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FT REPORT – CHEMICAL INDUSTRY: A downturn looms larger

By Salamander Davoudi, Financial Times
Published: Sep 18, 2007

Volatility in the financial markets and a growing credit crunch are fuelling fears that the next chemical industry downturn could come sooner than expected.

“This is exercising a lot of people’s minds. The problem may be relatively confined but people are nervous,” says one banker to the industry.

The plain truth is that across the industry people are looking at demand, capacity and the wider global economic outlook and scratching their heads.

“It’s a tough call. Some people genuinely believe we are in a super-cycle because of growth in India and China,” says Peter Cartwright, analyst at Evolution Securities.

But Deutsche Bank thinks the downturn could start next year. “We forecast the commodity cycle to transition through 2008 into a clear downturn by 2009,” the bank said in a report in February.

In recent years the global industry has been underpinned by voracious demand from the fast-growing economies of China and India. (The two most important sectors for the chemical industry are transport and construction.)

Many of the beneficiaries of this spike in demand have been chemical producers in the Middle East that are able to leverage their own natural resources.

“At the moment a lot of the supply, as well as uncertainty, lies in the Middle East. Plants are being built but there is great uncertainty as to when they will come online,” says Ben van Beurden, executive vice- president at Shell Chemicals.

“Demand growth sits in China. Understanding the dynamics of the cycle means understanding these two regions,” he adds.

There has been a construction boom, particularly in ethylene capacity, with plants planned in Saudi Arabia, Kuwait, Iran, Qatar and China.

The capacity additions being built are very large compared with the existing supply base.

“The faster the investment, the faster the emerging world sucks it up,” says Mr Cartwright.

Global petrochemical supply, analysts say, is set to continue to migrate away from both Europe and North America towards regions with low gas costs and areas of high demand such as China and India.

Ten years ago total global chemical sales were $1,500bn – China accounted for 6 per cent, Japan for 14 per cent and the rest of Asia for 12 per cent. North America and Europe dominated with 54 per cent.

Projections suggest that by 2010 global sales will reach $2,400bn and China will account for almost 12 per cent.

“Our growth strategy is that we are moving from the traditional heartland in Europe and North America to the east,” says Mr van Beurden.

“We build in the region closer to demand – integrating with our refineries, which gives us logistical and feedstock advantages.”

According to Deutsche Bank this trend will continue to erode the growth rate of the domestic US chemicals industry (as a multiple of GDP) and ensure that the country moves from being a net exporter of ethylene equivalents to being a net importer by 2009.

When the cycle does turn down, the extent to which chemical businesses are hit depends on their position in the chain.

“If you are a producer of bulk chemicals a major slowdown in demand will impact your ability to sustain margins,” says John Dawson, spokesman for ICI.

“However for speciality chemical companies closer to consumers, particularly those who have differentiation and pricing power, a slowdown in demand is unlikely to impact margins to such a great extent.

“You may see a drop-off in volumes, but these companies should have the ability to improve their margins overall. Profits are unlikely to be impacted dramatically.”

One way to defend against a slowdown is to follow the mergers and acquisitions path. Over the past five years chemicals companies have, by and large, done deals to increase their size or move into more defensive areas.

An example of the former includes the £8.2bn takeover of BOC by Linde. Bayer’s €17bn acquisition of Schering, which gave it more exposure to the less cyclical pharmaceutical and healthcare industry, is an example of the latter.

Recent valuations have been varied and some deals have reached and even exceeded the peak levels of 13.9 times underlying earnings seen in 1999.

“Chemical companies have been taking advantage of the current economic environment to make major changes in their portfolios or ownership structures,” says Saverio Fato, global chemicals leader at PwC, the professional services firm..

“However, the full impact of recent changes in the debt markets used to finance many deals has not yet been fully understood,” he adds.

“Also, as a result of some private equity firms making major investments in the mega-deal category, we expect to see additional mega-transactions as these firms look to exit these investments.

“The structure, valuation and timing of these exits may, however, be affected by the severity and duration of the recent shifts in the financing markets.”

According to PwC, chemical M&A activity, by deal value, in the first half of 2007 outpaced the first six months of 2006. In 2006 the largest number of deals took place in North America but so far this year the deals in western Europe have had the greatest value.

The speciality chemicals segment has driven most of the activity so far this year, increasing from $28bn in 2006 to more than $40bn in the first half of 2007, according to PwC.

Based on recently announced deals, however, it is expected that the commodity chemicals sector will show a significant increase in M&A activity.

“Merger and acquisition activity in the market will now depend on funding into the private equity market. There are still a lot of highly cash-generative large chemical businesses,” says Mr Dawson.

“To the extent that there could be further consolidation in the industry, it’s still a possibility – especially for those who want to broaden their portfolio into speciality areas. They may actually find this a more advantageous period in terms of pricing if private equity is less able to fund some of its current trend in acquisitions.”

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