While higher gas prices have put pressure on chemical companies, many still have prospered while others have developed strategies to mitigate exposure to the challenges related to current gas market trends, said Standard & Poor's in a new report.
"The recent run-up in prices...has not caused severe earnings shortfalls, highlighting the fact that most chemical companies can do reasonably well, or even prosper, in any raw material environment so long as supply and demand fundamentals support the ability to recoup costs from customers through price increases," said S&P analyst Kyle Loughlin in a report titled "Natural Gas Prices Keep The Heat On North American Chemicals Industry."
"This point is underscored by The Dow Chemical Co.'s (A-/Stable/A-2) 2005 results, as the company posted net income of $4.37 per share for the year, compared to $2.71 per share for 2004 (excluding unusual items) despite absorbing more than $4 billion in higher raw material and energy costs in 2005."
Nevertheless, the current run-up in gas prices remains "troublesome" for the chemical industry and is unlikely to subside soon, S&P noted. The American Chemistry Council has said that the U.S. has moved into a net import position in recent years. Low natural gas prices in the Middle East have led to the rapid development of basic petrochemical facilities there, creating greater competition for U.S. chemical companies. By the end of the decade, Middle East chemical producers will account for 20% of the global ethylene capacity.
"Fortunately, high natural gas prices are not insurmountable for the North American chemicals industry," said Loughlin. "The degree to which specific chemical companies or sectors of the industry are challenged, or even influenced, by higher natural gas prices ranges from modest to meaningful, depending upon a number of factors that impact a specific company's competitive dynamics."
Loughlin said longer range impacts are "somewhat speculative" at this point. Regional production costs will change and the supply-demand balance for individual products will "ultimately determine profits." Other factors that will influence future returns include a company's ability to differentiate products through technology or service, the extent to which gas-based products contributed to a company's overall portfolio, the level of energy intensity in the company's production process and the degree to which a chemical company is geographically diverse.
Many specialty chemical companies benefit from strong business models and technology or service capabilities that cannot be replicated by competitors, S&P said. "This is not to say that specialty chemical producers have not faced margin compression from high raw material costs, but rather to point out that these companies are well positioned to remain highly competitive even if natural gas prices remain elevated."
S&P listed 10 specialty chemical companies all which had profit margins greater than 13% in 2005: Dupont (17.7%), Sherwin-Williams (14.7%), Rohm & Haas (19.8%), Praxair (26.4%), Air Products (21.4%), Cytec (13.2%), Chemtura (13.4%), Lubrizol (14.8%), Valspar (13%) and Hercules (15.7%). Despite the solid profitability, S&P said there has been some "margin compression" over the past several years. But the causes have been diverse, including energy costs, fierce competition, customer migration and commoditization of technologies.
Companies likely to be most influenced by higher natural gas prices over the longer term will be commodity petrochemical producers, such as Nova Chemicals, Terra Industries and Westlake Chemical. These companies have business segments that contain ethylene chain chemicals, including commodity plastics, acetyls chain chemicals, styrenics, alpha olefins and vinyls. However, some companies in that group use relatively little natural gas-based raw materials, benefit from strong geographic diversity, have strong brand recognition or differentiated products. Many of the companies in this group enjoy strong profits today because of a tight supply and demand balance for their products.
"We view these companies as having the wherewithal to withstand cyclical downturns in their businesses although it is very likely that some of them could experience meaningful profit margin compression if high raw material prices were to coincide with another severe downturn in industry conditions," said Loughlin. "The vulnerabilities associated with this issue will not become fully apparent until the next cyclical downturn, as most of these companies have enjoyed strong results for the better part of the past two years."
S&P believes that many of the chemical companies have strategies in place that will continue to mitigate exposure to the challenges related to the current natural gas price trends.
"Those without a successful strategy and less feedstock flexibility to optimize their production economics may see long term prospects and credit quality diminish, while their peers gain further competitive advantages through geographic, product or technological investments." For more from the S&P report, contact Kyle Loughlin at (212) 438-7804.
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