Listen: How are high rates impacting industry?

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Thomas Watters:
Currently, right now our portfolio was clearly reflecting companies that have concerns about higher rates and what that could mean for their cash flows.

Vincent Valk:
Hi, and welcome to the Chemical Week Podcast. I'm Vincent Valk. Our guest today is Thomas Watters, Managing Director and Sector Lead for Oil, Gas and Chemicals at S&P Global Ratings. And we're going to talk a little bit about the outlook for the industry and how that relates to credit conditions and credit markets and the credit outlook for the industry. We'll get started here by talking about Q1. We're recording this on May 17th, so earnings season just wrapped up recently, at least in North America. And earnings were mostly in line with expectations, slightly improving demand to destocking in specialty chemicals, a lot of pressure in Europe. So first thing I want to ask you, Thomas, is did you see any surprises in Q1, and what do you think that can tell us about the current state of the industry? And related to that, considering what transpired in Q1 since the start of the year, has your view on the industry's outlook going forward shifted at all?

Thomas Watters:
Look, I don't think there were any real surprises here, and we didn't see any reason to change at least our forecast for this year. We know that destocking has been a four-letter word last year, and that impacted many sectors in the chemical space. But for most sectors we're beginning to see that kind of unwind a bit. We think there might be still some pockets where destocking overhang is still unwinding, but clearly heading in the right direction and there are signs of sustainable top line and margin improvement. We talk about some of the key end markets here. You look at packaging, energy, and maybe transportation, it seems to be improving somewhat modestly, but it's on the right trend and that's consistent what we expected. But then again, alternatively you've got weak growth in the automotive industry following a pretty strong last year, and China just remains extremely uncertain.
You've got particularly with regard to the real estate sector, and I think the labor markets, we don't expect much, if any, growth in the EU and at least the US has remained steady here. So overall takeaways, we see price and volumes improving, but I would describe it as modest improvement. So we're cautiously optimistic about the rest of the year and I think more improvement would be in the second half. I think many of the companies that we follow are very reluctant to give positive guides, because last year they basically blew it when they thought the second half of last year would meaningfully improve and that just didn't happen as destocking took a lot longer to run its course, they clearly got it wrong. But I will say, look, their line of sight this time around at this time versus last year and backlog assessments are much better than what it was. Just maybe as you know, chemicals has a lot of different industries in there.
Maybe just to hit on a few, the main ones, maybe like PETCHEM that's going to remain weak for quite some time. Given all the supplies coming off from the US and China and what's still coming up from China, we don't really see it getting worse, but kind of bouncing along an industry trough, if you will. We think that the destocking stories run its course in paints and coatings, expecting a bit of recovery there. Adchem is relatively stable. I would say some of the pesticides supply, especially Adchem's like FMC, Alba should have some modest improvement this year. Overall for specialty chems, we're expecting a more broader positive trend as we do see some upside on the lower rated spec chem space. We've taken a number of downgrades over the last 12 months, especially in that deep spec space reflecting a lot of these difficulties we've talked about. TI02, Tronox, KRONOS put out some good numbers. Chemours was kind of flat-ish in that, but I believe we had more to do with the management issues they're dealing with and that probably impacted their performance.

Vincent Valk:
Yeah, so some variation, but overall, as you said, kind of cautiously optimistic. I want to talk a little bit about the financial outlook here. Inflation has been somewhat more persistent than expected, although I suppose April's print was more in line with expectations, but that still led the Fed to say that they intend to hold rates steady at a higher level longer than was maybe expected a few months ago. What impact do you see this is having on the industry, both from a financing perspective and from kind of an in-market demand perspective? Because I do think looking at it from both of those points of view is pretty important.

Thomas Watters:
Yeah, no, definitely. I mean, I'm no economist, but clearly interest rates have been far stickier than I think the Fed or anyone would imagine. You think about consumer spending and they just keep spending, so the demand is definitely there. So it's been hard to get inflation down. But look, high interest rates will always have a dampening effect on end-use demand, no doubt, especially in the chemical space considering all the various industries all tied to the GDP. And considering where the rates are right now, it kind of supports our narrative here of cautious optimism. When we have this high inflationary and high interest rate environment, which we haven't really had for years, we get very concerned about the low-rated deep speculative companies that we rate. We tend to in general have higher leverage and thinner cash flows. Now clearly many of them had benefited over the last decade or so of these low rates and the ability to issue a refinance debt at favorable rates.
So when the rates pop, it clearly is going to impact their already insane cash flows. Now we have taken several reviews of the lower-rated portfolio over the last year, and in many cases we've lowered their ratings, in fact, most of our rating actions have been at the deep end of the rating spectrum, the speculative rate companies. Basically reflecting the poor performance and of course the impact of higher rates on the cash flows. We always get concerned, well look, we always look at the maturity wall, what maturities do these companies have coming due? And for the most part, the maturity wall is pretty good because a lot of companies have took advantage of refinancing at low rates when the getting was good, but I would say overall, currently right now, our portfolio was clearly reflecting companies that have concerns about higher rates and what that could mean for their cash flows.

Vincent Valk:
Yeah, for sure. And just curious, I mean, you said that you've taken some ratings actions on deep speculative rated chemical companies. Is there any kind of through line on those ratings actions in terms of any thread you can pick up on where things that those companies might have in common?

Thomas Watters:
Look, they tend to be companies that don't have a lot of business or product diversity or scale or their costs may be a little bit higher than typically what we see. And again, they're prone to any type of increase in their interest rates and financing and bank lines or public debt or whatever, term loans. They don't have a lot of wiggle room and that's typically why they're rated beginning with spec grade. Investment grades can obviously typically withstand these cycles, and we are seeing that. And by the way, I want to comment on the balance sheets for investment grade. During when times were pretty good, not that long ago, a lot of these companies pay down their debt. So the balance sheets were pretty good and hopefully they can withstand these cycles that we're seeing right now, especially in the petchem space. But small guys, they just don't have that staying power. And the last thing they need when you have weak industry conditions is to have rates going up. So their ratings tend to move pretty quickly.

Vincent Valk:
Yeah, yes, that makes sense. So it's essentially they just don't really have, as you said, kind of the wiggle room if their interest costs go up to necessarily cover those costs, whereas an investment grade rated company probably does.

Thomas Watters:
They're rated investor grade because they should have staying power.

Vincent Valk:
Kind of looking at the big chemical companies, most of which are investment grade or close to investment grade, are there any sort of trends you see or concerns that you see there with regard to the impact of higher rates? And to be clear, I mean, the answer very well could be not really. They refinanced in 2020 and 2021 and conditions aren't great, but they're not horrible and they're going to be fine, but just curious.

Thomas Watters:
Yeah, typically they don't have material impact for investment grade companies. That's just not the MO. If we're moving ratings on investment grade companies, it's for other issues. Leverage is too high, it's an M&A type thing, or industry conditions are just really great or really bad. These guys, they did pay down a lot of debt in the IG space in general, and they pushed out their maturities. So the maturity oil looks pretty good overall for the industry luckily. But the IG guys, I'm not too worried about access to capital markets. I don't know if you recall during COVID, the heights of COVID, the deep spec guys, there was high concern about the ability to refinance maturing debt, because capital markets just kind of walked away. The investment grade guys were still able to do that, if it wasn't for the Fed coming in and supporting the markets, I shudder to think what would happen to many of the deep spec credits who just didn't have capital market access.

Vincent Valk:
Yeah, yeah, definitely capital markets froze up for several months or more in 2020.
Thomas Watters:
Yeah, yeah. That's why it's important for these companies, especially in deep spec, to manage their maturity rule to get out ahead of these things. You never know what can happen. You just never.
Vincent Valk:
And want to shift to talking a little bit about the outlook for different regions, particularly Europe and China. I think there's a bit of a consensus in the industry that if you look at the US or North America, Europe, China is kind of the three big economies. North America's outlook is probably the best or at the very least the most stable. Talk about Europe first. I mean, it does look as though Europe has bottomed out and we're starting to see some major announcements around capacity rationalization there. What impact do you see this as having on the European producers that you cover and looking ahead in sort of the medium term, is there a financial case for maintaining some petrochemicals production in Europe?
Thomas Watters:
So the way we're looking at Europe right now, we sort of believe it's at a transition point. Look, Europe remains the high cost producer and that's due to their high energy costs and because their feedstock usage. I mean, any crackers that are NAFTA or butane base are just not making the returns. They're poor performs. We know that Europe has mostly NAFTA, so again, they can't really generate the terms to justify running them. And these crackers, they tend to have high operating leverage. So whatever utilization rates, I think they're high 70s or something like that. That's just not even covering your breakevens, your fixed costs. So looking out, when you think of the outlook for oil, which is NAFTA comes there, it doesn't appear that feedstock costs are going to change much and to the energy story, we know all about their gas prices following the invasion of Ukraine by Russia, the gas price have come down a lot and Europe has done a very good job at rationalizing gas usage while getting a big lift, I'd say from Mother Nature and we've had a lot of unseasonal weather patterns there.
So I actually believe they've exited the heating season at around somewhere in the mid-60s as far as storage levels go, which is I think almost 50% higher than the five-year average. So they should have no trouble reaching their inventory goals, which I believe is 90% before they head into the heating season which starts November 1st. But having said that, gas prices still remain relatively high vis-a-vis historical levels, we're going back years ago. Look, there was likely more announcements to come on rationalization, especially when you think of some of these older facilities coming up for maybe a large maintenance projects, older facilities will likely going to get shut. The focus in Europe will be, I think for these companies will be sort of on repurposing and on circularity. We believe that the petchem outlook is going to remain weak through to 2026. In terms of rating action, we've taken a lot of rating actions in Europe over the last 12 months and I would say maybe about 1/3 of the companies there right now have negative outlooks assigned to them.
Vincent Valk:
And the negative outlooks are kind of due to all the factors that you just mentioned in terms of the high energy costs?
Thomas Watters:
Yeah, it is, and when you think about what a negative outlook means, I would say it's an assessment is about a third of a probability that the companies could be lower in the next year or two.
Vincent Valk:
Okay, okay. Interesting that you talked a little bit about the future in Europe being sort of circularity. I think the announcement that LyondellBasell made earlier this month regarding selling its European petchem assets, but then I think they were keeping some of their circularity investments going is a pretty good illustration of that idea. Talk to me a little bit about China here. So will the coming rationalizations have any impact on the China-driven global capacity overhang? And just for a bit of context here, I mean, one of the kind of strange things I think about this sort of new capacity coming on in China is that China is not exactly a low-cost production region itself. It's closer to Europe on the cost curve I believe, than it is to North America or the Middle East. Especially considering that it's not exactly that cheap to produce in China, do you see the coming rationalizations having any impact on that capacity overhang?
Thomas Watters:
A lot of good topics there. I would say just in terms of rationalization, in our opinion, it's way overdue and it's probably the only way to get the PEC-TEM industry to begin to pull out of this trough that it's in, but we believe it's going to take years pull itself out of this. Look to your point, we know about the Lyondell announcement and I think they follows Exxon and SABIC closing their steam crackers. Look, it's a step in the right direction, but the industry clearly needs more. Those announcements, I think by Exxon and SABIC, it only represents, I remember reading somewhere, it only represents only 4% of total EU ethylene capacity. So clearly that is nowhere near enough what's needed when you think about the olefins and polyolefins. But these decisions, they're taken with a medium to long-term view on industry and economics and when you shut capacity permanently, it's never taken lightly. But to your point, it looks like it's starting.
I thought it was a matter of who's going to blink first here, but we definitely expect to hear more announcements during the year. Now with China, you're right, they're not the low-cost producer either, and a lot of them are definitely not making money on these things, but we don't believe anything they've announced that they're going to stop it. They're going to continue to add that capacity. I mean, you know as well as everyone, they're sort of state-run or quasi-state-run entities and that they're driven by completely different motivations and it's not economic. So China's push here, they're trying to become self-sufficient, and it's just resulted in the structural oversupply for most of the olefin, the polyolefin change.
We put out a report recently, I'm going to quote a couple of stats here from this thing. I mean, olefin capacity is increased at a compound growth rate driven from 2019 to 2023, I believe at 12% for ethylene, 10% for propylene, and that's compared to capacity growth in the US of six and 2% respectively and about two and 3% in the Middle East respectively. So China's really going gangbusters with this, but again, they just completely kind of shot the industry down. If you're not low cost, you really have to question your business model, because it's going to last for years and the only way to get survive this thing is to remain low cost and obviously have a very good balance sheet now. But China's not slowing, they're going to continue to build out.
Vincent Valk:
An interesting point that you made there about it isn't necessarily about the economics. China wants to be self-sufficient. The sort of impact of Chinese industrial policy on so many aspects of global supply chains and petrochemicals being obviously an important part and relevant to our discussion, but you see this in other sectors too, I think is really a story that is probably going to be playing out over the next five or 10 years and is something that I imagine we're all going to be keeping our eye on.
Thomas Watters:
I mean, look to your point, I used to cover steel years ago and it would keep these mills running even though they were losing money and it was just to keep their labor employed, I guess they kept feeling at some point, prices are going to recover, et cetera, but they fund these things and they're uneconomic and it really doesn't do any good for the industry, and people are competing, the company's competing in there. It destroys capital. It clearly destroys capital, but again, different motivations.
Vincent Valk:
Finally, one more question on China, and I'm glad you mentioned that report that S&P Global Readings produced. Definitely some good information in there if anyone is a subscriber who's listening and wants to check it out, but for what parts of the industry is the impact of this capacity overhang the biggest threat?
Thomas Watters:
All of it in the petrochemical space. It's largely, when I'm talking about, I'm largely focusing here on petchems, but it's really the scale's unprecedented expansions, it's dwarfed incremental demand growth, nameplate capacity, olefins, polyolefins during that four year period has grown a double-digit rate. It's just vastly exceeding any incremental global demand growth and was pushed their imports back to the people that were exporting us. So it was created this glut through the chain. When we kind of look at the petchems, I would say maybe LDPE holds up a little better than maybe some of the other grades like HDP or LLDPE, just given what's being built. But at the end of the day, it's all kind of just suffering there. It really is. I mean, it's just an enormous amount of capital and products that they're building out all in the name's sake of being self-sufficient.
Vincent Valk:
And I guess it's really just as you said, as a matter of the areas where there is the threat is kind of the lowest would just be low cost producers and basically North America, Middle East.
Thomas Watters:
The ones that we believe are steering power are North America, because clearly they've got access to low cost energy and feedstock, not gas. I mean, we all know what's going on with gas prices. I will say though, gas prices, we're expecting that to creep up over the couple of years. Don't know if you're aware of that, but an awful lot of LNG capacity is being built in the Gulf of Mexico. So we got a price deck this year. We got net gas averaging about 250, and the Biden administration, I think you're aware of, has paused permitting for LNG facilities at this point as they're doing a review. But we don't review that as stoppage. Permanent stoppage is more temporary, but there is a significant amount of LNG capacity that's going to be built in the Gulf of Mexico and the feedstock for LNG is not gas.
So we expect gas prices to start to creep up. I think we're looking at 350 next year. In the following year, 425, but some people say that maybe underestimating prices. That LNG is going to go to Europe to keep themselves efficient and all. So you wonder, hopefully the US can continue to maintain its cost advantage. And you're right, the other region is the Middle East, which has tremendous access to gas and low feed stock, et cetera. So crackers there should be able to withstand as this industry drops, it's Europe that's probably going to have to take it on the chain.
Vincent Valk:
And as we already discussed, we're already seeing that. And I guess Japan too, there's been some capacity rationalization there as well.
Thomas Watters:
I kind of look more into China as driving what Asia's doing and they're not going to rationalize, it just [inaudible 00:20:19]. Yeah, there are pockets in Asia that's more based on economics that probably could do some rationalization as well. Again, the feedstocks don't work there.
Vincent Valk:
Yeah. So if you're not China and willing to subsidize uneconomic production, then it does make some sense probably to rationalize in Asia.
Thomas Watters:
Yeah, yeah, absolutely.
Vincent Valk:
Okay, well thanks very much for your time, Thomas, and this is Vincent Valk signing off for Chemical Week.