(Editor's Note: Michael McCafferty of S&P Global Platts Analytics, a division of S&P Global, contributed to this report)
- We have taken negative rating actions on about one-third of chemical companies in EMEA since February 2020 due to COVID-19-related disruption.
- Highly leveraged speculative-grade rated companies and those with more exposure to demand from end markets tied to economic activity will take longer to recover credit quality and earnings.
- We don't foresee a recovery to 2019 levels of revenues and EBITDA of chemical companies until the second half of 2022.
Many chemical companies in EMEA face a long climb to recover ratings and earnings levels that have been hit by the global supply chain disruption and demand slump caused by the COVID-19 pandemic.
Since February, we have taken rating actions on 35% of the 62 companies we rate in the sector. The weakening of credit quality has been unprecedented. But, given chemical companies' end-market diversity, it has not been as sharp as in some other sectors, such as automotives. About 29% of company ratings now carry a negative outlook compared with just 15% before the pandemic. A further 3% are on CreditWatch negative compared with no companies before the pandemic. By contrast, 17% of companies we rate in the transportation sector, 19% in media and entertainment, and 30% in automotive sectors are on CreditWatch with negative implications.
We don't foresee a recovery in chemical companies' revenues and EBITDA until the second half of 2022. To date, companies have supported their credit quality by adopting a crisis financial policy response, with management teams initiating or accelerating cost-saving programs, reducing capex, cancelling dividends or share buyback programs, and redefining strategic goals. A recovery will therefore depend--in addition to the rebound in the general macroeconomic environment--on how quickly companies alter their financial policies to support growth and shareholder remuneration.
Speculative-grade chemical companies have been most heavily affected by the disruption: 16 of the 22 rating actions since February 2020 were on companies rated 'BB+' or below. This is not least because they already had limited headroom within the ratings before the pandemic following a wave of leveraged buyouts and refinancings. They are also likely to take longer to recover their credit quality, owing to high indebtedness. This stood at €41.3 billion at 2019 year-end and we expect it will have risen significantly by the end of the second quarter 2020 because many issuers are proactively drawing on their available credit facilities to bolster liquidity.
Specialty chemical companies should be better protected against COVID-19-related disruption, as their prices hold up better than commodity chemical prices. Still, we expect their credit quality to come under pressure in the months ahead because many issuers have highly leveraged capital structures. Commodity producers have been hit both by contraction in demand for plastics and a sharp decline in oil prices earlier in 2020, which in turn fed into the prices of basic polymers. The fertilizers segment is faring better, as demand is decoupled from general economic growth, but prices are under pressure due to overcapacity in potash and phosphate.
Below, we address investor questions from a recent live webcast on the outlook on the chemical industry and how the COVID-19 pandemic is affecting the sector.
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S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The consensus among health experts is that the pandemic may now be at, or near, its peak in some regions, but will remain a threat until a vaccine or effective treatment is widely available, which may not occur until the second half of 2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.
How heavily affected are chemical company ratings by COVID-19 disruption?
We've taken negative rating actions on 35% of the chemical companies we rate in EMEA since February 2020. This translates to 22 rating actions, nine of them downgrades. Based on our GDP forecasts, we anticipate a double-digit drop in revenues in our rated chemical portfolio on average in 2020. Second-quarter revenues will likely be the weakest, reflecting significantly reduced activity in companies' industrial end-markets such as manufacturing, oil and gas, automotive, and construction. We forecast a gradual recovery starting in the second half of 2020 in line with our macroeconomic scenario and in anticipation of a pick-up in demand from sectors as lockdowns are eased.
Most rating actions have been on speculative-grade rated issuers. We have so far downgraded seven companies and revised the outlook on nine.
The EMEA chemicals sector now has a strong negative bias, with 32% on a negative outlook or CreditWatch negative compared with 15% before the pandemic. Unsurprisingly, our issuers in the 'B' category have been hit the hardest. While investment-grade issuers ('BBB-' and above) have been more resilient, we have nevertheless downgraded two companies, assigned negative outlooks to two, and two more are on CreditWatch with negative implications. There is now one potential "fallen angel", at risk of dropping from investment to speculative grade: Russia-based petrochemical producer PJSC Sibur Holding (BBB-/Negative/--).
Why have speculative-grade chemical companies suffered more rating actions?
First, many of them already had limited rating headroom before the COVID-19 pandemic because of leveraged buyouts, refinancing activity, or for company-specific reasons. By contrast, most investment-grade companies had healthy rating headroom at the start, although this will be at least partly consumed in 2020.
Second, investment-grade issuers, due to their greater size and scope, are typically more diversified and therefore more resilient in a downturn. With lower leverage, they have more room to maneuver under stress. The financial policy response from many investment-grade issuers was swift and effective in protecting credit metrics. We expect that they will maintain this discipline through the crisis to keep to their investment-grade commitments.
A third important factor in maintaining credit quality in the current crisis is a company's ability to generate positive free operating cash flows (FOCF). We anticipate that investment-grade issuers will typically still generate positive, although reduced FOCF. For many speculative-grade issuers, on the other hand, we see a risk of escalating cash burn, even if we factor in capex reductions.
Are specialty chemicals companies better protected than commodity chemical peers in the current situation?
Prices for specialty chemicals tend to be less volatile than for commodity chemicals because they play a critical role in certain applications. They were nevertheless still affected by demand from sectors they serve that have been hit by the pandemic, and therefore suffered from a decline in end-market demand.
Lower raw materials costs, which represent a significant portion of the total cost base, should also help support specialty chemicals' margins. However, we think this may be partly offset by a higher degree of operating leverage arising from lower volumes and operating rates in certain business lines hit by the pandemic. Ultimately, companies will have to pass lower feedstock costs to end customers typically within three to nine months, depending on price pass-through contracts, which vary by issuer and product line.
We therefore expect free cash flows in our specialty chemical portfolio will shrink significantly or turn negative, even if helped by lower working capital requirements due to lower product and input prices, and lower capex. At the same time, the gross debt of many chemical companies has not been static, given proactive drawings of credit lines to strengthen liquidity.
What is the impact of COVID-19 on commodity chemicals, given low oil prices and pressure on demand for polymers?
Commodity chemicals also face a tough test. The contraction in demand for plastics in the second quarter was made worse by the sharp decline in oil prices earlier in 2020, which in turn fed into the prices of basic polymers. We assume that the reduction in prices of natural gas and oil will only partly offset the loss in volumes. On balance, absolute profits will therefore be lower. This expectation has already put pressure on the ratings of commodity producers in the first half of 2020.
Petrochemicals clearly suffered in the wake of COVID-19, but the impact is mixed. While transport fuels, for example, suffered universal downward demand, the effect on downstream petrochemical markets has varied. Still, the top-line reduction in global economic growth in 2020 will mean that overall demand for key building blocks such as propylene and ethylene will fall. This, in turn, will filter into the upstream feedstock markets and reduce demand for products such as naphtha, ethane, propane, and butane.
Petrochemical markets held up fairly well in the first quarter of the year. Production of ethylene in the U.S. was at record levels, while production in key Northeast Asian markets was stable as well. However, May data has started to show the impact of COVID-19 on downstream markets. In the U.S., sales of polyvinyl chloride (PVC), high-density polyethylene (HDPE), and polypropylene (PP) were all significantly lower month on month. Meanwhile, demand for low-density polyethylene (LDPE) fared better. These results are in line with current downstream demand. Durable demand for applications such as construction (PVC) and automotive (PP) were severely hampered. Meanwhile, demand for films (LDPE) for fast-moving consumer goods performed better.
U.S. exports of petrochemicals were hit severely in April and a similar story is likely in May. After reaching record levels at the start of the year, petrochemical exports for products such as polyethylene (PE) and PVC took a hit in March and April as global demand for U.S. exports fell. According to Platts Analytics, which, like S&P Global Ratings, is a division of S&P Global, May and June will be the bottom of the downturn and exports will pick up during the summer as global demand increases.
Overall, Platts Analytics estimates that the significant downward trend in global GDP will slow petrochemical demand growth. However, it will not be as severe as the demand loss for transport fuels such as gasoline and jet fuel. Certain applications such as films will perform better than more durable applications that go into automotive and construction, with the net results being a total demand growth loss for chemical between 2%-4% in 2020 and 5.2% in 2021.
Are fertilizers faring better, given that they are decoupled from economic growth?
We expect demand for fertilizers will remain generally stable in 2020, notwithstanding the impact on farm economics due to weaker agricultural commodity prices. Still, we assume that the pandemic will hit the agriculture sector and demand for fertilizers far less heavily than the broader chemicals sector. This reflects their indispensable role in security of food supply.
Several factors play into fertilizer pricing. For potash we assume no further meaningful deterioration of prices in 2020, given that Chinese benchmark contracts will provide a price floor and some certainty with regard to offtake of the product. We expect potash prices will improve gradually in 2021 if major producers maintain supply discipline, notably as capacity additions from Eurochem Group AG come on stream.
In phosphate, we believe that prices will remain under pressure in 2020, owing to abundant supply on the market and competition among the key producers. An important determinant of prices will be the pace and size of reductions in Chinese phosphate exports, due to environmental concerns, which in our view could help offset some oversupply in the industry.
In nitrogen-based fertilizers, we anticipate that operating conditions will be less favorable than in 2019 because we now expect prices for the products to be more robust than we previously expected. Nitrogen fertilizer prices will be weaker on average in 2020 despite a strong start to the year, especially in North America, where lower oil prices had a trickle-down effect on ethanol prices, a key driver of corn prices. The margins and cash flows of European producers, such as Yara, will however be supported by lower natural gas prices, which we expect to continue.
Long-term demand trends for fertilizers are favorable, owing to fundamental trend of growing population and the need for higher output per acre, and some future capacity additions will be required to meet demand growth. Both potash and phosphates markets will remain vulnerable to downturns caused by greater competitive capacity. In addition, fertilizer markets are subject to seasonal fluctuations as well as weather conditions, changes in government policies, foreign exchange-rate movements, and contract negotiations with large buyers.
Will the negative outlook bias to continue over a longer period?
Our recent downgrades and outlook revisions to negative have already built in our expectation of weak second-quarter results due to pandemic-related lockdowns in Europe and North America. A stabilization of credit quality will first depend on whether a rebound materializes in the third quarter of 2020 by way of higher order books and an improvement in customer confidence. We will also assess whether companies' progress on cost-cutting measures, capex, and working capital management is in line with our initial expectations.
Whether issuers have sufficient liquidity is also a key consideration, especially for speculative-grade issuers. We already indicted before the pandemic in early 2020 speculative grade issuers' persistent high indebtedness, which stood at €41.3 billion at 2019 year-end. We are anticipating that this will have risen significantly by the end of the second quarter 2020 because many issuers are proactively drawing on their available credit facilities to bolster liquidity.
For the time being, we do not consider liquidity will be an issue for the vast majority of our speculative-grade issuers, because many of them refinanced or extended their maturities into covenant-lite structures over the past few years. Still, the negative FOCF which we expect this year, and a need for working capital investments to finance the recovery, represent a risk to liquidity positions, as do a new wave of infections.
What will be the post-COVID strategy for chemical companies?
We think chemical companies may rethink their global supply chains and aim to locate production closer to demand centers. The pandemic highlighted a real need for local supplies, especially of products that are critical during the pandemic, such as antibacterial gels, masks, other active ingredients. But supply chains for other products were also disrupted or delayed amid fast and unexpected border closures. We therefore expect that management teams may reconsider supply chains and business continuity under various "what-if" scenarios. They may, for example, model the impact of a second wave and how to tackle events that even three months ago they would have considered remote.
We expect chemical companies will continue to innovate to stay competitive. The pandemic will change how we live and work, while other trends will remain intact, for example the need for sustainability, products that enable light-weight applications, or those used for water treatment. The industry will likely seek new products to respond to these opportunities. Notably, BASF recently issued a green bond to finance sustainable projects.
Finally, we think continued portfolio rebalancing into higher-margin, lower-volatility specialty chemicals and away from lower-margin higher volatility commodity-grade products will remain a trend.
How long will it take for the credit quality in the sector to recover?
We don't foresee a recovery to 2019 levels in revenues and EBITDA of chemical companies until the second half of 2022. To date, credit quality was supported by a crisis financial policy response from chemical issuers, with management teams initiating or accelerating cost-saving programs, reducing or delaying discretionary capex, cancelling dividends or share buyback programs, and redefining strategic goals from M&A to liquidity preservation, working capital management, and cash flow generation. Therefore, in addition to the rebound in the general macroeconomic environment, the recovery will depend on how quickly companies alter their financial policies to support growth and shareholder remuneration. One area that we will be keen to watch is when, and under what scenarios, we will see reductions in revolving credit facility drawdowns or reimbursements of credit lines that were used to shore up liquidity at the beginning of the pandemic.
How will low oil prices affect specialty chemicals companies?
The decline in crude oil prices and the impact across production and refining activities will harm demand for oilfield production polymers and for catalysts used in the wider petrochemical sector. In combination with the fall in underlying economic activity, this will limit sales growth and volumes for specialty chemicals in 2020. Lower oil prices may primarily affect demand for dispersions and recovery chemical products used by the North American oil and shale gas production sector and challenge project economics.
In the near term, chemical companies' margins will be impaired by weaker capacity utilization and an adverse effect on operating leverage. However, this will not affect all specialty chemicals producers equally. In certain cases, a significant reduction in oil-based raw materials and energy costs could lead to a temporary improvement in gross margins, as raw material prices typically represent a variable but significant portion of the total cost base of chemical producers. Supply and pricing agreements are typically negotiated on a monthly or quarterly basis, allowing in certain instances a pass-through time-lag effect that will provide a temporary benefit to certain producers. Formulaic pricing methods that are however also in force in the industry may entail limitations to that strategy and leave lower room for retaining a portion of the margin benefit in the short term. The relief may in turn also be transitory, as we could observe further volatility in hydrocarbon prices.
Could the current environment drive further consolidation and private equity interest in specialty chemicals?
We expect M&A to be subdued in the near term because some issuers could be rather bruised financially by the pandemic, and many will delay disposals due to low valuations. Buyers will need confidence in an improved economic outlook and in a target's ability to generate attractive cash flows. We therefore think the M&A scene will belong to issuers with healthy balance sheets and cash flows that are resilient to the current crisis. For example, on June 12, 2020, Dutch chemicals producer Koninklijke DSM N.V. acquired certain assets of the Erber group, a supplier of leading animal nutrition and health specialty solutions, for an enterprise value of €980 million.
Over the medium term, we believe that the chemical sector, and notably specialty companies, will continue offering attractive return opportunities to investors, including private equity. This is because specialty chemical companies offer relatively stable and predictable cash flows, promising growth, and opportunities to add value, for example by bolt-on acquisitions.
This report does not constitute a rating action.
|Primary Credit Analyst:||Paulina Grabowiec, London (44) 20-7176-7051;|
|Secondary Credit Analyst:||Lucas Hoenn, London + 44 20 7176 8597;|
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