Take a Lesson from Past Economic and Chemical Downcycles and Prepare to Weather The Storm

What you need to know about this down cycle and previous downturns to chart a course for success

THE CHEMICAL industry is immersed in the depths of an industry capital cycle event that hit us like a tsunami. However, unlike a tsunami, which builds suddenly as it embraces landfall and then ends almost as suddenly as it appeared, this cycle is likely to be of prolonged duration and impact.

The current industry cycle promises to be extreme from both the supply-side and demand-side perspectives, and it features something unique: a significant economic event that is directly in sync with the traditional industry supply-side capital cycle.

DEMAND SIDE: STRONG HEADWIND
While the recent global economic environment has been robust - the US has averaged 3% annual growth since 1970 - there has been a consistent pattern of short-term fluctuations that produced the all-too-familiar, and painful, boom-and-bust cycles.

The chain of events that led to our current bust cycle stretches back to at least 2000. It was driven, in large part, by unprecedented liquidity - low real interest rates, financial securitization, and reduced consumer lending regulation. 

Currently, home prices are declining, credit is tightening, production and demand are falling, and layoffs are widespread. This whipsaw effect made itself known in November 2008 as liquidity "choked" demand.

Chemical industry prices fell precipitously as downstream end-users sat on the sidelines, destocking while commodity prices (including oil and hydrocarbon feedstocks and derivatives) dropped precipitously, presenting low or negative cash margins for producers.

To date, the overall depth of the current economic event mirrors the US recession of 1980-1982 where equities declined by about 50%, consumer confidence declined to about 54 (verus a long-term average of 87), and the steepest quarterly GDP decline was 6%.

However, there are some critical differences. In 1980-1982, we had high inflation (10-15%) and relatively low debt. Now, we have the opposite - low inflation (0-4%) and extraordinarily high debt (government + household is 175% of GDP), and a liquidity crunch that may be more similar to the economic events of the 1930s.

SUPPLY SIDE: NAVIGATING SHOALS
On the supply side, petrochemical capacity growth in the Middle East and Asia has been moving at a fast pace for almost three decades. Over the past decade, investment has accelerated. Growth has been based, in large part, on fundamentally advantaged feedstocks. Pursuing regional economic development goals, future investments in the Middle East and Asia will include a broader range of petrochemicals and derivatives, thereby raising the region's overall level of importance as a global supplier.

Over the period 2000-2012, companies in the Middle East and Asia will contribute 85% of all growth in ethylene and derivatives, and the rest of the world will contribute only 15%.

This represents a considerable and unprecedented investment in capacity - both in absolute terms and from the perspective of a footprint shift. North America and Europe have scaled back investment in their home markets because they foresee a diminished competitive position and buildup of capacity in the Middle East and Asia.

SYNCHRONY: WHEN WIND MEETS SEA
The synchronous effect of a deep economic and financial event occurring at the same time as a wave of capacity additions is somewhat unprecedented. The chart below provides a retrospective view of prior industry cycles.



The gray shading indicates a recessionary event, and the blue line provides a proxy for chemical industry profitability illustrating the "shape" (U,V, L), parameters and duration of historic industry cycle events.

Over the next four years, new ethylene capacity totaling 20% of total installed capacity is slated to come on stream.

Because most of this capacity is based upon fundamentally advantaged ethane feedstock in a moderate to rising crude environment, we will see the majority of these facilities coming on stream. Given the challenging demand environment, we expect extreme levels of surplus capacity prompting near-term industry restructuring focused predominantly on nonintegrated (as it refers to refinery integration) plants cracking heavy feedstocks. Most of the restructuring will occur in North America, Europe and higher-cost Asian sites.

The impact to date on the sector has been considerable:
Average company share price decline of 45% 
Mean bond rating of BBB- 
Significant percentage of the company population in violation of debt covenants or filing for bankruptcy protection

 

WHEN CAN WE EXPECT CALMER SEAS?
While the duration, magnitude, and breadth of the economic downturn are still unclear, it is generally acknowledged that the economy will recover once functioning asset and credit markets are restored.

But something else is going on too. There is a growing sense that we could be witnessing a big shift in how we - as individuals and as nations - think about economic matters. Some, like Jeff Immelt, CEO of US-based conglomerate General Electric, have called it a "reset."

At a macroeconomic level, this includes a recalibration of our views on the role of government and regulation, the benefits and extent of globalization, mobility of goods, services, and factors of production like labor and capital.

At the individual level, consumers are resetting their attitudes toward consumption and saving. 

On the positive side, history suggests we should be within a couple quarters of the end of the downswing. Equity markets typically begin recovering three to six months before the real economy. So far, US equities appear to have hit bottom in mid-March.

Severe recessions typically last six to seven quarters. The current recession began in December 2007. Tentative signs of recovery are visible - commodity prices (oil, copper) are rising, and financial firms are beginning to report profitable months or quarters.

We will likely see economic recovery two years out with a question mark around the level of normalized demand growth moving forward. 

We believe that industry restructuring is likely to take a phased approach:
Considerable restructuring of high-cost assets and focus on distressed companies. Likely fire sales, "secured debt" transactions, and asset closures occurring in 2009. 
Well funded strategic players and selected financial players driving portfolio restructuring - focus on high value properties and deep value over the next 18 months. 
Broader and "normalized" level of deal activity accompanying an ease in liquidity - broader mix of financial and strategic players. Likely period of portfolio optimization but probably two or more years out.

 
CHARTING A COURSE FOR SUCCESS
The key question is: What course should you plot to position your company for success? We believe there are several key actions that companies can take to position themselves.

Position yourself for growth through mergers and acquisitions (M&A). In the months ahead, there will be many opportunities to buy weaker competitors at attractive valuation levels. There will also be limited competition from financial buyers whose ability to lever-up made these properties expensive in the past.

Companies with strong balance sheets will be able to grow during the crisis through M&A. Financial players may present alternatives to debt that, given the current valuation levels, may present adequate value for strategic and financial partnerships.

Rethink your financing options. Access to financing from traditional sources will likely be curtailed and more expensive as these players tighten lending standards.

Nontraditional sources, e.g., private equity, might become attractive financing alternatives under more creative terms. Financial buyers will likely profit from distressed debt, and access equity through discounted debt.

Vary your cost structure. As uncertainty and demand variation occur, firms with the ability to rapidly ramp up and down supply chain volumes will excel. The more variable your cost structure, the better your ability to deal with volume fluctuations.

Also, there is an opportunity to reduce capital costs by "capturing the deflation" in key supplies and major project components.

Companies that embrace these actions and seize opportunities in today's tumultuous environment will likely be best positioned as the storm subsides.

quoted from: www.ICIS.com