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Chemical Industry's 2010 Outlook Mixed

Recovering demand will likely be overshadowed by new capacity coming on line.

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Chemical producers have had a wild ride in 2009. The year started off with companies facing abysmal demand and sorry prospects for profitability. However, meaningful cost-cutting, inexpensive North American natural gas, and relatively strong demand in emerging markets--particularly in Asia--have improved the picture during the course of the year. Going forward, improved cost structures should help to improve profitability, but companies will still need to deal with relatively weak near-term demand in developed countries and a wave of new supply coming on line in the Eastern Hemisphere.

Chemical makers' significant cost reductions have lowered break-even sales levels. In response to weak demand for chemicals in late 2008 and through 2009, many producers got busy mothballing and closing plants and laying off and temporarily furloughing employees. During the third quarter, chemical firms began to see the benefits of these cost-cutting measures.  BASF (BASFY),  Dow Chemical (DOW), and  PPG Industries (PPG) all saw meaningful sequential improvements in operating income. Structurally lower costs will be an important earnings driver going forward given that demand is still relatively weak--while emerging market demand has certainly been strong, developed market demand seems to be merely stabilizing at depressed levels.

North American petrochemical manufacturers' profits have been given a boost by weak natural gas prices. Although oil prices have improved since the beginning of 2009, North American natural gas prices have remained weak as a result of new supplies and moderate weather. This has placed North American petrochemical manufacturers using gas feedstock at a significant advantage to local and global competitors using relatively higher-cost naphtha feedstock (a byproduct of crude oil refining). The wider spread between oil and gas prices bucks the historically tighter relationship, and a narrowing of the spread could erase these producers' advantage. The relationship between oil and gas prices will depend in part on North American winter weather and natural gas drilling activity as well as global supply and demand for oil (among other factors). Clearly, these factors are outside of chemical producers' control, and the presently benign cost environment could prove fleeting.

Recovering demand for chemicals will likely be overshadowed by new capacity coming on line in the Middle East and China. It's no secret that we should expect a massive wave of new petrochemical capacity in the Middle East and China to come on line during the course of the next few years. What remains uncertain is the exact timing of this onslaught and, more importantly, the magnitude of the impact it will have on North American and European chemical producers' profitability. The supply coming on line in the Middle East in particular is taking advantage of an abundance of relatively cheap feedstock, potentially placing incumbent producers at a significant cost disadvantage.

Chemicals players will likely continue to right size commodity chemical assets in mature markets, seek access to low-cost feedstock in areas such as the Middle East, and look for exposure to above-average demand growth in Asia. In response to the wave of new capacity coming on line, we expect chemical firms to continue restructuring assets in North America and Europe. Meanwhile, firms will look to partner with resource-holders in the Middle East to gain access to low-cost feedstock. Finally, exposure to more rapidly growing markets--particularly in Asia--remains an important aspect of producers' near- and long-term growth prospects, especially in light of a demand picture that is still relatively weak within developed markets.

Elizabeth Collins does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.