How Sustainable Is Demand in the European Chemical Sector?
We refreshed our industry supply and demand estimates to incorporate a grey-sky scenario and assess potential earnings downside. Additionally, we compared current performance with midcycle and bottom-quartile history.
At the sector level there are a few issues from a supply/demand perspective affecting global chemicals:
Firstly, product profitability spreads and demand are currently significantly above midcycle for most industry players, with initial signs of roll-off now visible across some end markets, implying risk to the downside. A chemicals cycle from peak to trough has also historically been 2-3 years, implying this trend is in line with history (prior trough Q2 2020).
Secondly, inventory levels are at 10-year highs and we estimate ~mid-single-digit above midcycle on a volume basis (implying companies now have more ability to destock than through the pandemic if we do see any abatement in inflation). We also remain sceptical on the quality of order books; despite companies noting demand as robust, we believe customers are more likely to double order in order to secure material given current global supply chain/logistics issues.
Thirdly, from a supply perspective, plant outages in the market are running at ~double historical averages, implying an incremental 2% capacity could return to market even before the impact of organic capacity additions (we estimate 3%). Combining these supply and demand impacts could therefore result in a grey sky scenario where utilisation rates fall by ~mid-single-digit (to trough levels, not seen since the peaks of the pandemic). We estimate every 100-bps decline in global utilisation rates affects gross margins by 100-400bps (dependent upon each company’s capital intensity). The impact of the fall in utilisation rates could therefore result in double-digit earnings downgrades across the sector.
Despite these issues we still believe there are some reasons to be positive and take a "glass half full" approach. Firstly, for the most part, full-year 2022 earnings recent guidance appears conservative. Companies that have given guidance have achieved 36% of this in Q1 2022 (on average) vs. 27% historically for Q1 (implying a downside to historic implied earnings for the balance of the year). Secondly, balance sheets are also healthier than in past cycles. Average leverage across the sector is ~1.2x Net Debt/EBITDA, lower than pre-pandemic (1.8x) and pre 2008/2009 (1.7x). These stronger balance sheets should result in a lower probability of capex/dividend cuts vs. historical cycles.
By subsector, for the industrial gases the outlook into 2H is more optimistic given the long-term nature of their business models (10+ years take or pay contracts). Similarly for the consumer and nutrition exposed names, the defensiveness of the end markets should support earnings. For this reason investors have historically preferred these names in periods of downturn. Conversely, in the commodity/conglomerate names the cyclicality of end markets and lack of earnings visibility into the second half poses far more risk. We also believe pricing power will only truly be tested as demand rolls off. Despite some of the conglomerate names containing "specialty" businesses, we believe investors are taking a "wait and see" approach before giving credit for this when faced with earnings risk into the second half.