(Macro) The Chemical Sector Bottom And The Path To A Recovery
By: Jon Costello
Please read part 1 of the chemical sector macro piece.
All of the chemical sector names that we are long are below:
Note: This is the second of three articles that take a top-down look at the chemical sector, which I’ve been exploring and investing in. This article provides a high-level overview of the sector’s fundamentals and recovery prospects. The next article will examine case studies of past chemical cycles that offer perspective on the current downturn.
The global chemical industry is working through one of its worst downturns in decades. Sales volumes have declined for several years, utilization rates have fallen to 70% to 80%, and margins across a broad swathe of producers are hovering around cash cost. For many producers, conditions are akin to a deep recession, even though broader GDP continues to grow.
The downturn has caused earnings of the more cyclical chemical companies to decline for three years in a row, with their stock prices following suit. Expectations of continued earnings weakness keep many of the stocks at multi-year lows.
This business and stock price performance begs the question of whether cyclical chemical companies represent an attractive buy at a low point of their cycle. And if so, how should an investor time an investment? Should they take the plunge now or wait for a macro recession to push chemical stocks even lower?
With full acknowledgement that the downturn has longer to go and chemical stocks are likely to remain weak, I believe equity valuations in a large part of the sector are sufficiently attractive to buy now for a multi-year holding period.
The fact of the matter is that downcycles end; this one will, too, like all the cycles that have preceded it. The inevitable upturn will deliver far higher stock prices and outsized returns for those who invest today, in the depths of the downturn.
Investors seeking to position for an upturn should understand the supply-and-demand factors that led to the current downturn, what will drive the transition to an upcycle, and where to look for opportunities throughout the sector.
Chemical Value Chains
When selecting stocks, investors should view the chemical sector not as a single entity but as a set of “value chains” with their own supply-and-demand dynamics.
Chemicals move across a manufacturing chain that adds value at each step. Starting from raw materials, the industry’s products are developed into base chemical building blocks, then intermediates, then polymers, and lastly, formulated and specialty products. Formulated/specialty products are then sold to end users. There are dozens of core platform value chains. The further down a chain you go, the more specialized and less commodity-like the companies tend to be, and the greater the number of companies that exist to add value from precursor chemicals.
The diversity of value chains makes the chemical sector unique among cyclical commodity sectors. For one, the moves of a single commodity do not determine sector-wide economics the way energy producer results are heavily influenced by oil and natural gas prices, and copper or gold mining results by metal prices.
A chemical operation’s economics are dictated first by the particular value chain in which the company resides and second, by where it stands on that chain.
The existence of multiple value chains means that industry economic cycles differ across chains, as each has distinct supply/demand dynamics, logistical requirements, customer behavior, return characteristics, and so forth.
This isn’t to say that GDP recessions don’t depress earnings in the chemical sector. Of course, recessions lower earnings, and as such, remain a risk. However, a macro recession is not necessary to trigger a downturn in a chemical value chain. Furthermore, a GDP upturn isn’t necessary to spur a recovery in a value chain. Chemical value chain downturns and recoveries can and do occur independently of macro recessions. So investors can sit on their hands waiting for a macro recession to arrive and completely miss out on participating in a full cycle that could deliver outsized returns by buying in the downturn and selling during the recovery.
Factors Driving the Downturn
Today’s downturn in the chemical sector is clearly not being driven by a classic GDP recession. Instead, it’s the result of a nasty combination of overbuilt global capacity, weak industrial end-markets in Europe and parts of Asia, and a long destocking cycle that has reduced orders below end-use demand. The result has been a prolonged downturn that feels like a recession within the industry, even though the broader economy continues to grow steadily.
Just as a GDP recession wasn’t necessary to cause the downturn, a GDP upswing won’t be necessary to drive a recovery. Historically, chemical downturns have ended when inventories in a value chain have normalized and high-cost capacity has been rationalized. Demand does not have to be strong; it simply has to tick higher from the depressed levels specific to a value chain during the downturn. In fact, in the early stages of a chemical recovery, demand is significantly below mid-cycle levels. One of the reasons timing a bottom is so difficult is that recoveries begin during times of still relatively weak demand while supply is still adjusting downward. There is no obvious “all clear” signal, such as a visible surge in demand.
Global Demand Weakness
Demand has been weak across various chemical value chains for various reasons. Tepid industrial demand in major economies has reduced activity in several demand-driving sectors, including construction, autos, electronics, packaging, and consumer durables. This demand weakness has affected various chemical value chains in different ways and to varying degrees. Still, most have seen their sales volumes decline significantly over the past two to three years.
European demand has been particularly bad. The contraction of Europe’s manufacturing base in recent years has reduced demand for polymers, intermediates, coatings, and engineering plastics. At the same time, European chemical producers have suffered an industrial crisis brought about by high energy costs, unfavorable policies, and weak manufacturing activity, all of which have eroded the industry’s competitiveness on the global stage.
In North America, where the macro backdrop is better relative to other regions, higher interest rates and slower housing activity have weighed on value chains for nylon, isocyanates, PVC, and packaging-linked products.
In China, a drawn-out property bust and weak heavy-industry activity have cooled demand for construction-related and freight-dependent value chains.
Another important cause of weak global chemical demand has been an unusually long restocking phase. During Covid and its immediate aftermath, chemical end users over-ordered and built excess inventories in response to supply-chain chaos and rising prices. However, once conditions normalized, buyers flipped to a hyper-conservative posture, drawing down inventories and ordering only what they needed. This behavior persisted much longer than the typical quarter or two seen in a typical recession. The result is that apparent demand has fallen below actual end-use demand for an extended period, amplifying the downturn in volumes and capacity utilization.
Persistent Oversupply
This downturn has been unusually stubborn because the global chemical industry massively overbuilt capacity during the last cycle, particularly in olefins. I covered the olefin downturn in greater depth in a previous article here.
While olefins are likely to be mired in a downturn for years, other value chains face varying supply situations. In some, new production capacity continues to ramp, reinforcing pressure on trade flows and export prices. Even as demand stabilizes and destocking runs its course, the sheer amount of capacity, especially in Asia, caps pricing power and keeps margins low.
Until enough high-cost capacity exits the system—or demand grows long enough and fast enough to absorb it—the industry will remain in a low-return state. For example, the vinyl and polyester chains are in this group. In other chains, however, supply rationalization has been ongoing for years, and inventories are closer to normalizing.