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What Could Spoil the Chemical Industry's Upturn?

The chemical industry is gaining momentum on continued strength across major end-markets and an upswing in the global economy. While chemical makers are poised to gain from strategic growth measures and investment in capacity expansion, the industry remains exposed to certain challenges. There are a few reasons to be watchful about the chemical industry in the near term, which we have outlined below:

China Worries Linger

Uncertainties surrounding China -- a major market for chemicals -- remains a deterrent over the short to medium term. While China’s second-quarter GDP growth of 6.9% was slightly higher than analysts' expectations, the world’s second-biggest economy remains hamstrung by financial stability risks. The country’s economy is still plagued by rising corporate debt, persistent industrial overcapacity and weak private investment. In particular, ballooning debt levels (manifested by rising debt to GDP ratio) and rapid credit expansion have raised a red flag on the Chinese economy.

China’s GDP expanded 6.7% in 2016, a deceleration from 6.9% a year ago, also the weakest annual growth in 26 years. The International Monetary Fund (IMF) projects China’s GDP to grow 6.7% in 2017, moderating to 6.4% in 2018. Moreover, the Chinese government has set a slower GDP growth target of roughly 6.5% for 2017. Rapid credit expansion poses a downside risk to the country’s economic growth.

Still-Difficult Fertilizer/Agrichemical Space

Fertilizer and agricultural chemical companies are still grappling with a difficult pricing environment. Potash prices, although recovered somewhat of late, remain under pressure due to elevated supply. Producers of the nutrient witnessed a slump in prices in the first quarter, dragging down their potash margins.

Potash miners continue to ramp up production amid a still sluggish demand environment. The potash market is expected to remain oversupplied in the near future (overshooting demand), thereby weighing on prices. Adding to the concern is the prospects of lower demand from India (a major consumer) in 2017. Potash imports in India are expected to be hurt by a spike in retail prices of the commodity as a result of the recent reform in indirect taxes (in the form of rollout of the Goods and Services Tax) in that country and a cut in government subsidy on the nutrient.

Moreover, higher supply has also contributed to a softer nitrogen pricing environment. Abundant nitrogen supply driven by new production capacity is expected weigh on global prices in 2017. Additional nitrogen capacity including a significant increase in North America is expected to come online globally in the back half of the year.

Global capacity expansion continues to exert pressure on urea and other nitrogen fertilizer prices. Elevated supply in the global nitrogen market is hurting prices, causing farmers to delay buying activities. As such, margins of fertilizer producers remain thwarted by a weak nutrient pricing environment.

Moreover, agriculture market fundamentals remain weak and there is continuous negative sentiment among agriculture investors that can create uncertainty in the near term. According to the U.S. Department of Agriculture (USDA), net U.S. farm income is expected to drop 8.7% to $62.3 billion in 2017. This would also mark the fourth straight year of decline. The USDA outlook reflects a slump in prices of most crops. Prices of major crops (such as corn and soybeans) remain at their multi-year lows.

The prevailing softness in agricultural commodity pricing is a concern for fertilizer and agricultural chemicals companies as it is hindering fertilizer use by farmers given the adverse effect of lower crop pricing on growers’ income. Lower farm income has a negative influence on growers’ nutrient purchasing decisions. Given the bleak forecast for farm income, growers are expected to remain cautious while making crop input decisions in 2017. Insipid economic growth in certain key markets including Latin America is also affecting demand for nutrients.

Sluggish Demand in Energy Sector

A low crude oil price environment, with prices consistently remaining at sub-$50 a barrel levels, is still affecting demand for chemicals in this important end-use market. Depressed crude oil prices have also kept chemical prices under check as they essentially move in tandem with oil prices.

Moreover, the recent weakness in crude oil prices has renewed concerns over the sustainability of the cost advantage of the U.S. chemical producers over their global counterparts who use oil-based feedstock such as naptha.

Oil prices crashed to a ten-month low of $42 a barrel in late June 2017 in the face of a surging U.S. oil output, officially entering into bear market territory. Notwithstanding a recovery since then, oil prices are persistently trading below the important psychological level of $50 a barrel amid a relentlessly oversupplied market, exacerbated by a ramp up in U.S. shale drilling activities and production.

Sustained increase in U.S. shale output continues to counteract the efforts of the Saudi-led OPEC cartel to drain the glut in the market and drive up prices through production cuts. As such, a still-weak energy sector continues to pose a headwind for the chemical industry.

Pricing, FX Headwinds

Commodity pricing remain a concern for many U.S. chemical producers. Their ability to pass these costs on to end consumers is not always easy, given the competitive pressures in play. A number of chemical companies (including Dow Chemical, PPG Industries, Celanese and Eastman Chemical) are witnessing a spike in raw material prices as seen in the first quarter. As a result, margins of these producers may be under pressure moving ahead amid an inflationary environment.

In addition, chemical companies generate a major chunk of their revenues outside the U.S. and therefore are exposed to foreign exchange fluctuations. A strong U.S. dollar created a significant headwind for these companies in the March quarter and is expected to continue to be a drag on profits in the near term.

Stocks to Get Rid of Now

As you can see, there are certain reasons to be cautious about the chemical industry. As such, it would also be a prudent choice to get rid of certain companies in the space that show weak fundamentals and carry an unfavorable Zacks Rank.

We suggest staying away from stocks such as FMC Corp. (FMC), PPG Industries, Inc. (PPG), Huntsman Corp. (HUN), Methanex Corp. (MEOH), PolyOne Corp. (POL), Ferro Corp. (FOE) and H.B. Fuller Company (FUL), all carrying a Zacks Rank #4 (Sell).

(Check out our latest Chemical Industry Outlook for a more detailed discussion on the fundamental trends.)

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