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COMMENTS

Credit FAQ: What’s In The Mix For The Global Chemicals Sector?


Credit FAQ: What’s In The Mix For The Global Chemicals Sector?

On July 23, S&P Global Ratings Global Chemicals Ratings analysts held a live interactive webcast to discuss hot topics and S&P Global Ratings' outlook for the global chemical industry. The analysts discussed a variety of issues. Some of the topics highlighted during the webcast were:

  • The U.S.-China trade tariffs and their impact on the chemical sector;
  • Petrochemical oversupply and the related credit risks;
  • Investor activism and mergers and acquisitions (M&A) in the sector;
  • Our outlook for the Latin American chemical sector;
  • The impact of China's tighter environmental regulations; and
  • What's new in the fertilizer industry.

With so many topics discussed, many questions followed. Below are the answers.

Frequently Asked Questions

How does S&P Global Ratings view the overall U.S. macroeconomic picture and how will it influence the chemical sector?

On the date of the webcast, our baseline U.S. macroeconomic outlook considers that the country is transitioning from a temporary and approximate 3% growth equilibrium to a long-run structural potential growth that is closer to 2%. We expect 2019 will be that transition year, with annual average real GDP growth of 2.5% (it was 2.9% in 2018).

The slowdown has already started in the private fixed-investment sector, particularly the broader manufacturing and energy industries. We believe this will translate to a slowdown in real gross output in the chemical sector. The upswing the sector has enjoyed since 2017 has likely run its course, consistent with a slowdown in demand from industrial and consumer product sectors. This is especially true given how the products from the chemical industry are ubiquitous in the broader economy.

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One of the key risks to the economy stems from the escalation of U.S.-China trade tariffs. Tariffs on goods traded between the U.S. and China have increased in several stages since early 2018. Although the downside risk from additional tariffs on more goods--about $300 billion worth of additional goods--have simmered for now (due to the late-June trade truce held on the sidelines of the G20 meeting), we can't ignore that the respite may prove temporary. Besides, the tariffs already in place on $250 billion imports from China--and retaliatory tariffs on U.S. exports to China--remain.

Chart 2

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That said, it's also important to put the chemical sector's exposure to the conflict as a percent of total industry output in perspective. When measured this way, the potential impact appears more manageable because exports to China represented less than 2% of chemical industry's gross output in 2016. Still, it will be the smaller players without the vast global networks of production facilities or the diversified suppliers that will suffer more than the global behemoths.

What is S&P Global Ratings' outlook on the petrochemical sector?

We expect overcapacity in the U.S. and global markets for polyolefins, resulting in a decline in EBITDA margins (relative to 2018 margins).

The anticipated large capacity expansion in olefin and polyolefin capacities in the U.S. is well underway. We expect additional capacity in the U.S. via a "second-wave" beyond 2020. We also believe capacity expansion in Asia--including China--over the next five years or so will replicate, or even surpass, U.S. capacity growth. We think the net effect of this surge in global capacity will be an excess demand for polyolefins. For example, we believe that polyethylene supply will exceed demand by about 10% by 2023 or so. The overcapacity in the U.S., where domestic capacity is being set up in part to meet global demand, could be as high as 50% (of demand).

We believe this overcapacity will result in a decline in margins starting this year despite potential for favorable raw material pricing. Input costs for U.S. producers in particular could be lower in the next few years. We expect the lower margins will likely offset an increase in earnings for global petrochemical producers, including those bringing on new capacity, where the margin decline will likely offset an increase in volumes.

We don't think petrochemical producers' credit quality will weaken significantly, particularly those in the U.S. because many companies have some financial cushion at their current rating. Also, we assume these companies' financial policies, especially with respect to M&A and shareholder rewards, will reflect the subsector's new reality: a likely slowdown despite the benefits of margin expansion for many of the past 10 years following the financial crisis.

We base our outlook on several assumptions related to the timing of capacity growth, and on demand growth expectations, which doesn't include a severe economic downturn

Why does S&P Global Ratings believe activist investors have stepped up their pressure on U.S. chemical companies and what does this mean for their targets' credit quality?

Activist investors have been flexing their muscles in the U.S. chemicals sector for some time now, which is a trend we think will likely continue through 2020. About 15% of public U.S. chemical companies we rate have activist shareholders (based on regulatory filings) agitating for change. The rise in activism in this sector since the beginning of last year is consistent with the upsurge of this phenomenon across various corporate sectors. Last year was a banner year for activists across corporates, with their nominees winning a record number of board seats, deploying more capital and beginning an unprecedented number of campaigns, including some by first-time activists.

Activists in the U.S. chemicals sector have been primarily focusing on specialty chemical companies, probably because they have more resilient cash flows than commodity chemical players do, and there's opportunities to divest noncore, commodity chemical businesses and concentrate on the more specialty part of the business. The combination of more predictable cash flows and potential divestiture proceeds lends itself to activists pushing these companies to increase shareholder rewards. The paints and coatings sector has been of particular interest to activists, because the top 10 players represent only about 50% of the global market, and provide plenty of opportunities for M&A. We also think the sector is attractive because there's opportunity to improve margins by capturing synergies, not just by rationalizing footprint and headcount, but also on the procurement of raw materials, as the larger companies have better negotiating power with key suppliers.

Since last year, we haven't downgraded any U.S. chemical company based solely on shareholder agitation. However, we believe activist investors are more likely to trigger negative rating actions rather than positive ones because they typically aim for shareholder-friendly goals that could come at the expense of debtholders. Because we expect activist investors to remain prevalent in the chemicals sector, we continue to see this trend as a key ratings risk. The magnitude of any potential rating action depends on a number of factors, including the impact of any changes in the company's portfolio (e.g., upon completion of a divestiture), and a re-assessment of future financial policies, including the potential for increased leverage to support growth or shareholder-friendly initiatives.

For additional information relating to activist involvement in the U.S. chemicals sector, please see: Is Targeting U.S. Chemical Companies A Successful Formula For Activist Investors?, published June 25, 2019, on RatingsDirect.

What does S&P Global Ratings see as the credit trend for large chemical producers in Latin America?

Overall, we expect the main chemical companies in LatAm to maintain solid credit metrics in the region for this year and next, with net debt to EBITDA below 3.0x. Lower margin spreads in polyethylene due to additional capacity coming online in the U.S. and expected hydrocarbon price volatility for 2019 and 2020 should impose a more challenging scenario compared with the previous positive price dynamics. Although we expect cash flow generation to remain strong given last years' inorganic growth strategies, overall operating efficiency and geographical diversification should support the maintenance of adequate profitability levels.

How does S&P Global view China's second environmental inspection compared with the first one? Will there be a third inspection?

China's second round of environmental inspection started from this past June and will last until 2021. There will be a "look-back" in 2022. The overall plan is similar to that of the first inspection round. In addition, both inspection rounds cover all 31 provinces. However, the second round inspection is more extensive than the first because it includes central government state-owned enterprises and ministries. Moreover, the inspection duties extend to the provincial level, not just the central level. In addition, the scope will include the overall ecological system sustainability, rather than just dealing with pollution only in the first round. And, the approach won't be blanket shutdown. In a nutshell, the second inspection round is more holistic yet more flexible than the first.

Environmental protection remains a top priority of the Chinese government. Therefore, we believe this kind of inspection will be an ongoing process. However, we don't believe a national inspection every five years is all that China has planned. Apart from this routine inspection, there will also be ongoing surveillance of pollution emission and the government has been striving for tighter and better execution of environmental protection policies.

What is S&P Global Ratings outlook for key fertilizer companies?

The outlook on prices for nitrogen, potash, and phosphate is broadly stable, but there are different risks depending on the supply-demand balance in each market.

In the nitrogen market, after several capacity additions, the supply-side pressure is easing, with an uncertain and limited amount of projects in the pipeline. This, in combination with steady demand, contributes to our view that there's some upside in nitrogen fertilizer prices. Still, this upside wasn't quite clear in the first quarter due to a delayed planting season stemming from challenging weather conditions in North America, with volumes and prices only catching up in the second quarter. We believe the capacity reductions and lower exports from China due to high production costs and environmental regulations are already factored into the recovery in prices. For example, average prices for urea in the U.S. Gulf were $265 per tonne in in the second quarter of this year, about 13% higher in comparison with last year for the same period. Lower natural gas prices clearly support nitrogen producers' profitability, as illustrated by Yara International ASA's second quarter EBITDA, which increased by 62% thanks to higher volumes and lower energy costs.

Chart 3

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Chart 4

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Chart 5

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Chart 6

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In the potash market, we don't expect large capacity additions coming on stream and therefore our outlook on prices is broadly stable. We base that outlook on our expectation of about 1%-2% growth in demand for commodity grade potash, and 2%-3% for specialties, supported by stable underlying demand in Brazil and China. We continue to look for the announcement of the new level of benchmark contract prices with India and China, which will be an important indicator of the recovery in prices. On the supply side, there are no additional significant capacities coming on stream at the moment, with K+S AG's Bethune production being the single most important addition. In 2018, the company produced 1.4 million tonnes of potash from this mine. Other producers have delayed their capacity additions, while K+S also closed certain mines, such as, the 600,000 tonnes per year high-cost Sigmundshall mine in Germany. The biggest risk over the longer term could come from new entrants to the market, such as BHP Group PLC's Jansen project in Canada, but we note that competitors such as The Mosaic Co. and Nutrien Ltd. have already warned that they have brownfield projects too, and could bring these to production faster and at a lower cash cost.

Chart 7

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So far, additional potash supply from OCP S.A. and Saudi Arabian Mining Co. (Ma'aden) has been brought on stream in a measured fashion, and the impact was offset by mining closures like The Mosaic Co.'s Plant City or Nutrien Ltd.'s Redwater. In addition, we are observing declines in exports from China due to environmental regulations, which are putting pressure on local producers. At the heart of the issue is the disposal of gypsum into the Yangtze River. The question is, of course, how fast China will curtail its phosphate exports. Nevertheless, the reductions were not as steep as we anticipated initially. China produces about 35%-40% of the global phosphoric acid, but its environmental policies could possibly disrupt some production. Even though the prices of phosphate declined somewhat in the first half of 2019 due to unfavorable weather in North America and high inventories, we anticipate that prices will be broadly stable over the longer term, supported by healthy underlying demand.

Does S&P Global Ratings think the trade issues will hurt ratings on fertilizers producers?

We think the industry is approaching mid-cycle conditions now, after a difficult time over 2016-2017 when bottom-of-the-cycle prices pressured cash flows for many fertilizer producers at a time of significant capacity investments, putting pressure on leverage and ratings. We now see fertilizer producers regaining their balance sheet strength, as prices recover gradually and long-term demand is stable, helping to absorb the additional capacity. As credit metrics recover, financial policies, shareholder distributions, and future spending comes to the forefront of our rating considerations. We note for example the increasing shift in investments among fertilizer producers from production assets to plant nutrition solutions, distribution infrastructure, farmer services, value-added products, and digitalization.

Still, we don't anticipate significant increases in nitrogen, potash, and phosphate prices because risks to supply-demand balance persist, and farmer incomes remain low, albeit recovering. The USDA forecasts net farm income will increase by about 8% this year but remain about 50% below 2013 levels and also below the historical average from 2000-2017. Another key variable is the ongoing China-U.S. trade dispute, and how it may link to farmers' decisions about next year's crops.

Chart 8

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Chart 9

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Overall, it's an interesting time for the global commodity and specialty chemicals industries. The sector for the most part continues to be tied to GDP, and S&P Global Ratings expectation of continued modest economic global growth will likely continue to support credit quality for the most part. We do, however, believe that macroeconomic risks have increased since the start of the year, and the ongoing trade issues between the U.S. and China is a key risk we will continue to monitor.

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Please register for the complimentary replay of the webcast:
The Global Outlook For The Chemicals Industry

This report does not constitute a rating action.

Primary Credit Analyst:Edward J Hudson, New York + 1 (212) 438 2764;
edward.hudson@spglobal.com
Secondary Contacts:Daniel S Krauss, CFA, New York (1) 212-438-2641;
danny.krauss@spglobal.com
Paul J Kurias, New York (1) 212-438-3486;
paul.kurias@spglobal.com
Satyam Panday, New York + 1 (212) 438 6009;
satyam.panday@spglobal.com
Danny Huang, Hong Kong (852) 2532-8078;
danny.huang@spglobal.com
Felipe Speranzini, Sao Paulo (55) 11-3039-9751;
felipe.speranzini@spglobal.com
Paulina Grabowiec, London (44) 20-7176-7051;
paulina.grabowiec@spglobal.com

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