As we have been suggesting for some time, there are pockets of real strength in chemicals; identifying them is the hard part. It is not enough to have pricing strength in a market where raw material prices are volatile daily and we have seen plenty of examples of companies with very strong end demand dynamics missing earnings because of a cost squeeze. We continue to highlight the competitive strength in the US in basic chemicals because of the decoupled and relatively low natural gas price and this is likely a large piece of the Dow earnings strength – strong polyethylene demand against a backdrop of relatively stable and lower costs. While polypropylene (Braskem) remains extremely profitable in the US, it has seen more sequential weakness than polyethylene – as we show in Exhibit 1 of today's daily report. That said, both polyethylene and polypropylene margins in the US are significantly higher than was likely expected this year and certainly what has been reflected in stock valuations, even with the commodity chemicals rally. Dow is also seeing the benefit of a very strong silicones market – something that was covered in detail in Wacker’s release earlier this month.
More confirmation from Covestro that global demand growth is strong, supporting reports that we have seen from most companies over the last few weeks. Some have struggled with raw material cost squeezes and either late attempts to raise prices or pricing lags in contract agreements, but almost all have pointed to very strong demand outside of auto OEM. We have questioned how much of this strong demand is inflation-driven, but it is very hard to tell as the last time we had significant inflation we did not have such an interwoven global supply chain as we have today, and consequently, it is harder to assess how much pre-buying may be going on, not because of fear of higher prices but because of fear of supply. Note that we have at least two European automakers (VW and Renault) shutting down facilities this week because they cannot key parts from Ukraine. This adds to the already problematic path for parts from China as well as the semiconductor shortage. If everyone is looking for a little bit more it would explain the very high 1Q 2022 demand that all are talking about and it likely means that inflationary pressures will continue as chemical and polymer makers try to make more, against a backdrop of higher raw materials and find it easier to increase their prices because their customers are as concerned about availability as they are prices.
Part of our confidence/concern that prices can continue to rise in the chemical space in general stems from what seems to be very strong demand – again confirmed in earnings reports overnight, as well as in the rail data from today's daily report, as well as inventory data that suggest we are below recent ratios to shipment trends. The inventory piece is the great unknown here because the supply chain shocks of the last 20 months will have reset expectations around “safe” levels of inventory and it is hard to judge whether the new “comfort” normal will be back to the trend in the chart or 50% higher! If the new comfort level is materially higher than in the past, demand growth will remain strong and price momentum could continue through 2022. Our expectations for a mega-cycle in basic chemicals and polymers – targeting late 2023 and 2024 could be dragged forward because of higher apparent demand the time to buy the equities could be now, on that basis.
In a recent report, we discussed the relative demand strength in the US, as well as the high costs of importing chemicals and polymers into the US and suggested that higher energy and feedstock costs could arrest price declines in the US at levels that still drive significant profitability for US producers. With that in mind, it is interesting to note the upward move in propylene spot prices in reaction to higher propane prices and the resulting flat settlement in propylene contract prices.
We are seeing pockets of real demand strength in some areas of chemicals, such as building products, and this is allowing producers to push through price increases to reflect higher costs and most likely add some margin. In other areas where the fundamentals might not be quite as supportive, we are still seeing attempts to pass on higher costs. Sika has supported what we have heard from many over the last few weeks, which is that the building products chain remains tight, as demand is strong, capacity is running hard and logistic issues continue to cause problems in some cases from a raw materials perspective and in others from getting finished products to market. Where there is limited ability to increase supply, those selling into the building products space are likely to make more money as they should have strong pricing power – in the US chemical space, we would favor Westlake as a potential big winner from this trend, but Huntsman should also be on the list.