What Are the Downside Risks for the Chemical Industry?

While chemical makers are poised to gain from strength in the automotive industry, recovery in the construction space, strategic growth measures and investment on capacity expansion, the industry still remains mired by several headwinds. There are a few reasons to be careful in the chemical industry space in the near term, which we have outlined below:

China Worries Cast a Dark Shadow

Economic cooling in China -- a major market for chemicals -- remains a key concern over the near term. A downturn in the country's housing market, persistent credit crunch, overcapacity, a flagging export sector and weak infrastructure investment are hurting the world's second-largest economy.

China's export sector, which had been a significant contributor to its economic growth in the past, is witnessing a slowdown. Exports slumped 6.8% in Nov 2015, hurt by depressed overseas demand. The country's manufacturing sector also remains sluggish with manufacturing activity contracting for the ninth straight month in Nov 2015, also indicating subdued foreign demand. The final Caixin/Markit China Manufacturing Purchasing Managers' Index (PMI) was 48.6 for November. A reading less than 50 indicates contraction in manufacturing activity.

China's GDP rose 6.9% in third-quarter 2015, slipping from a 7% growth achieved in the previous quarter. While the growth number was modestly better than expected, it still represents the weakest pace in the last 6 years. The country's economy is expected to slow this year on a year over year basis as the official GDP growth target for 2015 has been pegged at 7%. As such, a sluggish Chinese economy may weigh on demand for chemicals in this significant market.

Europe Continues to Sputter

The European economy is still not out of the woods, as evident from the paltry Eurozone GDP growth of 0.3% in the third quarter of 2015, a contraction from a 0.4% gain in the second, hurt by weak export performance. While the French economy returned to growth in the third quarter after a complete stagnation in the second, Germany and Italy witnessed slowdown.

Sluggishness in some of Europe's major economies continues to deter recovery of the chemical industry in that region. Western Europe continues to pose challenges on chemical stocks due to weak demand, thus remaining a source of near-term uncertainty. Weak investments and high energy costs remain as overhangs on the European chemical industry.

Headwinds from Oil Price Crash

The sharp decline in crude oil prices has put a host of industries, including chemical, on thin ice. Oil prices remain under significant pressure on surging crude oil production in an already oversupplied market and a stronger dollar.

Oil prices have been on a freefall of late. West Texas Intermediate (WTI) crude oil sunk to near seven-year low at $37.65 a barrel on Dec 7, 2015 after oil cartel OPEC decided to keep production at current levels in its latest meeting in Vienna. Brent crude also languished to its lowest level since Feb 2009 after the OPEC decision.

Moreover, WTI crude further slipped to settle at $35.62 a barrel on Dec 11, 2015 after the International Energy Agency (IEA) warned that the global oversupply could worsen and oil demand could slow in 2016. The absence of production cuts by OPEC coupled with a growing global supply glut is expected to continue to hurt oil prices.

U.S. chemical makers are enjoying the fruits of the abundance of low-cost North American feedstock. Affordable natural gas and ethane (derived from shale gas) has so far offered U.S. producers a compelling cost advantage over their global counterparts who use a more expensive, oil-based feedstock such as naptha. However, the oil price slump has raised concerns regarding the sustainability of this advantage.

On top of that, lower oil prices are hurting demand for chemicals in the energy space, an important end-market. Depressed crude oil price may also keep chemical prices under pressure as they essentially move in sync with oil prices.

Pricing, Currency Pressure

Commodity pricing remain a concern for many of the U.S. chemical producers. Their ability to pass these costs on to end consumers is not always easy, given the competitive pressures at play. As a result, margins for a number of producers may be under pressure.

In addition, chemical companies generate a major chunk of their revenues outside the U.S., and therefore are exposed to foreign exchange fluctuations. Strengthening of the U.S. dollar against a basket of currencies (especially the euro) created a significant headwind for these companies during the first three quarters of 2015 and is expected to continue to be a drag on profits in the December quarter.

Cloudy Fertilizer/Agrichemical Space

Fertilizer and agricultural chemicals makers continue to face challenges from low farm commodity prices, affecting their margins. Weakness in agricultural commodity prices represents a concern for fertilizer companies which may hinder fertilizer use by farmers given the adverse effect of lower crop pricing on growers' incomes.

U.S. farm income is set to tumble to its lowest level since 2006 this year. According to the U.S. Department of Agriculture ("USDA"), U.S. farm income is expected to skid 36% in 2015. The projected decline reflects continued downturn in crop prices amid expectations of bumper harvests by U.S. farmers. A big harvest would lead to a glut of grains and oilseeds, thereby depressing prices of these commodities. Lower farm income unfavorably impacts grower's purchasing decisions.

Weak crop pricing is expected to continue to weigh on demand for nutrients. Increased production from China is also keeping fertilizer prices under pressure.

Moreover, the crop protection market is expected to remain under pressure in the near term, in part, due to a slowdown in Brazil. Agricultural market conditions remain weak in Brazil. Tighter profit margins and credit are making growers in that country more cautious in their spending. Lower insect pressure and reduced seed volumes are also contributing to a weakening demand for crop protection products.

Bottom Line

As you can see, there are a number of reasons to be cautious about the chemical industry despite the recovery in the space. We hold a bearish view on FMC Corp. ( FMC ) and Methanex Corp. ( MEOH ). It would also be a prudent choice to steer clear of certain companies in the fertilizer/agricultural chemicals space that show weak fundamentals. Companies that fit the bill are Potash Corp. ( POT ), CF Industries Holdings, Inc. ( CF ) and DuPont ( DD ).

Check out our latest Chemical Industry Outlook here for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector.

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POTASH SASK (POT): Free Stock Analysis Report

METHANEX CORP (MEOH): Free Stock Analysis Report

FMC CORP (FMC): Free Stock Analysis Report

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CF INDUS HLDGS (CF): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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