Chemicals and Market Impact

We see BASF taking a major risk by reaffirming its 2022 outlook today, as the uncertainty factors, especially in Europe, are rising. This week’s inflation and economic growth data in Europe, suggest an economy that is lowing quickly and the confidence levels in Europe are much lower, as we have discussed already this week. BASF and others will likely continue to push prices, but if consumer spending continues to slow, volumes will disappoint and at some point, there will be pushback on both volumes and pricing. Separately, as we mentioned above, we could see another leg up in energy prices as we approach next winter in Europe, especially if there is no resolution to the Ukraine conflict, which seems likely.

While we remain advocates of “stronger for longer” with respect to chemical demand and pricing in the US, the auto data does suggest that the US consumer may be cooling off a bit in reaction to higher prices and higher borrowing rates. Historically, the chemical industry has a habit of running headlong into a downturn while waving an “everything is great” flag, and the RPM results and outlook have a vague “deja vu” feel to them. We also note some surprise at the robustness of the MDI market in the chart below, and it would be wrong not to admit that our cautionary antennas are rising. The auto exposed products should still see some upside from higher auto production in the second half of the year, but otherwise, a possible consumer pullback to take the wind out of the sector sales, especially if the US is constrained moving out products because of container and shipping issues. The significant cost advantage remains in the US but the ethylene market over the last week is a reminder of what can happen when you struggle to find someone who can take the last pound. Given infrastructure, energy, and clean energy investment, as well as reshoring, many materials could see significant offsets to consumer spending pullbacks and our focus would remain on PVC and building products, as most of the hit would be in consumer durables. Metals demand should remain strong regardless. For more see today's daily report.

Following on from the core theme of today's daily report, demand could provide the lifeline that the US chemical industry needs to get through what looks like a potentially oversupplied 2022 – note the successful start-up of the ExxonMobil/SABIC facility in Texas, announced today. While we still think that the US market will be looser in 2022 than in 2021, barring any above-trend weather events, strong demand growth could offer some pricing protection for the industry – especially given the input inflationary pressures that we are seeing. If the customer base is looking for increases in deliveries, which we expect to be the case in 2022, it will be easier to defend pricing and gain pricing where costs are higher. Some of the momentum that we are seeing in the commodity stocks year to date is a function of a broader inflation trade, but some is likely in anticipation that 2022 will not be as bad as had been expected and on that basis, the sector looks particularly inexpensive – even today after the early year rally. It will be a little harder for the specialty and intermediate companies depending on how long they have to play a lagging catch-up game with costs. But if, and when, costs peak, they should see margin expansion as costs fall and will be able to keep some of the gains, especially if their demand is also growing.

The ACC forecasts below leave us a little confused as the implication for specialty chemicals is that production declines in the US by an average of 2.0% per annum from 2019 to 2023. Given the demand that we are seeing for US manufacturing, as covered in our most recent Sunday Report, we would expect demand for all inputs to rise and it is unlikely that the gap would be filled by a swing in net imports. The lower demand from the Auto industry in 2020 and 2021 and broader manufacturing shutdowns in 2020 explains the 2020 and 2021 numbers to a degree, but it is not clear why there would not be a rebound as auto rates increase. We would also expect to see a stronger rebound in polymer production in 2022, assuming weather events are less impactful than in 2021, given substantial new capacity for polyethylene from ExxonMobil/SABIC, BayStar, and Shell.

While we will talk more about the Dow project in Alberta on Sunday, one of the problems that the stock faces in the light of the announcement is largely unrelated, which is the growing expectation that margins in 2022 will be significantly lower than in 2021. This is the view coming out of the recent EPCA meeting and as the ethylene/propylene chart below shows, monomer pricing is already weakening in the US as production ramps back up following the recent storms – we note in Exhibit 1 from today's daily report the squeeze on ethylene margins as prices fall, while costs rise. But it is also worth noting that margins remain quite healthy, while well below their highs. Those companies who built new ethylene capacity in the US over the last 5 years would have had a margin similar to the current level shown in Exhibit 1 in an optimistic capital case.

The Air Liquide announcement linked is consistent with the widely held view that semiconductor markets desperately need new capacity and shows that existing China-based manufacturers are stepping up. Air Liquide will supply new capacity in Wuhan, where it has been an active producer of high purity gases for the semiconductor industry for decades. While this is likely a sound investment for Air Liquide, backed by strong “take or pay” agreements from customers, the risk to the expansion is that while the world is in dire need of new semiconductor capacity, it is unclear how much of that need is for more China-based production. There is significant semiconductor demand in China and that demand will continue to grow, but consumers in the West are not only looking for more semiconductor supply but also more semiconductor supply security, and with the concentration of production in China and Taiwan, supply from outside the region is more desirable. We see new semiconductor capacity announced for the US and the auto industry, in particular, is calling for more diversity of supply, not just for semi’s but also for other EV components, especially batteries. There is already anecdotal evidence of a preference for non-China-based materials – all the way back to lithium - but how much more US and European producers are willing to pay for this “preference” will dictate the ultimate level of spending.   Despite these concerns and absent broader geopolitical risk, this is likely a relatively safe project for Air Liquide and the capital commitment is not going to break the bank.

The weakness in polymer pricing in Asia and the drag that auto sales had on US consumer spending in May (spending was up ex-autos) should begin to undermine the very strong polypropylene market in the US, and the fall may happen at a reasonable clip. Polypropylene is more fungible than polyethylene, in that much more of the customization of polypropylene comes post-production rather than during production. There are several unique polyethylene technologies, especially for linear-low where the process drives the properties and adds value. For polypropylene, while there is some of this, most product is compounded and consequently, there is more fungibility before compounding and less risk from experimenting with suppliers. If freight rates were not so high as discussed in today's daily, we believe that we would have seen a notable amount of polypropylene moving from Asia to the US by now.