The Mood of the Chemical Industry – Its Déjà vu, Almost
Every year the global petrochemical industry gathers in Houston for the (now) IHS World Petrochemical Conference, an event that I first attended in 1988, regularly through 1996 as a partner in then-hosts CMAI, and occasionally thereafter. This year was an interesting event, less so from a presentation content perspective and more so from a sentiment perspective:
- A host of ever more positive adjectives were used to highlight the opportunity presented to the petrochemical industry (mostly the US industry) by the shale gas and oil developments in the US.
- Projections of possible capacity additions and capital spending were high and getting higher by the day.
- There is a sense of optimism and almost euphoria that is in my mind both similar to and different from the last conferences I attended that had the same positive degree of anticipation – 1989 and 1990. And here is where we can learn some lessons…
The mood in 1989 and 1990 was different in that it was almost reckless. At that time everyone in the business, everywhere in the world was making more money than they ever thought possible. I would guess that every night time establishment in Houston saw record revenues in March of 1989 and March of 1990! Then it was all about everyone spending money to add capacity to exploit shortage and the very optimistic forecasts of demand growth.
Today it is different – in that not everyone is making money. The very high attendance at the conference and the very international mix of attendees, suggests that there are two questions that people are trying to answer:
How do I get a piece of the action?
How do I defend against it?
If US shale gas and NGLs are exploited to the full, existing high cost producers in Asia, Europe and Latin America look pretty precarious unless they can find a way to put up barriers or make themselves more competitive.
Many companies made a lot of mistakes in the 1988-1992 period – they spent too much and overestimated both demand and their fair share of that demand. Industry profitability took a major hit for several years: some companies emerged stronger; some did not emerge at all. Note that in the chart below, margins fell from a high in 1989 to a low within 4 years that was below the levels seen in the early 1980s – a period of near despair for the chemical industry. Dow Chemical and DuPont are the only companies that we have good history for during this period. DOW had net income of $2.5bn in 1989 (a 14% net income margin), and lost $0.5bn in 1992 (but had an after tax charge of around $1bn in that year). DD also took a huge write down in 1992, but on a like for like basis saw net income fall from $2.4bn in 1989 to less than $1.0bn in 1992. (DD had Conoco in that period which added to earnings in both years, more in 1992 than in 1989).
As companies react to the current opportunity, some are going to make mistakes, but in essence they will be the same mistakes that were made last time around. The disaster stories in the early 90s were companies who moved outside their comfort zones in order to try and take advantage of what they thought was a long-term gain.
Things you should not do:
- Assume that the oil/natural gas differential we see today will last. It will not: these dislocations ALWAYS correct and we can never see the mechanism that causes them to correct while we are in the middle of them. Can we get 4-5 years, possibly; more than that and you are looking at very long odds.
- Stray into regions or businesses that do not fit with your core competence, longer-term goals and competitive advantage. If you are not in these businesses/regions today, there is likely good reason for it. Those reasons do not change because of the current feedstock situation. Someone else is better placed to do that.
- Strain you balance sheet. Mistakes that were made in prior cycles included both taking on too much debt and concentrating refinancing obligations into a too narrow timeframe. When the market has turned against you it may be possible to refinance 20% of your debt in any given year, but not 50%.
- Assume that the apparent disadvantaged regions/companies are simply going to roll over and admit defeat – read the Total Chemicals presentation and look at the “coal to chemicals” plans in China.
- Build anything that is not cost competitive on a normalized feedstock slate.
- Allow yourself to be dragged off-piste by any “really good idea” particularly if the person with the good idea is not taking any risk – just a fee from you.
- Note that Dow Chemical did not do anything “off-piste” in basic chemicals in the 1988 to 1992 period; they invested, but they did so where they had competitive strengths and economies of scale. Moreover they did not put excessive strain on the balance sheet. Despite this, the decline in profitability in the industry had a severe impact. Dow’s stock fell from a current equivalent of $24 per share in December of 1989 to $13 per share by September of 1990. DD’s stock price fell by around 20% over the same period.
We will be writing more quantitative research about the various aspects outlined above over the next few month to follow on from what we have already done.