Chemical Industry Stock Outlook - April 2014 - Zacks Analyst Interviews

The chemical industry had a bumpy ride in 2013 as a weak European economy, effects of sequestration in the U.S. along with certain industry-specific challenges led to subdued demand for chemicals for most of the year. Nevertheless, the December quarter showed signs of life with improving trends across key industries, raising hopes of a recovery.

Although the quarter showed continued recovery across commercial construction and electronics end-markets, the industry is not out of the woods. Questions about the emerging markets and a still-challenging economic backdrop in Europe remain roadblocks. But the industry is expected to fare relatively better in 2014, aided by a shale gas boom in the U.S., healthy Chinese demand and significant capital investment.

Chemical makers are ratcheting up investment on shale gas-linked projects to take advantage of ample natural gas supplies which is expected to boost capacity and export in 2014 and beyond.

Strength across agriculture and automotive markets and healthy demand in emerging geographies represent tailwinds for the industry. Strong agricultural market fundamentals in Latin America and a gradual revival in the housing market bode well for recovery prospects this year.

Chemicals are used to make consumer goods and are also used in the agriculture, manufacturing, construction and service industries. In fact, the chemical industry -- a roughly $5 trillion global business -- itself consumes 26% of its own output. Major industrial consumers include rubber and plastic, textiles, apparel, petroleum refining, pulp, paper and primary metals.

The chemical industry is among the biggest industries in the U.S., a roughly $770 billion enterprise. It is cyclical by nature and heavily linked to the overall condition of the U.S. and world economies. The chemical industry touches 96% of manufactured goods, making the manufacturing industry the biggest consumer of chemical products.

The U.S. chemical industry represents more than 15% of the global chemical output and employs nearly 800,000 people. It constitutes roughly 12% of the nation's exports, aggregating $188 billion annually. Roughly 6 million additional jobs are backed by the purchasing activity of the chemical industry. The U.S. chemical industry supports around 25% of the nation's gross domestic product

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Within the Zacks Industry classification, the chemical industry falls under the broader Basic Materials sector (one of 16 Zacks sectors) which had a 3.1% share of total earnings for the S&P 500 in 2013. We rank all of the more than 260 industries in the 16 Zacks sectors based on the earnings outlook for the constituent companies in each industry. To learn more visit:

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The way to look at the complete list of 260+ industries is that the outlook for the top one-third of the list (Zacks Industry Rank of #88 and

lower) is positive, the middle 1/3rd or industries with Zacks Industry Rank between #89 and #176 is neutral while the outlook for the bottom one-third (Zacks Industry Rank #177 and higher) is negative.

We have three chemicals related industries: Chemical Plastics, Chemical Diversified and Chemical Specialty. The Chemical Plastics industry currently retains a Zacks Industry Rank #10, placing it in the top 1/3rd of the 260+ industry groups. Both Chemical Diversified and Chemical Specialty industries lie in the middle one-third with a Zacks Industry Rank #164 and #172, respectively.

Looking at the exact location of these industries, one could say that the general outlook for the chemical industry as a whole is positive-to-neutral.

Looking at the overall results of the broader Basic Materials sector, earnings shot up 20.7% in the fourth-quarter 2013, due mostly to easy comparisons -- a marked improvement from a 2.2% rise in the third. Total revenues were up 1.5% in the fourth quarter versus a 1.1% rise a quarter ago. The sector racked up an earnings beat ratio (the percentage of companies coming out with positive surprises) of 66.7% and revenue beat ratio of 54.2% in the fourth quarter.

The earnings picture for the first quarter shows broad-based weakness. Basic Materials is among the major sectors that are expected to witness a decline in earnings in the first quarter, with an expected 2.5% fall in earnings. Revenues, however, are forecast to move up 2% in the quarter.

For 2014, earnings are expected to show a 9.8% increase. Revenues are forecast to expand 2.4%.

For more details about earnings for this sector and others, please read our latest '

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The chemical industry uses oil, naphtha and natural gas as energy and feedstock inputs. According to chemical giant BASF SE (BASFY), the price of Brent crude oil averaged $109 per barrel in 2013, below 2012 average of $112.

Brent crude prices touched a nine-month high of $119 in Feb 2013, triggered by geopolitical tension in the Middle East, exacerbated by Iran's nuclear program. Prices eased to below $100 in Apr 2013 on weak demand outlook for oil. Brent crude has hovered between a high of $112 and a low of $104 so far this year, averaging at around $108.

The price of the other key raw material, naphtha, which is produced from oil, ranged between $985 per metric ton and $820 per metric ton in 2013, based on the BASF report. Naphtha prices averaged $902 last year, lower than the 2012 average of $937. The average annual price of natural gas in the U.S. was $3.73 per million British thermal units (mmbtu) in 2013, higher than $2.75 in 2012.

The chemical industry is poised for a recovery this year and the next. The American Chemistry Council

, an industry trade group, foresees national chemical output (excluding pharma) to rise 2.5% in 2014 (up from a 1.6% increase in 2013) and further improve to a 3.5% gain next year. Growth will be backed by strong agricultural market fundamentals, healthy demand from light vehicles market and a recovery in the housing market manifested by increase in building permits and a steady pick-up in home prices.

U.S. chemical exports are expected to rise 6.6% this year and 7.6% in 2015, leading to continued generation of trade surplus. Trade in chemicals is expected to rise with a recovery in global manufacturing activities.

On the global front, ACC sees production to move up 3.8% in 2014 and 4.1% in 2015 with healthy gains expected across North America and emerging markets.

The ACC expects strong capital spending in the coming years, stemming from new investments in petrochemicals and derivatives. It envisions U.S.

capital spending to reach $61.2 billion by 2018.

The shale gas boom is expected to drive investment on plants and equipment in the U.S. The ACC expects U.S. chemical revenues to surpass $1 trillion and the industry to rake in record trade surpluses by 2018, partly boosted by significant share gas-driven chemical capacity.

According to the European Chemical Industry Council (CEFIC), which represents the European chemicals industry, chemical output was flat year over year in Europe in 2013, modestly better than an expected 0.5% decline. Weak demand across automotive and construction markets remain as overhang, contributing to fragile recovery. Nevertheless, CEFIC expects recovery in the European chemicals industry to continue at a sluggish pace and sees a 1% rise in output in 2014, aided by an uptick in exports.

According to the ACC, emerging market growth and favorable oil-to-gas price ratios resulting from abundant shale gas production are driving U.S.

chemical exports. A string of factors are driving growth in the export markets, including favorable energy costs stemming from the abundance of shale gas and healthy demand from the emerging markets.

Affordable natural gas and ethane (derived from shale gas) offer U.S. producers a compelling cost advantage over their global counterparts who use a more expensive, oil-based feedstock. New methods of extraction such as horizontal drilling and hydraulic fracturing are boosting shale production, bringing down prices of ethane in the process.

Leveraging the abundant natural gas supply and cost advantage, chemical companies are investing billions of dollars for setting up facilities

(crackers) that produce ethylene from ethane. The U.S. has emerged as an attractive investment location and chemical makers are aggressively expanding capacity in the country.

A recent ACC report indicated that potential domestic chemical investment related to share gas has reached as high as $100 billion, more than 50% of which are from firms outside of the U.S. Already 148 projects -- backed by Federal government support -- have been announced by chemical makers to take advantage of ample natural gas supplies.

These projects may lead to $81 billion in new chemical industry output annually and 637,000 permanent new jobs by 2023. Such investments are expected to boost capacity and export over the next several years.

Major chemical makers are increasingly shifting focus on businesses that cater to agriculture and nutrition markets in an effort to cut their exposure on other businesses that are grappling with weak demand and input costs pressure. In particular, agriculture is emerging as a lucrative market as evident from recent trends.

A healthy start in the North American growing season, strong planting activity by growers across North and Latin America, solid order book and healthy supply of seeds and crop protection products represent driving factors.

Mergers and acquisitions offer chemical companies another means to shore up growth in a still challenging economic scenario. These companies remain focused on exploring growth opportunities in the fast-growing emerging markets, particularly in the lucrative regions of Asia-Pacific and Latin America.

Moreover, cost-cutting measures implemented by chemical companies including plant closures and headcount reduction should yield industry-wide margin improvements. Cash flows derived through these actions can be used for growth.

China, a major market, is expected to see a recovery in 2014. Government stimulus actions coupled with efforts to stem inflation appear to bear fruit and exports to the U.S. and other key markets are regaining momentum. An improved demand outlook for China augurs well for the chemical industry this year.

Chemical stocks that we like include

,

,

,

,

and

. Dow and DuPont, in particular, are witnessing strong momentum in agriculture, driven by higher demand for crop protection products.

Persistent weakness in Europe and its impact on global growth remain sources of near-term uncertainty. Western Europe continues to pose challenges on chemical stocks due to weak demand. Given the industry's sensitivity to the global economy, any negative current in the macro economy would be reflected in the prospects of the chemical companies.

In addition, weakness still persists in commercial construction, which is among the key end-use markets. Demand from some of the major manufacturing industries remains below the historic levels.

Commodity prices, though subsiding of late, still remain a concern for many of the U.S. chemical producers. Their ability to pass these costs on to end consumers is not always easy, given the competitive pressures at play. As a result, margins for a number of producers may be under pressure.

In addition, chemical companies generate a major chunk of their revenues outside the U.S., and therefore are exposed to foreign exchange fluctuations. Currency exchange translation remains a headwind for these companies.

Agricultural chemicals and fertilizer makers face challenges following the exit of world's largest potash maker Uralkali Group from one of the biggest potash cartels -- the

(BPC) -- that influence potash pricing by controlling the production and supply. Uralkali's Board decided to end export sales through BPC and direct all potash export through its Switzerland-based trade arm Uralkali Trading. This game-changing move has put pressure on pricing.

Moreover, demand for potash and phosphate remains somewhat weak in India, a key import market. Indian government's move to trim potash subsidy levels coupled with local currency devaluation contributing to lower demand for the nutrient in that country.

We hold a bearish view on

and

. We also steer clear of companies in the agricultural chemical space. Companies that fit the bill include

,

and

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