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Credit FAQ: Our View Of Chlor-Alkali Industry Fundamentals And Olin's Potential For An Investment-Grade Rating

Investor interest in potential chemicals sector crossover credits remains high, with the preponderance of inquiries focused on Olin Corp. (BB+/Positive/--) and Celanese Corp. (BBB-/Stable/--). We recently published a Credit FAQ on Celanese that can be found here: Our Views On Celanese Corp.'s Credit Quality Following Release Of Its Fourth-Quarter. In this article, we focus primarily on Olin, and answer frequently asked questions regarding our view of chlor-alkali industry fundamentals, Olin's credit quality, and its potential to achieve an investment-grade rating. We also review the risk of potential downgrades for rated chemical companies in the 'BBB' category.

Frequently Asked Questions

What is S&P Global Ratings' view of the current supply outlook for the chlor-alkali industry?

We expect global chlor-alkali supply fundamentals to remain favorable over the next few years, supported by a lack of new electrochemical unit (ECU) capacity under construction, particularly outside of Asia, and recent facility rationalizations in North America. Since 2021, Olin (the world's largest chlor-alkali producer) has shuttered about 1,000,000 metric tons (mt) of uneconomic, less-energy efficient, diaphragm-grade capacity at its Plaquemine, McIntosh, and Freeport facilities. Additionally, Oxy Chemical Corp. (OxyChem), the world's third-largest chlor-alkali producer, closed 170,000 mt/year of ECU capacity at its Niagara Falls facility in 2021. Most importantly, from an industry supply perspective, these shutdowns have coincided with few new project announcements, even as pricing and margins have reached reinvestment economics.

According to public comments by Olin's management, the next five to six years are forecast to have the lowest global capacity additions in the past 25 years, with the bulk of incremental supply growth coming from India and China. Additionally, even if a project reached final investment decision (FID) today, the construction of a new greenfield integrated world-scale PVC plant would require significant capital (about $3 billion) and take anywhere from four to five years to complete (per an Olin estimate from its first-quarter 2022 investor presentation). OxyChem's recent modernization and expansion project, for example, which will expand and convert its Gulf Coast chlor-alkali assets from diaphragm to membrane technology, is expected to cost $1.25 billion and take about three years to complete. Analysis by S&P Global Commodity Insights also suggests chlorine and caustic demand will outstrip capacity growth over the next five years, with chlorine capacity rising at a rate of only 0.9% per year, versus 2.6% per year between 2010-2020.

Table 1

Chlorine And Caustic Soda
Capacity, average annual growth rate 2010-2020 2020-2025
Chlorine 2.6% 0.9%
Caustic soda 2.4% 1.4%
Consumption, average annual growth rate 2010-2020 2020-2025
Chlorine 2.5% 2.5%
Caustic Soda 2.5% 2.3%
Source: S&P Global Commodity Insights.

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Given your macroeconomic assumptions, what is S&P Global Ratings' current demand outlook for chlorine and caustic soda? What are your assumptions for global production costs?

Table 2

S&P Global Ratings Macroeconomic Assumptions
2020 2021 2022 2023f 2024f 2025f
U.S. real GDP (% change) (2.8) 5.9 1.8 (0.1) 1.4 1.8
Eurozone real GDP (% change) (6.5) 5.3 3.3 0.0 1.4 1.5
China real GDP (% change) 2.2 8.1 3.2 4.8 4.7 4.6
U.S. housing starts (mil.) 1.4 1.6 1.5 1.2 1.3 1.4
U.S. light vehicle sles (annual total in mil.) 14.5 14.9 13.7 14.7 15.7 16.0
Henry Hub ($/mmBtu) 2.03 3.89 6.45 3.50 4.00 2.75
TTF ($/mmBtu) 3.16 15.71 37.10 22.00 20.00 20.00
f--Forecast. Source: S&P Global Ratings.

Over the long-term we expect global chlor-alkali consumption will generally track global GDP growth and industrial demand, with S&P Global Commodity Insights forecasting chlorine consumption will rise by about 2.5% per year over the next five years. Chlorine demand is primarily driven by activity in the construction sector, with its use in the production of vinyls products, primarily polyvinyl chloride (PVC), accounting for about a third of total consumption. In the short term, we expect that demand weakness in the vinyls chain, as a result of reduced construction activity, will pressure both volumes and pricing for chlorine and chlorine derivatives (such as VCM and EDC). This is consistent with our assumption for a significant decline in U.S. housing starts to 1.2 million in 2023 and 1.3 million in 2024, from around 1.5 million in 2022. Partially offsetting the risk from a slowdown in the U.S. housing and construction sectors, is the potential for a rebound in construction demand in China. Mainland China is the largest consumer of chlorine and chlorine derivatives, and any rebound in domestic demand could tighten the global supply/demand balance.

Demand for caustic soda primarily reflects manufacturing sector output, as it is used as an input in a wide variety of industrial end uses including pulp and paper, alumina, and water treatment, as well as in the production of soaps and detergents. While caustic soda consumption declined marginally in North America and Western Europe between 2010-2020, S&P Global Commodity Insights expects worldwide consumption to increase by about 2.3% per year over the next five years. In the near term, a slowdown in global growth and manufacturing activity may pressure caustic volumes; however, a rebound in light-vehicle sales/production could increase alumina consumption, and offset weakness in other industrial end markets. We forecast GDP in the U.S. will contract by negative 0.1% in 2023, remain flat in the eurozone, and expect U.S. light-vehicle sales will rise to 14.7 million units sold from 13.7 million units sold in 2022. We also note that caustic soda is a key input in the pulp and paper market, which is in structural decline in certain parts of the developed world.

The production of chlorine and caustic soda is energy intensive, and requires a significant amount of electricity/natural gas. Chlorine, caustic soda, and hydrogen are co-produced simultaneously by the electrolysis of salt, in a fixed ratio of 1 ton of chlorine to 1.1 tons of caustic soda and 0.03 tons of hydrogen (this is termed an ECU). Based on our assumptions for global natural gas and energy prices, we anticipate U.S.-based chlor-alkali producers, with their access to relatively low-cost natural gas, will retain their position on the lower end of the global cost curve for at least the next two to three years. This relative cost advantage for U.S. producers is illustrated by our assumption for Henry Hub natural gas, which we assume will average between $2.75-$4.00 per million Btu (mmBtu) over the next few years, versus around $20/mmBtu for the European TTF benchmark.

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How does S&P Global Ratings view Olin's value over volume strategy in the context of its overall industry outlook?

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Caustic soda and chlorine are co-produced in a fixed ratio, which has historically resulted in volatile profitability for chlor-alkali producers, since strong demand in one co-product can incentivize overproduction and create pricing weakness in the other. Olin has sought to mitigate this volatility by matching its participation according to the weaker market and has stated that it will not supply additional volume into the relatively stronger market if this results in softer pricing on the other side of the ECU. Since 2020, the company's strategy, along with a cyclical rebound in demand beginning in 2021, has supported a substantial increase in pricing for both products and led to steadily increasing ECU profitability.

While other companies across the commodity chemical space have recited a version of Olin's value over volume mantra, we believe the global supply environment for chlor-alkali, and Olin's market position as the largest, lower-cost, merchant producer, make it particularly well suited to tighten supply by limiting or reducing marginal molecules. However, despite relative underinvestment in capacity from a prolonged period of weak pricing, near-term capital discipline from producers, and environmental and energy constraints, chlor-alkali production remains a commodity industry, and we would expect a supply response from either upstream producers or downstream consumers if pricing remained at or above reinvestment economics for a prolonged period. Recently, for example, Westlake Corp. increased ECU capacity by 120,000 (mt) through debottlenecking efforts at its existing facilities along the Gulf Coast. Net capacity additions present a long-term risk to the company's strategy, as any increase in global capacity will reduce the effectiveness of Olin's volume curtailments, and erode its ability to support pricing on the margin. Additionally, Olin risks losing market share over time, as competitors do not appear to be tempering operating rates to a similar extent.

S&P Global Ratings' upside scenario states that Olin must achieve a weighted average ratio of funds from operations (FFO) to debt of around 45% to reach an investment-grade rating. What does this imply in terms of a recession-case EBITDA?

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Olin ended 2022 with S&P Global Ratings-adjusted debt of around $3.2 billion. This figure includes gross balance sheet debt of about $2.6 billion and our routine debt adjustments, including operating leases and tax-effected unfunded pensions (minus net cash) of about $700 million. Given the company's current capital structure, this implies the company would need to achieve weighted average FFO of around $1.46 billion to maintain an FFO to debt ratio of 45%. Adding back the company's 2023 assumptions for cash interest ($155 million) and cash taxes ($325 million) to FFO of $1.46 billion, we arrive at an EBITDA figure of around $1.9 billion. This is roughly the level of EBITDA we would expect the company to realize on a weighted average basis, throughout a complete economic cycle, to achieve an investment-grade rating.

For investment-grade chemical credits, we generally apply a weighting scheme of 10/15/25/25/25 when calculating weighted-average metrics, with a 10% and 15% weighting applied to two past years, 25% applied to the current year, and 25% to each of the next two years. Thus, while Olin's current FFO to debt ratio at year-end 2022 sits well above our 45% upgrade threshold at around 60%, we would expect FFO to debt would drop slightly below the threshold at the mid-point of the company's "recession case" EBITDA of $1.5 billion to $2.0 billion.

Would one or two quarters of below recession-case EBITDA lead to a negative rating action? If S&P Global expects a recession in 2023, does that rule out an upgrade over the next 12 months?

Not necessarily. The company's operating model is predicated on preemptively paring back volumes in the face of weak demand, which could impair earnings in the short term, in order to support pricing and earnings over the medium to long term. We would likely not take a negative rating action if earnings declined over the course of one or two quarters, if we viewed the drop as short term, particularly in the case of a moderate decline in product pricing. However, ratings could be pressured over the long term if a consistent decline in volumes fails to support pricing during a period of demand weakness, or if the company was unable to significantly increase volumes, without affecting price, once demand strength returned, ultimately leading to market share erosion.

Does S&P Global Ratings believe Olin's financial policies could support an investment-grade rating? What are the major financial policy risks?

We believe Olin management has been generally consistent in its financial policy messaging over the past few years, first in its prioritization of debt repayment in 2021 and 2022, when it reduced gross balance sheet debt by $1.3 billion (or about 33%), and second in its preference for using discretionary cash flow for share repurchases over transformational M&A. We believe Olin will continue to focus primarily on inorganic growth including the pursuit of certain capital-lite growth vectors, such as additional parlaying activity. Larger transactions, which could include the acquisition of incremental ECU capacity, the addition of other chlorine derivatives, or a partnership with a PVC producer, remain a key financial policy risk, however, we believe this risk is balanced by our expectation that Olin will continue to generate substantial free cash flow, even in a prospective downturn. Lower cash outlays in the form of reduced cash interest expense, relatively stable maintenance capex requirements, and a lack of further contractual long-term supply payments, along with the company's ability to reduce share repurchases, if necessary, provide the company with increased financial flexibility. These levers could potentially allow Olin to fund a portion of any prospective M&A transaction using cash on hand and/or to rapidly delever post-acquisition. This is particularly relevant given the company's stated commitment to achieving and maintaining an investment-grade rating.

Given that S&P Global expects slowing global economic growth, and forecasts a mild recession in the U.S. during 2023, how much cushion do other 'BBB' rated credits have at the rating against potential downgrades?

Broadly speaking, we have seen credit quality at the lower end of the investment-grade chemicals universe improve over the past few years. The median 'BBB' chemical sector credit now has a FFO to debt ratio of around 40% and a debt to EBITDA ratio of less than 2x (as of year-end 2022). This compares with a median FFO to debt ratio of only 25% and median debt to EBITDA above 3x for the same group of credits in 2019 and 2020. This improvement has come both as a result of record earnings and substantial debt repayment, and most companies in the 'BBB' category ended 2022 with leverage metrics at the stronger end of our expectations at the rating. This includes both of our 'BBB-' rated companies, Huntsman and FMC, which both ended 2022 with credit metrics slightly above their respective upside triggers.

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Related Research

Credit FAQ: Our Views On Celanese Corp.'s Credit Quality Following Release Of Its Fourth-Quarter, March 6, 2023

This report does not constitute a rating action.

Primary Credit Analyst:Daniel G Marsh, CFA, Englewood + 1 (303) 721 4433;
Secondary Contact:Daniel S Krauss, CFA, New York + 1 (212) 438 2641;

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