massive energy reserves. Most countries in the region enjoy significant cost advantages due to the abundance of relatively cheap feedstock. In some cases this advantage is made larger by government guarantees on prices for natural gas and oil inputs. As a result of this massive amount of investment, the Middle East will soon dominate the export trade for ethylene. In 2008, the global trade for polyethylene amounted to net exports of 24 million tons, of which 8 million came from the Middle East. By 2013, it is estimated that total global net exports will increase to 28 million tons, and 17 million (or 60% of the total) will come from the region--in effect doubling the Middle East's market share.

China can't save the industry

China is currently the largest petrochemical importer in the world. The country is a huge consumer of three key plastics--polyethylene, polypropylene, and PVC. In total, it consumes 33 million metric tons of plastic per year--10 million tons of which are imported. But the country is also in the midst of building a significant amount of chemical capacity. Given its domestic build-out and the prospects for weaker demand (especially in light of fading export demand), we think that China will not be able to absorb a good portion of the new supply from the Middle East. Additionally, the latest Chinese stimulus package devotes $15 billion to upgrading refineries and building new petrochemical facilities in an effort to promote self-sufficiency. Much like the Middle East, the motivation behind building these plants is not entirely economic, but derives also from a desire to create local employment and self-sufficiency.

Both Sinopec and PetroChina, the national oil majors, are investing in a large amount of new chemical capacity. From now through 2012, it is estimated that over 21 million tons of new aromatics and plastics capacity will be added in China. This could result in China's plastic imports shrinking to 6 million tons per year by 2012, from 10 million tons now. Another factor contributing to the growth in Chinese supply is an effort to produce basic chemicals from coal. It's estimated that coal-to-olefins projects will result in 1.5 million additional tons of chemicals capacity by mid-2010.

Looking at these numbers, we think that it's clear that China will not be able to absorb an outsized share of the new supply coming from the Middle East, and basic chemical companies in the Western world need to focus on reducing costs and closing operations.

Who will survive?

There's no doubt that every chemical company has been affected by the financial crisis. Specialty chemical producers seem to have fared no better than commodity producers, although those companies that have exposure to agrochemicals are doing relatively well. There are many ways that companies are responding to these challenging conditions: squeezing working capital, cutting capital expenditures, shelving acquisition plans, and scaling back R&D. Many are considering divestments, but the market for chemical assets is very soft at the moment. Closures of plants are also being considered--and in some cases, like that of bankrupt petrochemical behemoth LyondellBassel, have been implemented--but these can be difficult to execute given the integration of many petrochemical complexes with refineries. In Europe, companies are faced with the additional challenge of labour laws that make reducing their workforces nearly impossible. Other companies are considering mergers, but in the wake of a massive round of consolidation within the industry it has become increasingly difficult to find valid business reasons to merge. Furthermore, some of those firms that made acquisitions are now struggling to stay afloat, making financing a merger or acquisition an ominous--and likely impossible--proposition.

While some firms may be headed for bankruptcy, that doesn't mean an automatic reduction in global capacity. In most instances of debt restructuring, the company and its assets survive, with shareholders and banks absorbing the losses. Many companies need new cash and have been getting it, and therefore might not necessarily idle or shut in plants. It's also unlikely that private equity firms will scoop up many assets soon. Private equity firms had until recently been active investors in the chemicals industry, but many funds are hurting under current conditions, where debt has become more expensive, multiples have collapsed, and institutions are exiting funds. The Middle East could continue to be a source of investment in Western chemical assets (as in the recent case of Nova Chemicals). Many sovereign funds are still flush with cash after the recent spike in oil prices and downstream integration is a key long-run strategic objective of many Middle Eastern nations.

All told, the chemical industry will undoubtedly survive, but it will ultimately look much different than it does today. The asset base will shift further east. Basic petrochemical production will be more focused in the Middle East, and specialty chemicals will continue to follow customers to their respective end markets. And if the industry can't coordinate a large cut in global capacity, it will take a long time for any of these companies to recover acceptable levels of profitability.

How companies in our coverage universe are responding

Dow Chemical has taken a two-pronged approach to shielding its profits from the world glut in commodity chemicals--simultaneously investing in assets in the Middle East and shifting its portfolio to more specialized products. Not only has it closed plants in the high-cost regions of North America and Europe, but it has also formed joint ventures with companies located in the Middle East, where petroleum inputs cost less and plants are closer to rapidly growing end markets, such as Southeast Asia. Dow has also made strides in diversifying away from basic chemicals and beefing up its portfolio of more customized chemicals and materials. These specialty products usually require a working relationship between producers and consumers, which can lead to sticky customer relationships and relatively stable profit margins. The acquisition of Rohm and Haas, an industry leader in many specialty products, will considerably advance Dow's ambitions in these end markets.

BASF SE has focused on increasing its operating efficiencies within its chemical assets and it has also managed to move further into the specialty chemicals space. The firm's suite of businesses is divided into six segments--chemicals, plastics, performance products, agricultural products, functional solutions, and oil and gas. These disparate segments often intersect at sites termed Verbund, the German word for network. BASF operates six of these sites around the globe, where production plants, energy and waste flows, and logistics are all integrated. This structure creates efficiencies by constructing long supply chains that start with basic chemicals and end with higher-value products such as crop-protection chemicals. Overall, this leads to above-average operating rates, reduced transportation costs, and minimal waste, all of which can save BASF cash. In addition, the company has grown its presence in specialty chemicals through the acquisitions. Its acquisition of Engelhard in 2006 gave BASF a leading position in the global catalyst market. BASF's acquisition of Swiss specialty chemicals maker Ciba, completed in the first quarter of 2009, will further expand its specialty chemicals portfolio. Furthermore, while there's little BASF can do about the coming flood of new chemicals capacity, its oil and gas business provides the firm with an enviable natural hedge against the threat of rising input costs.

Eastman Chemical. During the past several years, Eastman has implemented a restructuring process aimed at cutting exposure to commodity plastics. It was formerly the world's largest producer of polyethylene terephthalate, or PET, a plastic used to make beverage containers. Over the past few years, the firm has either closed or sold nearly all of its less competitive PET assets. By the end of 2009, more than 60% of Eastman's remaining PET production capacity will use the firm's proprietary Integrex technology, which will help it become more profitable, as Integrex dramatically reduces production and storage costs. Eastman has also made strides in diversifying away from traditional petrochemical feedstock. It has a large coal gasification facility that provides a portion of the feedstock to its US operations, and is currently investing in additional coal gasification capacity. As long as coal prices are lower than natural gas prices on an energy-equivalent basis, Eastman is able to enjoy a substantial cost advantage over many of its competitors.